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Credit Policy

Special Report

Hedge Funds: An Emerging Force in the Global Credit Markets

Summary Credit-oriented hedge funds have quickly become important sources of capital to the credit markets. The recent proliferation of credit hedge funds operating independently has the potential to promote liquidity and diffuse credit risk. That said, there are legitimate concerns that these funds may end up inadvertently exacerbating risks. The credit markets recently experienced a confluence of negative events involving credit downgrades in the automotive sector, reported hedge fund redemptions, and credit derivative losses. Even having weathered these events, market participants are still wary of the circumstances that may result in hedge funds acting more synchronously in response to some market dislocation. This is natural, as hedge funds' significant participation in the credit markets is a relatively recent, not wellunderstood phenomenon and is growing rapidly. This report seeks to assess hedge funds' participation in the credit market, the potential for any synchronous risk this represents, and the potential impact of such risk, especially the implications for corporate and structured finance credit quality. Key highlights include the following summary findings: · Credit-oriented hedge funds are growing assets under management at a faster pace than the overall hedge fund market, and their impact in the credit markets is not well understood. · Hedge funds' impact in the global credit markets is greater than their assets under management would indicate due to their higher trading volume and willingness to invest in higher risk markets, such as high yield corporate securities and subordinated structured finance tranches.

Analysts

Roger W. Merritt 1 212 908-0636 [email protected] Ian Linnell 44 20 7417 4344 [email protected] Robert Grossman 1 212 908-0511 [email protected] John Schiavetta 1 212 908-0619 [email protected]

Hedge Funds Participation in the Credit Markets

Banks and Investment Banks

Leverage

Credit-Oriented Hedge Funds

Purchase

Credit Instruments · · · · · · · Subordinated ABS/MBS High yield bonds Subordinated/mezzanine debt CDO equity CDO2 Credit derivatives Leveraged loans

· ·

As some hedge funds pursue credit strategies, they increasingly purchase all forms of higher risk, less liquid credit instruments. These hedge funds often use short-term financing from investment banks to achieve leveraged returns.

ABS/MBS ­ Asset-backed securities/mortgage-backed securities. CDO ­ Collateralized debt obligation. CDO2 ­ CDO squared.

July 18, 2005

www.fitchratings.com

Credit Policy

Employing Economic Leverage

Typical Subprime RMBS Structure

`AAA' (78%)

`AA' (7%)

$10 Million Unlevered Hedge Fund Investment

`A' (8%) 5.0x Leverage via Street Financing

$60 Million

Achieve Capped First Loss Exposure to $850 Million of Residential Mortgages

`BBB' (4%) NR/Subordinated (3%)

RMBS ­ Residential mortgage-backed securities. NR ­ Not rated. Note: Hedge funds' investments can be "economically leveraged" by purchasing subordinated tranches. Represents theoretical maximum, which may be spread across multiple transactions and lenders.

·

· ·

Hedge funds appear to be adding liquidity to the credit markets, as a growing number of individual funds pursue differing strategies even within the same collateral sectors Nonetheless, the potential for credit-oriented hedge funds to move in lock-step in response to some market dislocation cannot be ruled out. A forced deleveraging of one or more large credit-oriented hedge funds would likely be felt most immediately in the form of price declines and spread widening. In particular, such an event could be felt across multiple segments of the

·

·

credit markets, rather than being contained to one or a few sectors. Secondary effects of such a deleveraging could include some potential rating volatility in the high yield corporate sector, as these companies are often reliant on access to liquidity and refinancing needs. Tertiary effects could include reduced issuance of high yield corporate and structured finance securities, as hedge funds shrink their participation, although this may be offset over time by traditional investors increasing their exposure to these markets.

Punching Above Their Weight: 2004 Hedge Fund Trading Volume

90 80 70 60 50 40 30 20 10 0 Below Inv estment Grade Credit Deriv ativ es CDOs Distressed Debt Emerging Market Bonds Lev eraged Loans (%)

CDOs ­ Co llateralized debt o bligatio ns. So urce: Greenwich A sso ciates survey entitled "Hedge Funds: The End o f the B eginning?"

