Hedge Funds And The Credit Collapse: A Tale Of Two Ratings Agencies

Aug 17 2007 | 1:38pm ET

For two ratings agencies, it is the best of times and the worst of times.

It's the season of light for Standard & Poor’s, which notes the funds of funds have proven more or less immune to the troubles befalling their single-manager brethren (and constituents). Its S&P Fund Services says that funds of funds have done a good job of diversifying, mitigating the “immense” risks posed by “black-box quant hedge funds,” such as those run by Goldman Sachs, AQR Capital Management and Tykhe Capital. In fact, S&P says a number of funds of funds it rates have posted double-digit returns this year.

“Our rated fund of hedge fund managers have done well so far this year despite the turmoil in equity and fixed-income markets,” S&P analyst Randal Goldsmith said. “Examples of funds of hedge funds, as opposed to individual hedge funds, getting in trouble are extremely rare.”

For its part, Moody’s Investors Services chooses to focus on the season of darkness, warning that a Long-Term Capital Management-scale hedge fund collapse may well be in the offing.

The growing credit crisis has hedge funds with exposure to collateralized debt obligations and other debt instruments behind the 8-ball, according to Chris Mahoney, vice chairman of Moody’s.

“A possible consequence of the repricing of risk assets would be the failure and disorderly liquidation of a hedge fund or institution of sufficient size to disrupt the markets, as LTCM threatened to do in 1998,” he said on a conference call. “There is always a risk in such a process that there could be one or more smaller institutions that could be hurt badly enough to require intervention.”

Moody’s glum prediction is sure to stick in the craw of the hedge funds for which it is forecasting doom: Many hedge funds burned by the credit crisis lay the blame squarely at Moody’s’ feet, as the agency had given its highest ratings to some of the now-distressed debt, and failed to take action to cut ratings until, many say, it was too late. That led French President Nicolas Sarkozy to demand an investigation into the role of ratings agencies in the credit crisis.

But Moody’s sees far, far better things in the offing: a market rebound. “What we are seeing now appears to be largely a cyclical, not a secular, event,” Mahoney said.


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