2008 outlook of hedge funds

There are several things which worry us as 2007 ends. --First, as further losses are taken by funds and other counterparties on subprime assets and derivatives, the possibility of a loss to the sponsoring broker or bank becomes increasingly likely. Again, remember that the relationship between a hedge fund and a dealer, and a SIV and a dealer, are not that different. In both cases, the dealer really owns the assets and the risk. --Second, we remind one and all that among the tricks of the hedge fund trade in recent years was to write credit default protection on everything from corporate default swaps to subprime CDOs. As long as their was no apparent risk, the premium income seemed as free money, just like banks thought that lending was a zero cost activity. But hedge funds are not insurance companies and have neither permanent capital nor reserves, preferring instead to treat premiums on selling derivative put options as regular income. --Third, the failure to perform on a derivative obligation by a hedge fund that causes a loss to a bank could seriously damage what remains of market confidence. Part of the "markdown" process which must occur is valuing the derivative guarantees made on subprime assets or corporate debt when spreads were tight vs. where the spreads are trading today. --Now that defaults on subprime collateral as well as corporate names are starting to rise, hedge funds with commitments to offset these defaults are in a trap. Widened spreads make it uneconomic to sell the obligation to offset defaults, but as calls to perform come in from counterparties, these same funds must begin to consume profits and then that tiny bit of client capital that is available. --Whereas 2007 was the year of imploding structured assets, 2008 could be the year of hedge funds decimated by losses on cash positions as well as unfunded credit default insurance obligations. Then you can "turn out the lights."