Hedge Funds: An Emerging Force in the Global Credit Markets 2

Credit Policy

Possible Effects of Overlapping Credit Markets

4

Market Reaction Forced selling further widens credit spreads and mark-tomarket losses

1

2

Investment Banks Margin call on certain creditoriented hedge funds and reduction of credit lines

EVENT

Credit-Oriented Hedge Funds Forced selling of assets under management to meet margins/delever positions

3

· · · ·

Possible Credit Market Impact Spread widening Deleveraging (i.e. market value structures) Refinancing risk (i.e. high yield credits) Reduced issuance (i.e. ABS/RMBS)

ABS ­ Asset-backed securities. RMBS ­ Residential mortgage-backed securities.

The rapidly emerging role of hedge funds has important implications for the credit markets. Specifically, the degree to which these important new investors diffuse capital markets risks or may move more in lock-step in response to future market dislocations is relatively unknown at this time. In effect, it is valid to ask: "Has credit risk exposure become more diffused, or has it become reconcentrated within certain hedge funds?" Overview Globally, hedge funds increasingly participate in all segments of the major credit markets. As a result, the credit markets now may be more fundamentally linked than in the past in the event of a market dislocation. In this report, Fitch Ratings seeks to articulate the dynamics of credit hedge funds and the potential market and rating implications, using information from prime brokers, industry surveys, and discussions with market participants. Since the near-collapse of Long-Term Capital Management (LTCM) during the 1998 global

liquidity squeeze, the markets in general and hedge funds in particular have evolved significantly. Prime brokers and more established hedge funds have expanded their risk management and monitoring capabilities to better manage credit, market, and counterparty risks. Many of these enhancements are embodied in industry-led initiatives, such as "Sound Practices for Hedge Fund Managers," published in early 2000. Nonetheless, most hedge funds continue to rely on short-term financing from prime brokers to pursue leveraged investment strategies. As a result, some players in the industry remain susceptible to margin calls and deleveraging due to a market dislocation. Hedge funds have experienced explosive growth, fundamentally changing the composition of the credit markets. Hedge funds now are estimated to manage more than $1 trillion in assets on an unleveraged basis, and actual assets under control are likely several multiples in excess of this, taking leverage into consideration. While relatively small, fixedincome strategies have outpaced overall growth in hedge fund investments (see chart, page 5).

Hedge Funds: An Emerging Force in the Global Credit Markets 3

Credit Policy

Hedge Fund Strategies -- Indicative Leverage

Strategy Fixed-Income Relative Value Long/Short Credit Derivatives CDS Leveraged Carry MBS and ABS Arbitrage Long/Short Cash Credit Convertible Arbitrage EM Long/Short Distressed Credit Long/Short Equity Leverage (x) 10.0­15.0 10.0­15.0 20.0 6.0­8.0 5.0­6.0 3.0­4.0 3.0­4.0 1.5­2.0 2.0

Global Credit Markets

($ Bil., As of Dec. 31, 2004) Total U.S. Corporate Bonds U.S. High Yield Bonds European High Yield Bonds U.S. Leveraged Loans* European Leveraged/Mezzanine Loans ABS** CDOs Credit Derivatives 3,000 700 118 460 441 1,828 366 8,400

CDS ­ Credit default swap. MBS ­ Mortgage-backed securities. ABS ­ Asset-backed securities. EM ­ Emerging markets. Note: The table reflects indicative leverage ratios by strategy and may not reflect actual leverage employed or the leverage cushion at a given fund. Sources: Various prime brokers.

*U.S. syndicated leveraged loans underwritten in 2004. Source: Bloomberg. **Asset-backed securities (ABS) source: Bond Market Association. Collateralized debt obligation (CDO) issuance in 2004. Source: J.P. Morgan. Estimated global notional amount of credit derivatives outstanding. Source: International Swaps and Derivatives Association, Inc.

