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Monday, August 20, 2007

New Twist on an Old Rule

Generally speaking, banks and other financial institutions extend themselves far beyond the amount of cash they actually have on hand. They keep just enough around to handle the normal influx of clients wishing to make withdraws. So there’s nothing scarier than an old fashion “run at the bank” and thats exactly what’s going on at many hedge funds these days…with a twist.

The latest hedge fund to undergo a rapid collapse is Sentinel Management Group, who describes itself as a “cash management firm.” Perhaps that’s a misnomer because once a few clients got wind of downward pressure on some of Sentinel’s investments, they started to pull out.

Apparently to fund the early redemptions, the firm made a deal with Citadel Investment Group, another secretive hedge fund. Citadel bought the most valuable of Sentinel’s investments at a major discount; some are saying as much as 30 percent.

Issuing more redemptions may have been a noble cause, but hedge funds have many different investors with different agendas. Institutional investors may have longer time horizons and are willing to sit through downturns, while high net worth individuals panic when their net worths are at stake. Such was the case with Sentinel Management. Several clients were large money management funds who didn’t take kindly to Sentinel selling its most valuable assets. Here’s the statement from one fund that had a stake in Sentinel:

"Based on what we have heard of the proposed terms, we believe that this sale occurred at discounts of up to 30% from market prices. This portfolio consisted of short term AA or better corporate bonds or US government agency bonds, as required under CFTC rules. We believe that to liquidate such a portfolio at such a discount to market value constitutes, among other things, a reckless disregard of industry fair practice responsibilities by all parties involved."

The lesson here is that an old fashion run on the bank has an equally damaging effect on hedge funds as it does on traditional banks. Furthermore, the Sentinel collapse shows that there are diverging interests at play and in seeking to appease one investor a hedge fund may be hurting another. The breaking news now is that the SEC will bring charges against Sentinel. The firm is accused of misrepresenting the true reasons for the collapse, which may not have been redemptions but excessive use of leverage.

Either way, the latest hedge fund collapse shows that the blood bath isn’t over on Wall Street. Bear Stearns, Goldman Sachs and many others likely to come show that the Wild West days are coming home to roost and investors are the ones taking the hit.


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