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Can Hedge Funds Survive the Ailing Credit Market's Devastating Aftermath? (August 7, 2007)

Location: New York
Author: Lenny Broytman
Date: Tuesday, August 7, 2007

It's only August but it's fair to say that the financial community has already experienced a year's worth of headlines. With the subprime meltdown within the housing sector and the Bear Stearns debacle taken into account, many experts are starting to ponder what the true ramifications of the credit market's sharp downward slope will be in the near as well as the distant future.

According to an article which ran on, Grantham, May, Van Otterloo & Co. chairman Jeremy Grantham believes that one of those ramifications will be felt by the hedge fund industry. In his eyes, the sector doesn't stand a chance; he says that within just five years, half of all hedge funds will cease to exist as a direct result of the credit market in the US.

In an interview with Bloomberg News, Grantham stated that "Probably the most stretched silly credit that ever walked the face of the earth was subprime, and that was the start of it. And then you started to see more of the fixed-income market getting contagion."

He added that hedge funds are guilty of "piling on risk of different kinds and presenting as outperformance," saying that "In a weak world, they pay the price of all the risk they've taken."

It is no secret that the appetite for risk is gone in the US. Grantham estimated that high levels of leverage will lead to heavy losses for investors and will even claim "one or two" private equity firms. He also went on to say that a few "very large" firms would most likely collapse as a result of overwhelming debt.

Even with his own GMO Emerging Markets Fund seeing a 51 percent gain over the course of the past year, Grantham remains pessimistic about the future and insists that most of his predictions will be realized in the near future.

And as it turns out, Grantham is not alone. According to, if the bleak future Grantham paints is ever realized, the effects will be felt across the board. Besides heavy losses suffered by those with their interests embedded within the hedge fund sector, many feel that a drastic interest rate cut will also follow.

Money manage John Hussman writes: "If you look carefully at the CPI figures (and tinker with the monthly numbers), you'll also discover that even if the figures average a 2% annual rate in the months ahead, the year-over-year headline CPI inflation rate will be pushing 4% by November. This is already 'baked in the cake.' Since Bernanke is clearly concerned with the inflation expectations of the public, as well as the Fed's credibility, that headline CPI figure may create some complications for cutting rates in the months ahead, unless resource utilization falls out of bed."

The housing market in the US is the absolute worst it's been in a long time. As John Maudlin sites in the same article, "Existing home sales declined for a fourth straight month, down 3.8% in June, although median prices rose 0.3% and inventories fell to an 8.8-month supply. In the largest drop since January, new home sales declined 6.6% in June, and are off 22.3% from a year earlier. Median prices were down 2.2%. Housing starts rose 2.3% in June although construction permits declined 7.5%. The monthly average of 1.462 million starts in the second quarter was barely above the 1.460 million figure in the first quarter. The National Association of Homebuilders' confidence index dropped to 24 in July--its lowest level since January 1991." (

Mauldin explores the credit crisis with a rather keen eye. "Anything labeled CDO or ABX or CLO lost liquidity. There were no bids," writes Mauldin. "The market was clearly shooting first and asking questions later."

Although he does concede that Grantham is "one of the smartest and most successful investors in the world," he thinks that 50 percent is just too high of a number. He agrees with Grantham that hedge funds are in trouble and that many will in fact flounder but for Mauldin, the subprime meltdown is not the only culprit. For him, the failure of many hedge funds to generate a decent cash flow to be able to survive these types of unexpected industry blows is also to blame.

Citing one key factor that Grantham fails to analyze, Mauldin also adds that although quite a few hedge funds will fail within just a handful of years, the hedge fund industry will be twice as large in five years' time. This, he feels, will help to offset the high number of funds that do shut down and will also prove to be a healthy addition to the US economy.

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