Growth in hedge funds has unquestionably provided liquidity to the markets by providing much-needed risk capital and fostering new means for risk transference. Nonetheless, as hedge funds become embedded in the fabric of the credit markets, Fitch believes there are important and evolving ramifications that should be considered. With hedge funds providing a significant source of risk capital for a variety of credit markets, Fitch notes that there may be potential for a single event to create wider spread distortions to multiple segments of the credit markets, rather than being contained to one or a few sectors. In effect, risks that, in theory, have been dispersed throughout the capital markets via disintermediation may, in fact, have become reconcentrated by some hedge funds. A Market Paradigm Change In the past few years, hedge funds have emerged as a dominant force in the capital markets, benefiting from a relatively benign environment of low interest rates and easy credit. This environment has allowed hedge funds to pursue a wide range of investment strategies, with short-term financing provided by banks and investment banks. Hedge funds now are estimated to drive up to 25% of revenues for many of the larger global banks. At the same time, investments in the credit markets continue to grow, with hedge funds controlling as much as 30% of the trading volume in high yield bonds and 26% of leveraged loans, according to a recent survey by Greenwich Associates (see Punching Above Their Weight: 2004 Hedge Fund Trading Volume chart, page 2). Some of this recent drift into credit strategies has been driven by declining returns in other core strategies. For

Hedge Funds: An Emerging Force in the Global Credit Markets 4

example, multistrategy funds have the flexibility to move between equity- and credit-oriented strategies as market conditions change. In many of the structured finance markets, Fitch analysts understand that some hedge funds now play a critical role in financing the least liquid, highest yielding subordinated tranches of transactions, giving them a degree of influence that far outstrips the notional size of their investments. Credit-oriented hedge funds also are able to influence pricing in all segments of the credit markets through the use of credit derivatives. Alternative investment vehicles are thought to control as much as 30% of the trading volume in the $8 trillion global credit derivatives market (CDx), according to surveys by Fitch and others (see Global Credit Markets table above). More Synchronous Risk? In past cycles of illiquidity, the credit markets operated in silos, with distinct investor groups, many of which were long-term, buy-and-hold investors. As a result, these investors generally were able to weather a downturn in a single market without significant repercussions to other markets and investors. The market paradigm may have shifted to greater overlap. If so, this new paradigm potentially has important implications for the future behavior of the credit markets if a stress/dislocation were to occur (see Employing Economic Leverage chart, page 2, and Possible Effects of Overlapping Credit Markets chart, page 3). Fixed-income strategies by hedge funds grew to more than $60 billion in 2004 from $20 billion in 1997. Much of this growth has occurred in the past few years and appears to be accelerating. While not all fixedincome strategies involve credit-based assets, these

Credit Policy

numbers may understate the influence of hedge funds since they do not reflect the leverage they employ. Hedge funds employ varying degrees of leverage, depending on the strategy. For example, $60 billion of investments into hedge funds leveraged at 5.0 times (x) implies something closer to $360 billion of assets under control (see Hedge Fund Strategies -- Indicative Leverage table, page 4). However, it is worth noting that many funds chose not to operate at the maximum leverage allowed by the prime brokers, effectively creating a cushion in times of market stress. Furthermore, hedge funds appear to wield even greater market power, or economic leverage, by concentrating their investments in the more junior, leveraged investments within a capital structure. While other investors also purchase junior tranches, hedge funds are known to have become significant, influential buyers. By concentrating on the more junior risk tranches, hedge funds can influence the structuring and overall capital markets execution of a large block of assets by deploying relatively small amounts of money. For example, in a subprime residential mortgagebacked securities (RMBS) transaction, the `BBB' and lower rated tranches of risk may only represent 7% of the total capital structure. Assuming $10 million of capital leveraged at 5.0x through margin lending, a hedge fund could effectively achieve first loss exposure to more than $850 million of residential

Global Hedge Fund Investments: Fixed-Income Allocations

(Years Ended Dec. 31)

70 60 50 40 30 20 10 0 1997 1998 1999 2000 2001 2002 2003 2Q04

No te: Represents investments in hedge funds prio r to any leverage emplo yed by the fund. So urces: Greenwich A sso ciates, Hedge Fund Research, and J.P . M o rgan.

