Hedge Fund Losses May Lead to New Derivatives Meltdown

Hedge funds are getting hammered. And the co-chief executive of Europe’s biggest hedge fund is warning that thousands of hedge funds are on the brink of failure.

This could lead to a derivatives nightmare.

Remember that the economic crisis was bad when home values dropped and the “subprime” loans started being defaulted on, but it really got bad when the collateralized debt obligations (CDOs) – which repackaged those loans – started plummeting in value. (CDOs were highly-leveraged, so a small drop in home prices resulted in large declines in the value of the CDOs; then, as the companies which held huge sums of CDOs started bleeding out, credit default swaps started being heavily bet against them, which drove up their price of doing business, which caused them to fail).

As Nouriel Roubini pointed out on October 15th:

Rating agencies [are] start[ing] to downgrade collateralized fund obligations (C.F.O.) which are the hedge fund equivalent of mortgage-backed securities: securities backed by hedge funds. Some have a 7-year lock-up period. While few in number, C.F.O.’s represent a broad swath of the $2 trillion industry.

CFOs are a “CDO-type vehicle that invests in hedge funds or private equity investments“. Basically, if the value of the hedge fund increases, then the CFOs go up, and if they go down, they go down. Like CDOs, they are highly-leveraged derivatives, so that a small fall in the value of the hedge fund can lead to large losses in the CFO.

Because hedge funds are getting clobbered and many will go out of business, that creates a huge CFO derivatives exposure.

In addition, remember that hedge funds have a lot of derivatives exposure concerning other types as derivatives as well. As Roubini points out:

Hedge funds are among the net sellers of credit protection in the $54 trillion credit derivatives environment and might be called to perform on their obligations wrt Lehman, WaMu, Kaupthing, etc.

Therefore, if hedge funds go belly up, someone else will end up with their derivatives’ liability.

See also this.

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