Stock Market Fears Another Hedge Fund Collapse

Fears that another hedge fund could blow up, along with higher unemployment figures and poor retail sales data, are giving stocks their worst showing in two months.

Investors are watching with accelerating alarm as a growing number of hedge funds are treading water. With $1.9 tn under management, hedge funds are big players in the stock market, so any problems in the sector could leave the stock market in an invertebrate state in coming weeks.

Amid talk of the market's decline by the end of this week, chatter on trading desks was that at least one big hedge fund was collapsing.

Are many hedge funds at risk, and will at least the fear of a liquidation cause stocks to fall in the next few weeks?

Where there's smoke lately, there's usually fire.

Remember, it was the collapse of two hedge funds at Bear Stearns in the summer of 2007 that kicked off the credit crisis. The Federal Bureau of Investigation is also investigating potential criminal activity at hedge funds during the subprime and credit crisis.

By the end of the month, we may see another hedge fund shutting its doors. That's because numerous hedge funds give their investors a Sept. 30 deadline to do fiscal year-end withdrawals. Investor jitters are high.

"The problem for stocks in the next two months is that hedge funds, along with other institutions, will be selling stocks that are down for the year to take advantage of the tax benefits they can get from reporting the losses on their tax returns, as many have fiscal years that end either on Sept. 30 or Oct. 31," says Price Headley, founder of BigTrends.com, a stock market research firm. "After the election, we expect institutions to start repurchasing stocks, but September and October should be rough."

Forty-nine hedge funds collapsed in 2007, with $18.8 billion in assets under management, versus 83 hedge funds with $35 bn in assets under management that shut in 2006, according to Absolute Return, a research outfit.

As commodities rose and easy money inflated the housing bubble, money managers piled in, and hedge funds were launched at a record rate over the last few years. Christopher Wallace, a spokesman for Hedge Fund Research, says that "170 funds were liquidated during the first quarter of 2008. If that closure rate were to continue for the rest of the year, approximately 679 hedge funds would shut down."

The first half of the year for the $1.9 tn hedge-fund industry was an excruciating one, as it posted its worst aggregate total return since the sector was first tracked in 1990. Just $33 bn in net new money came into the sector in the first half, versus $119 bn for the same period in 2007.

Hedge funds have been deleveraging at a rapid pace. Many had geared up during the credit and housing bubble, via options, futures, margin and other financial instruments used to create leverage.

Many hedge funds executed their own version of the carry trade where they borrowed cheaply at lower rates and invested long-term hoping for a sweet return, borrowing at 30 to 1, or $30 backed by just $1 in assets--even as much as 50 to 1. Using borrowed money to buy profits is a dangerous game. Just look at the two sinkholes now threatening to suck in the stock market-and taxpayer wallets--Fannie Mae (FNM) and Freddie Mac (FRE).

Whipsawing the market now are rumors that Atticus Capital was liquidating positions and possibly shutting its doors, a rumor its executives heatedly denied. It's estimated Atticus posted losses of between 25% and 32% year-to-date at its two main hedge funds.

Atticus Capital took a big hit in July, coming fast on the heels of Ospraie Management shutting its commodities fund, after bad bets on energy, natural resources and mining plays caused it to lose 38.6% this year. Ospraie Management said it lost about $3 billion of the roughly $7 billion it manages due to failed bets on energy, mining and natural resource stocks.

Ospraie is 20% owned by Lehman Brothers (LEH), though my sources tell me Lehman saw it coming at Ospraie. Nevertheless, Lehman is now under the gun as it's expected to report $4 bn in losses in its third quarter results coming out in a few weeks.

The firm is now racing to get a capital infusion in the form of an equity stake sold to an overseas investor like Korea Development Bank, hoping it can avoid the Federal Reserve park its ambulance in front of its doors. Any equity offering will create massive dilution and cause its shares to slide to $12, from $15 to $16 now.

Hedge funds are caught in a dilemma. After months of hitting the bulls' eye in the bull run in oil and commodities, they are now getting burned as prices of oil and commodities plunged. HFR's Macro (Total) Index, which captures the performance of commodity hedge funds, is up 3.78 % for the year. But as oil prices plunged last month, the index lost 2.63 %, erasing May and June's gains as oil prices reversed.

Rumors are flying that some hedge funds are savaging other hedge funds by making short bets on their rivals' positions, with stocks popular at hedge funds such as Petrohawk Energy (HK), Burlington Northern Santa Fe (BNI) and Alpha Natural Resources (ANR) under attack.

Harbinger Capital Partners, a hedge fund that had invested in steel stocks, lost 16% in July as those stocks plunged amid a sell-off in metals. Its long position in oil quickly soured, according to a Dow Jones report. Harbinger's fund supposedly fared better last month after it cut its positions in commodities and oil, and the fund is still up more than 20% for the year to date. That's half of what it was returning at the end of June, when it was up 43%, according to a Dow Jones report.

David Knott's Dorset Energy Fund is in the red year to date after it lost more than 16% between June and mid-August. That's after the fund was up almost 20% in June. Ken Griffin's biggest fund at Citadel Investments is down 6% this year, its worst performance in 14 years.

Steve Mandel's Lone Pine Capital, Dinakar Singh's TPG-Axon Capital Management, and Tom Steyer's Farralon Capital, have all lost money, too.

Watch out.