mortgages, although any loss would be capped at the amount of the initial investment, or $60 million in this example and could be diversified across multiple transactions (see Employing Economic Leverage chart, page 2). The risk to hedge funds and the market as a whole is that a price decline in a particular asset class can result in forced selling of multiple positions that is magnified by the effects of leverage. For example, a hedge fund leveraged at 4.0x could be forced to sell 25% of its assets in the event of an initial 5% price decline, assuming that prices were not further depressed by one or more sellers acting in concert. An increase in margin requirements, which is not uncommon in times of stress, and/or further sellingdriven price erosion, would amplify this effect. In the prior example, a modest increase in the dealer's margin from 20% to 25% (75% advance rate) would require a fund to deleverage as much as 40% to meet margin calls and restore leverage to within limits. Of course, this assumes that a fund is operating at maximum leverage without a debt cushion, which is typically not the case. Similar leverage can be found in other segments of the structured finance markets, including collateralized debt obligations (CDOs) and commercial mortgagebacked securities (CMBS). For example, in the CMBS market, hedge funds are meaningful investors in relatively illiquid B notes, which represent the subordinated or equity carveout of a whole mortgage and/or mezzanine debt secured by real estate partnership interests. Hedge funds also are active in financing second-lien and mezzanine bank loans, as well as providing some one-off bilateral financings. In the high yield market, hedge funds control 25%­30% of trading in leveraged loans/high yield bonds and represent more than 80% of trading in distressed debt, according to the Greenwich survey. In many cases, these assets may wind up term financed in CDOs, thereby mitigating any liquidity risk. However, in the near term, hedge funds are reliant typically on short-term warehouse financing from banks and subject to margin calls and repricing risk. This is particularly true for less-established players. The larger, more sophisticated hedge funds have attempted to develop more robust, diversified funding sources over time by negotiating term repo lines with fixed margins and clear mechanisms for

Hedge Funds: An Emerging Force in the Global Credit Markets 5

($ Bil.)

Credit Policy

CDO Price Sensitivity: CDO vs. CDO2

CDO 5 4 3 2 1 0 (1) (2) (3) (4) (5)

(%)

2

CDO

Note: Chart compares hypothetical price sensitivity for `AAA' rated synthetic collateralized debt obligations (CDOs) vs. `AAA' rated synthetic CDO squared (CDO2), measuring price sensitivity to a parallel change in the spreads of the underlying credits. Source: J.P. Morgan.

pricing and dispute resolutions, as well as raising debt in the capital markets. Within the CDO/CDx market, hedge funds are understood to be significant buyers of subordinated and equity tranches of CDOs and certain synthetic structures, as well as investing in CDO squared (CDO2) structures. In fact, the explosive growth in the CDx has been propelled in recent years by hedge funds acting as both buyers and sellers of protection and providing much-needed liquidity. Some of these products are leveraged internally and may be more susceptible to mark-to-market volatility. For example, the effective leverage employed by synthetic CDO2 structures may be much higher than that found in traditional synthetic CDOs, and this leverage on leverage can be reflected in higher sensitivity to spread and/or correlation changes. For example, the price decline of a CDO2 if credit spreads widen may be as much as three times that for a similarly rated straight CDO (see chart above). This has important implications if these positions are financed with leverage and must be unwound. Credit Market Implications So what does this mean for the credit markets and risk managers? In 1998's liquidity crisis, it was not uncommon for even better quality, investment-grade assets to lose as much as 5% of their value, and the price declines for lower-quality assets were much more severe. For example, average spreads on `BB' rated CMBS and high yield corporate bonds widened

