Collateral DamageHedge Funds Facing Death By Margin Call?

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Several banks that have provided a large amount of leverage to their hedge funds clients are re-evaluating the value of their collateral, according to sources familiar with the situation. If the banks determine that the assets collateralizing the loans they have made to hedge funds are not as valuable as previously thought, they may reduce the leverage available for hedge fund clients to make investments and force hedge funds to sell assets to provide additional collateral.
The second look at hedge fund collateral has been prompted, in part, by recent events at Bear Stears and this morning’s announcement by BNP Paribas that it could not calculate the value of assets in three hedge funds. This comes amidst spreading fears that collateralized debt obligations held by many hedge funds may be worth far less than their internal models have indicated. Because many CDOs trade thinly, if at all, it can be impossible to determine their market values. Hedge funds and banks have relied instead on financial modeling to value the CDOs.
Hedge funds that have relied on CDOs to collateralize their margin borrowing could face a credit squeeze if lenders downgrade the value they attach to CDOs. With BNP Paribas calling a valuation of the value of their debt holdings impossible, some on Wall Street are arguing that many CDOs should be considered as having zero value for collateral purposes. If banks adopt this position, some hedge funds would face steep margin calls, forcing them to sell these assets. This in turn could result in a deluge of debt products in a thinly traded market, pushing their values even lower.

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