Hedge funds explained

Some in the market cheered while the Rock was sinking

As queues of worried savers snaked around branches of Northern Rock last week, bottles of Cristal champagne were put on ice in the wine bars of Mayfair. Read original article.

The upmarket district in the West End of London is home to many of the financial speculators who have made a mint out of the mortgage bank's woes.

Hedge funds - as well as traders in some of the big City investment banks - have been betting heavily for months that Northern Rock was facing serious funding problems and its shares were on their way south.

Their concerns proved well founded.

The collapse in Northern Rock's share-price has been spectacular since the BBC revealed that the Newcastle-based lender had applied to the Bank of England for emergency funding.

At 195p by Friday afternoon, they were changing hands for less than a third of the price that they were a little over a week ago, and well below the £12.58 they fetched in February.

Financial juggle

Hedge funds deploy a wider range of investment strategies across a broader range of markets - from currencies to commodities to shares - than traditional long-only fund managers in the pursuit of generous returns, even in declining market.

This may be a new story for many people, but it's not new for some sophisticated investor Julian Pittam, managing director, Data Exlorers

One of the most common of these strategies is to "short" shares they believe are over-valued.

Hedge funds borrow shares from long-term investors, such as pension funds or insurers, for a "rental" fee and sell them.

Later, they buy back the same number of shares and return them to the lender on an agreed date.

If the price has fallen, the difference between the price at which the hedge funds sold the shares and bought them back is profit.

Shorting the Rock

Last Thursday, Mervyn King, the governor of the Bank of England, said that he became aware that Northern Rock was facing serious difficulties only in August.

The hedge fund community seems to have sensed that something seriously awry much sooner.

At the end of June, rising interest rates triggered a profits warning from Northern Rock and prompted renewed questions about the bank's business model.

At that time only about 7% of Northern Rock's shares had been "shorted", according figures from Data Explorers, which collects securities-lending information for investors.

By the end of July, that short-position had grown to some 15% of the bank's shares, and ahead of last week's announcement from the Bank of England it has passed the 20% mark (with a single hedge fund said to have been behind almost half that position).

That compares to an average of short-position of about 3.5%across the banking sector as a whole.

Data Explorers puts the overall profits for those short-sellers of Northern Rock shares back in June at somewhere just north of £100m.

Others in the hedge fund community reckon the overall profit from shorting Northern Rock is much higher, and could be as much £1bn.

"This may be a new story for many people, but it's not new for some sophisticated investors," observes Julian Pittam, managing director of Data Exlorers.

"They've been sceptical about Northern Rock's funding model for some time. When it came to funding, Northern Rock was a one-trick pony."

Brave or foolhardy?

With a relatively small number of depositors, Northern Rock relied on borrowing from money markets for three-quarters of its funding.

Some of these guys have made shed-loads of money out of other people's misery and have imperilled the UK banking system Anonymous senior banker

Problems in the American sub-prime mortgage market prompted nervous banks to stop lending to each other, leaving Northern Rock struggling to meet its financial obligations.

However, traffic in Northern Rock shares has not been one-way this week.

Deutsche Bank picked up a touch more than 4% of company for clients, and one London-based hedge fund group - RAB Capital - took a stake in the bank of 6.05%, worth almost £50m, for its special situations fund, managed by Philip Richards.

Mr Richards has about $2.3bn under management, and placed about 5% of his fund in Northern Rock.

It is believed that Mr Richards thinks that Northern Rock's mortgage book is sound and the bank should be saved.

But with hopes receding of a speedy takeover of Northern Rock, Mr Richards' move looked a brave one to many within the City. It was said that other hedge funds took short positions in RAB as a result.

The flexibility of hedge funds' investment strategies has seen them deliver far more generous returns, even in declining markets, than traditional fund managers.

They have attracted ever-increasing investment from pension funds, big City investors and the very rich.

Hedge funds are now estimated to account for some 40% of all trading in London on any given day.

The industry has struggled, however, to fully shed its reputation as the bogeyman of the financial world, a reputation first earned by the legendary attack on the Bank of England in 1992 by the speculator George Soros that forced Britain out of the exchange rate mechanism and cost taxpayers £4bn.

Black Wednesday is still known in Mr Soros' firm as White Wednesday.

In 1998, the hedge fund world was dealt a further public relations disaster by the collapse of America's Long Term Capital Management.

And the role of the hedge funds in the crisis engulfing Northern Rock and unsettling the country's other lenders has angered some in the banking industry.

One senior banker, who asked not to be named, says "hedge funds actively drove down Rock's share price, and contributed to the panic and problems".

"Some of these guys have made shed-loads of money out of other people's misery and have imperilled the UK banking system."

Mr Pittam disagrees. "In no way did the activity of short sellers have any effect on Northern Rock's eventual demise," he says.

"The root cause of the problem is they couldn't meet their obligations. A better-run bank would have had the ability to fund itself in a crisis."

Rights and wrongs aside, short-selling of Northern Rock had slowed to a crawl by the end of last week after pension funds grew increasingly reluctant to lend the bank's shares.

And with money-markets tentatively re-opening for business, the bosses of all British banks will hope that the worst is finally behind them.