Hedge Funds: An Emerging Force in the Global Credit Markets 6

at least 300 basis points in the fall of 1998. Liquiditydriven selling by hedge funds to meet margin calls, as well as a general deleveraging by global banks, contributed to a downward spiral in prices for debt securities and other investments. Since then, the hedge fund industry has become more diverse and more sophisticated with respect to risk management, and there is potential for risk dispersion as funds may pursue dissimilar strategies. Still, many hedge funds remain reliant on short-term financing to pursue leveraged investment strategies, and the impact on the credit markets could be fairly broadbased if several credit-oriented hedge funds were forced to deleverage. A far-reaching liquidity squeeze and price dislocation across multiple, interlocking credit markets could ensue simply due to hedge funds' presence in most, if not all, of the major segments of the credit markets. The effects of such an event would be felt first and foremost in the form of price declines and credit spread widening across multiple sectors of the credit markets. In turn, this could present challenges to some market value structures with mark-to-market and deleveraging triggers. Beyond potential trading losses, including among some prime brokerage banks, cost-effective financing for all forms of credit could be adversely affected. In Fitch's opinion, potential ratings volatility would be felt most in the high yield sector and among borderline investmentgrade companies due to their sensitivity to liquidity

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Credit Policy

access and refinancing risk. The timing of such a liquidity event would be a determinant factor. In the near term, the risks appear to be mitigated partially, as most companies have fortified their balance sheets by raising cash and extending debt maturities. However, from 2006­2008, these bond issues begin to come due, with $377.3 billion of high yield and `BBB' rated bonds maturing in this period, elevating the overall level of refinancing risk. Additionally, key segments of the structured finance markets, such as subprime RMBS and CDOs, are reliant on hedge funds as the source of risk capital. If this capital were to recede, it is likely that yields would widen and a dropoff in structured finance issuance could ensue, at least until alternative investor classes entered the market, which has happened in the past. Depending on the depth and duration of any dislocation, there could be a ripple effect on the consumer and the broader economy. Widespread hedge fund participation in virtually all facets of the credit markets is a relatively young phenomenon and is growing rapidly. The financing techniques employed by hedge funds introduce the

Bond Maturities*

(Years Ending Dec. 31)

`BBB' Rated 90 80 70 60 50 40 30 20 10 0 2005 2006 2007 2008 (No.) Speculativ e Grade

*U.S. Corporate bond market.

possible scenario, however remote, of a synchronous deleveraging of credit hedge funds as a new risk element in the credit markets.

Copyright © 2005 by Fitch, Inc., Fitch Ratings Ltd. and its subsidiaries. One State Street Plaza, NY, NY 10004. Telephone: 1-800-753-4824, (212) 908-0500. Fax: (212) 480-4435. Reproduction or retransmission in whole or in part is prohibited except by permission. All rights reserved. All of the information contained herein is based on information obtained from issuers, other obligors, underwriters, and other sources which Fitch believes to be reliable. Fitch does not audit or verify the truth or accuracy of any such information. As a result, the information in this report is provided "as is" without any representation or warranty of any kind. A Fitch rating is an opinion as to the creditworthiness of a security. The rating does not address the risk of loss due to risks other than credit risk, unless such risk is specifically mentioned. Fitch is not engaged in the offer or sale of any security. A report providing a Fitch rating is neither a prospectus nor a substitute for the information assembled, verified and presented to investors by the issuer and its agents in connection with the sale of the securities. Ratings may be changed, suspended, or withdrawn at anytime for any reason in the sole discretion of Fitch. Fitch does not provide investment advice of any sort. Ratings are not a recommendation to buy, sell, or hold any security. Ratings do not comment on the adequacy of market price, the suitability of any security for a particular investor, or the taxexempt nature or taxability of payments made in respect to any security. Fitch receives fees from issuers, insurers, guarantors, other obligors, and underwriters for rating securities. Such fees generally vary from USD1,000 to USD750,000 (or the applicable currency equivalent) per issue. In certain cases, Fitch will rate all or a number of issues issued by a particular issuer, or insured or guaranteed by a particular insurer or guarantor, for a single annual fee. Such fees are expected to vary from USD10,000 to USD1,500,000 (or the applicable currency equivalent). The assignment, publication, or dissemination of a rating by Fitch shall not constitute a consent by Fitch to use its name as an expert in connection with any registration statement filed under the United States securities laws, the Financial Services and Markets Act of 2000 of Great Britain, or the securities laws of any particular jurisdiction. Due to the relative efficiency of electronic publishing and distribution, Fitch research may be available to electronic subscribers up to three days earlier than to print subscribers.

Hedge Funds: An Emerging Force in the Global Credit Markets 7

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