High-Flying Hedge Funds See Dark Days

Sept. 26, 2008 — -- Tough new regulations. A devastating bankruptcy. A growing government investigation.

Welcome to the new world of hedge funds. Once known for their outsized profits, many funds today are reportedly seeing losses that rival or exceed those of other investors caught in today's market turmoil.

But the stock slump aside, some hedge funds have a whole other set of problems: the bankruptcy of former brokerage heavyweight Lehman Brothers, an investigation by the Securities and Exchange Commission and new trading rules that ultimately limit how many funds do business.

Lehman Brothers' bankruptcy, the largest in U.S. history, directly affects a limited number of hedge funds. Still, the funds that are affected face traumatic times. One senior hedge fund manager, who declined to be identified, worried whether his firm would be able to extract the investments it had held with Lehman.

"We find ourselves in the unbelievably frustrating, infuriating position that our assets are stuck and no one will return our calls or return our assets. For a fund like ours it's an untenable position to surmise that our assets are completely frozen and we have no ability to trade them," he said.

"For the past week, we've been asking a simple question: Please tell us the status of our assets. Even more essentially, tell us where our assets are."

Some hedge funds are heading to court on the Lehman issue. Two New York-based funds are contesting Lehman's bankruptcy plan while a London fund filed a lawsuit to recover $50 million held by Lehman, the first in what is expected to be a series of such legal claims.

The SEC Investigates

The downfall of Lehman also plays into another legal headache facing hedge funds: an intensifying probe by the SEC, which is investigating whether hedge fund traders and others manipulated the stock market by spreading false information about various companies, including Lehman; Bear Stearns, which has since been purchased by JP Morgan Chase; and Merrill Lynch, which was recently sold to Bank of America.

Some hedge fund managers say they object to what has appeared to be the targeting of hedge funds.

"Why aren't they taking subpoenas to find out what were the senior executives of Lehman thinking about in their cavalier attitude toward risk?" said Hugh Hendry, the founder and chief investment officer of Eclectica Asset Management in London.

But a person familiar with the situation told ABCNews.com that the SEC is investigating more than just hedge funds. The commission has recently ordered dozens of entities, including investment banks and institutional investors in addition to hedge funds, to turn over information about their trades.

Short-Selling Frustration

Perhaps the most common gripe of hedge fund managers today is the recent crackdown on short-selling. Many hedge funds employ short-selling -- essentially, taking a bet that a stock is going to fail -- as part of their investment strategies.

But earlier this month, regulators in both the United States and the United Kingdom set major limits on short-selling, or shorting. The SEC announced Sept. 19 that it was temporarily banning the short-selling of 799 financial stocks. The day before, officials in the United Kingdom also placed a temporary ban on shorting financial stocks.

The bans came amid concerns that shorting by hedge funds and others was forcing the decline of share prices for vulnerable companies, including Lehman.

It's an argument that evokes ire from hedge fund managers like Eric Hovde, the chief executive officer of Hovde Capital Advisors in Washington, D.C.

"Lehman did not fail because of hedge funds shorting Lehman stock," he said. "That is the most ridiculous comment I've ever heard."

Hovde said that Lehman failed because "the assets on its balance sheet were junk." Its low stock price notwithstanding, another firm would have bought Lehman had the company been in good shape, he said.

"A litany of different financial institutions went in and looked at Lehman Brothers," he said. "If it was solely the stock was down because hedge funds were shorting it, they would have bought the company and said 'Thank you for [letting us be] able to buy this company so cheaply.'"

The new rules are hurting the hedge fund business, critics say, both here and across the pond.

"In the U.K. they used to hunt foxes," said Eclectica's Hendry. "We [hedge funds] are the fox and we are being hunted by gentlemen called the establishment."

Hedge Funds as Scapegoats?

The rules have forced some managers to change investing strategies at a whiplash pace.

Karsten Schroder, the CEO of London-based Amplitude Capital, said that he had about two hours to liquidate a "test portfolio" -- a forerunner to what might have someday become a fully-fledged hedge fund -- worth a couple of million dollars because its strategy included the short-selling of companies on the SEC's banned list.

"It was a very big deal," he said. "The list was published two hours before the market opening."

Schroder said that Amplitude Capital didn't lose any money on the liquidation. He added that the firm's flagship fund, which invests futures, currency and commodities, is performing well.

But Schroder is still frustrated.

"I think hedge funds are used as a scapegoat," he said, "but at the end of the day, they are not the reason that the financial markets have gone into the crisis they're in."

Hovde, meanwhile, said he objected to hedge funds all being painted with the same brush. Different hedge funds, he said, have different styles and different strategies.

"Could there be certain credit hedge funds that were buying a lot of the tail risk of these toxic mortgage securities that helped Wall Street sell off a lot of this junk to pension plans and foundations? Yes, but they're taking huge losses right now along with the investment banking companies," he said.

Excesses by the investment banks and their packaging of "toxic mortgage loans," he said, are "what's cratering the credit market."

"Fundamentally," he said, "hedge funds are not what is the problem."