Hedge Funds Are Pouring Into Distressed Debt

By: Money_Morning

Greg Madison writes: Regulators have demanded that banks stop engaging in so much risky behavior - chiefly, distressed debt investing. And the banks have begun to curtail this type of investing.

But this has led to an unprecedented - though not unpredictable - situation: It seems the hedge funds are picking up the slack.

The distressed debt that banks are leaving behind is getting bought up, in a big way, by credit hedge funds. Fully $108 billion worth of distressed debt investments is being picked up by these groups.

Hedge funds are not as big as the large banks, with assets running "only" into the mid-hundreds of billions. But the more moves they make, the bigger they become.

Hedge funds, money-market funds and REITs - engines of shadow-banking - have exploded recently, in terms of capital and headcount. And top talent - for top dollar - has been leaving companies like Deutsche Bank AG (NYSE: DB) and Barclays Plc (NYSE: BCS) for the greener, riskier pastures of BlueCrest Capital Management and Pine River Capital Management.

Hedge funds are less regulated than banks, because they cater to a savvier investor with different goals than someone who has a run-of-the-mill checking, savings or retirement account. Grandma is not opening up a Christmas Club account for you with the likes of Carl Icahn - yet.

This freer atmosphere makes hedge funds the natural place to turn once you begin to rule out banks. They've become "shadow banks," and they've been getting into some pretty interesting areas.

Their investment in bankruptcy claims and distressed debt is of particular note.

Why Hedge Funds Like Distressed Debt Investing

Distressed debtors are companies that have already defaulted on debt. If a run-of-the-mill gigantic bank wanted to dabble some of its trillions in assets in it, regulations dictate that they would have to beef up their reserves to offset the risk.

Not so with hedge funds. They can take advantage of the riskier opportunities that the newly hobbled banks have to pass up.

Deutsche Bank CFO Stefan Krause lamented this at a Berlin conference, saying, "There are businesses based on our capital regulation we'll not be able to do that hedge funds will be able to do."

Krause is not alone. Many large banks have scaled back some of their riskier, more capital-intensive operations, leaving what's left to the hedge funds.

And there is a lot of business to be done, with hedge funds and capital management firms beginning to resemble, at least on the surface, investment banks. Some of these firms have been able to recreate, with their poached personnel, the exact same trading teams as existed before the banks had to exit the business.

If this sounds like madness to you, there's a method to it.

When regulators force banks to give up these riskier behaviors, they're essentially transferring the risk onto these capital management firms. It's a lot easier for The System to absorb a capital management firm's going under that it would be if, say, Bank of America Corp. (NYSE: BAC) went belly-up.

We've seen what it looks like when the global banking system collapses under the weight of toxic debt.

But if a hedge fund were to go under?

We'd be treated to the sight of a hedge fund bandit fighting his way through hordes of incensed millionaires, all the way to Teterboro Airport in New Jersey and a Learjet bound for Tahiti.

Then there's the intangible, the question of character. We have seen what happens when greed overtakes all sanity at large banks. We've been there before, and we're lucky to have come out the other side.

A hedge fund manager is a horse of a different color. He's made a living on greed and elevated it to an art form. That hedge fund manager knows the difference between enterprising a worthwhile risk for a big payday and trying something beyond the limits of all stupidity. At Pine River Capital Management, they know the difference. They sure didn't at Lehman Bros.

Putting hedge funds out in front of distressed debt investing contains the risk, and somewhat limits the exposure of the financial system as a whole.

That's a good thing, right?

There's another edge to the sword, as usual.

When banks have to curtail their speculation and "alternative asset" business, it can cause problems with the banks' liquidity function, their ability to get cash from here and move it out into the markets to keep the wheels greased. Hedge funds don't have to function that way and they don't.

Moreover, hedge funds seem to have set up some real penalties for those traders who gamble and lose. Bloomberg News reported BlueCrest Capital Management traders stand to get their capital allocation slashed if they lose too much money - a serious wing-clipping. Little such disincentive exists at the banks. We all remember failed bankers taking home huge bonuses.

So the question is: Do we want to get our banks out of the heavy risk business once and for all, and put it into the hands of real pros? Do we want to risk the liquidity function of large banks and the role they'd play in easing a crisis? What role does calculated risk play in generating wealth and stability?

I get the feeling we'll see the answer soon enough.

Source :http://moneymorning.com/2013/05/10/distressed-debt-investing-now-a-favorite-move-for-hedge-funds/

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