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A Leveraged Affair: Macquarie's Fortress Fund Quandry

The past week has been a roller coaster ride for markets. And as far as roller coasters go, you could say that the Australian market took a nine G hit on Wednesday when the S&P/ASX 200 Index dropped 3.3%, the biggest one-day percentage fall in almost six years. The reason for the dive – Macquarie Bank, Australia’s most prestigious investment institution, issued a warning that retail investors in two debt funds face losses of up to 25%. Macquarie shares plunged 10.7% that day.

According to Macquarie, the losses are the result of supply/demand imbalances in the U.S. senior loan market, in large part caused by the spillover from the U.S. subprime mortgage credit crunch. And this is coming from funds that have no exposure whatsoever to the U.S. subprime market.

So how did Macquarie’s Fortress Notes fund and Fortress Fund end up in this position? It all boils down to liquidity risk.

Are You Liquid?

Liquidity risk is the danger, that not enough cash can be generated from either assets or liabilities to meet cash requirements. This makes lenders unwilling to continue lending the money needed to keep a fund (in this instance the Macquarie funds) going.

Liquidity risk is nothing new. Think back roughly ten years ago and no, I’m not referring to the Asian Financial Crisis. When Long-Term Capitol Management (LTCM) was established in 1994, it attracted large numbers of sophisticated investors including several prominent investment banks. Yet by September 1998, the highly leveraged hedge fund with only $4.8 billion in equity was more than $125 billion in debt and teetering on the brink of default. It would have completely collapsed if the U.S. Federal Reserve had not intervened with a US$3.5 billion rescue package.

The devaluation of the Russian ruble was to LTCM what the U.S. subprime mortgage crisis is to the Macquarie funds – the trigger to a credit crunch. This credit crunch, or flight to liquidity, took off in late June when Merrill Lynch and other lenders to two Bear Stearns hedge funds tried to sell collateral they had seized after margin calls, triggering a chain reaction that has spread globally, evidenced by this week’s events.

Chain Reaction

Very simply summarized, rising delinquencies and flat home prices in the U.S., have hit the value of some asset-backed securities that contained subprime home loans. This has spooked investors enough to widen the spread between interest rates on some of these securities and less risky debt like senior loans (corporate securitized loans) – the securities the Fortress funds are invested in.

Effectively, the whole credit market is being re-priced. Lenders are now looking for a higher rate of return vis-à-vis what they were asking for before the subprime panic. In order to meet these demands, borrowers may have to sell holdings to raise cash if they cannot come up with the extra money from elsewhere. If such sales occur in illiquid asset-backed securities at a big discount, this can force other borrowers with similar holdings to re-price their portfolios, possibly triggering more margin calls.

A Leveraged Affair

Let’s use the Fortress funds to illustrate what’s taking place in the market right now. The average price of loans in the portfolio of senior loans underlying the Fortress funds fell four cents to A$0.96 at the end of July from A$1.00 at the end of June. Given that the Fortress funds are highly leveraged, the upside as well as the downside, has been amplified.

Peter Lucas, director of Macquarie Fortress Investments explains, "For every (Australian) dollar that investors put into these funds, we borrowed an additional five dollars and invested the total of six dollars in senior secured loans. Since the market value of the funds’ loan portfolio has fallen by 4% in the month to July 31, the value of the investors’ funds has decreased by a factor of six times this amount (due to the leverage) so that there has been a reduction in the fund's net asset value of approximately 25%."

The devaluation has taken place, even though at maturity, the securities are still worth the full face value, and despite the fact that the credit on these securities is unchanged.

Investors, seeing that their holdings are dropping in value, will now seek to cut their losses and redeem their securities, making thing more difficult for already beleaguered funds.

If the fund holds the securities to maturity (assuming no defaults) then everyone is OK -- they get all their money back. However funds that allow redemptions today mean that they need to look at the market value of the portfolio todayin order to ensure people redeeming are getting the correct price. That means liquidating assets at potentially poor prices, which exacerbates the problems.

As one of the very last resorts, one step before complete insolvency, funds will halt redemptions. This is what Bear Stearns did with a third hedge fund, also this past Wednesday.

Things seem pretty bleak, especially after news today that yet another major U.S. mortgage company, American Home Mortgage , will close most of its operations. AHM’s collapse is both surprising and alarming because it makes loans to people who are considered good credit risks.

Correction Or Something Else?

But there are some who see the glass half full. A top executive of Bear Stearns shrugged off fears of a global credit crunch, saying that the recent market decline was healthy. Michel Peretie, chief executive of Bear Stearns International told Reuters that he thinks this is a healthy correction. "We've seen excess in terms of leverage and there was not enough premium for the risk structures," Peretie said.

"I think it's good that we are going back to more normal financial terms and normal spreads. I'm cautiously optimistic. I think the market will come back up in the third quarter." Peretie added.

Just keep in mind that Bear Stearns owns the two highly leveraged hedge funds that crumbled last month after betting the wrong way on securities backed by U.S. subprime mortgage loans. The third fund halted redemptions this week after nervous investors wanted to pull out their money.

Which brings us back to Australia and the Macquarie Fortress funds.

Lucas, the director of Macquarie Fortress Investments laid out a couple of directions the funds could go. "If the market value of the loans continues to go down, we can either selectively sell the loans or introduce new investors and use their money to reduce the debt and there are new investors entering the market. If these investors were to buy in at a NAV of 80 cents in the dollar, this represents a potentially very good return. Of course this is contingent on borrowers repaying their loans in full and that's something we are presently very confident of."

So, it’s back to the bottom line. In the face of these liquidity risks, should investors cut and run or, should they stay put? Something to mull over the weekend.

Send us your questions and comments to us at fundaffair@cnbc.com.