Hedge funds are starting to feel the effects of the credit crunch as getting credit from lenders becomes increasingly difficult. Many investment banks are cutting back on loans to hedge funds by eliminating some clients and raising borrowing fees for others after heavy losses forced them to slim down their balance sheets. This could put pressure on both banks and hedge funds that rely on each other to boost their profits and returns.

Many hedge funds, known as quants, use computerized models designed to spot and take advantage of small pricing inefficiencies in the marketplace. These funds rely on a massive amount of leverage to drive their returns, and trouble borrowing could soak up their profits. Meanwhile, activist hedge funds and private equity funds rely on large amounts of debt and credit in order to finance M&A deals that they have used to bolster their returns during the past few years.

Hedge funds often borrow through a “repo” operation whereby the hedge fund sells securities to banks in exchange for cash, while entering into an agreement to buy them back at a later date when they pay the money back. These rates are skyrocketing, however, as banks are increasingly worried that hedge funds won’t be able to repay the loans. Morgan Stanley, for example, has been asking for one percentage point over LIBOR to enter into a repo agreement using junk bonds as collateral, according to the Wall Street Journal.

Problems in the hedge fund industry could cause problems in the larger markets too. Many public institutions, high net worth individuals and retirement funds have large investments in hedge funds that have traditionally returned healthy profits. Any limits in lending could adversely impact the returns for these hedge funds. Meanwhile, hedge funds that are forced to abandon deals or liquidate large positions may also prove to be a drag on the market. In the end, this is a significant event worth watching!

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