Hedge funds' business model upended: James Saft

James Saft is a Reuters columnist. The opinions expressed are his own.

By James Saft

LONDON (Reuters) - It has been a bad few weeks for hedge funds, including perhaps the world's biggest, the United Kingdom.

Like so many hedge funds, Britain as a nation sought to maximise its gains in recent years by borrowing short term money, usually from overseas, and investing in higher risk, supposedly higher yielding assets.

Now the funding is gone, and even government intervention on a massive scale is unlikely to avert a very damaging contraction in credit.

Meanwhile the assets backed, be they property at home or foreign direct investment abroad, are hard to sell to meet margin calls, and, to put it politely, unlikely to yield as much as they have in the past.

As detailed last week in the Bank of England Financial Stability report, the British banking system hugely expanded the asset side of its balance sheet in recent years, making loans and holding securities, but without building up capital proportionally.

"I was shocked myself at the scale -- the leverage ratio of the banking system at 35 and some of them have 60," said Michael Hart, head of European FX strategy at Citigroup in London.

"If that comes back to the norm for commercial banks of 10 times leverage that means an awful lot of adjustment, an awful lot of balance sheet adjustment in the banking system but also a huge adjustment economy-wide."

In 2001 large British banks loaned about the same amount to their corporate and consumer clients as they took in deposits, but by the end of June were loaning out 740 billion pounds more than they had deposits, squaring this circle by borrowing money for short periods, often from abroad.

That short term funding is now largely gone and many of the loans made and the securities banks put on to their balance sheets are looking very suspect.

It is not a coincidence that while this was happening the household savings rate in Britain declined from just under six percent to just over nothing.

The country's government has offered to inject 50 billion pounds into banks and guarantee new short and medium term debt issuance; Royal Bank of Scotland (RBS.L), Lloyds TSB (LLOY.L) and HBOS HBOS.L have agreed to take up to 37 billion pounds of the funds.

This will help, but just as banks are trying to cut back gently on lending while growing deposits, a recession may mean that savings are even harder to attract, as households cut back on consumption yet still find it tough to put money aside.

Banks will have to brake hard on lending, despite pleas from the government.

CARRY TRADE ECONOMY

But the banking system is just part of the story. The current account deficit doubled in the second quarter to 11 billion pounds, or three percent of gross domestic product. And while Britain's net international investment position is not as bad as some other developed open economies, its gross foreign liabilities are 466 percent of GDP, bigger than all developed economies except Switzerland.

Britain has used much of this to make foreign direct investments, and done it profitably enough that it has a positive balance of payments.

But basically, it is on an economy-wide carry trade strategy -- borrow money short abroad and invest it in things that you hope will earn more than you must pay in interest.

"This is like a hedge fund -- a macroeconomic carry trade," said Hart of Citigroup.

The problem now is that, on a very broad basis, the funding may not be there and foreign direct assets can be tough to sell if you need cash quickly.

Britain is also very unlikely to continue to be able to make as much from its overseas holdings as it has in the past. A global recession is looming and the risk premia and profit expectations that held when many of these investments were made now look optimistic.

What does all this mean for the country's economy and asset markets?

The credit crunch will be sustained, even with government money to help recapitalise and despite pleas from this new class of investor to keep the taps open, hardly good news for profits and stocks.

The pound will also continue to be under pressure. It has fallen 20 percent since this summer against the dollar and hit record lows against the euro. Interest rates will fall very quickly, with some analysts even predicting the Bank of England may cut by a full percentage point when it meets this week.

In a lot of ways what is happening to the pound is a good guide for what might happen to the dollar, which has similarly bad fundamentals, if it wasn't a reserve currency and did not have a central role as the currency of exchange in commodities and financial markets.

Without hedge fund-like leverage, Britain will become more like a boring old pension fund, with shabbier offices, lower returns and lower salaries for its managers.

-- At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund --

(Editing by Ruth Pitchford)