Sprott warns on leverage

Acknowledging himself as “the apostle of the apocalypse” thanks to his warnings about overleveraged homebuyers and a shaky U.S. dollar, Eric Sprott says his greatest fear lies with his counterparties — the prime brokers from whom he borrows stocks to sell short.

“Where’s the cash? We can pretend we’re making money, but if you don’t have your money, have you made anything?” the hedge fund manager asked yesterday at a symposium sponsored by Ernst & Young. “We don’t carry around cash in the hedge fund business. When we short stocks, we have to send the cash out to somebody in the great financial nether land out there.”

That somebody is a prime broker. “They’re worried about me,” he said. “But I’m worried about you, too. You got my dough; you’ve got my client’s dough. If you go down, we do, too.”

Conceding that most hedge fund managers don’t think this way, he says his main concern is, “If it all breaks, I’ve got to cover my shorts and get the money back.”

The worry is that the prime brokers may be overextended, as are their parent banks. Financiers, he thinks, are in denial about the U.S. housing bubble. While Sprott sees parallels in today’s U.S. mortgage market with the collapse of the savings and loans industry in the 1980s, that isn’t the only area where credit may have been given too easily.

The notional value of derivative exposure jumped 24% in the first six months of the year — a rate of roughly $500 billion in new exposure every day for a total of $370 trillion, compared to a U.S. GDP of only $12 trillion.

Ironically, while G7 countries are calling for more research on the role of hedge funds in the derivatives marketplace to determine whether they pose a systemic threat to the global financial system, Sprott says, the G7 finance ministers have the tools in their own hands.

“There are lots of rules in place for regulated entities that should keep you from having a problem. A hedge fund only has its own capital to play with,” he said. “We can only do what the deposit-taking institutions let us do.”

But he agrees with greater regulatory scrutiny.

Looking at the collapse of Portus Alternative Asset Management and Norshield, “my gut reaction is that we need regulation,” he said.

One problem is that hedge funds “can appoint any old auditor.” But, he warns, “there’s only so many good auditors” that will prevent managers from “getting away with things they shouldn’t get away with.”

For his part, as a member of the IDA, he thinks the threat of a twice-a-year audit ensures the books are kept up to date, lessening the probability of excessively risky leverage.

Filed by Scot Blythe, Advisor.ca, scot.blythe@advisor.rogers.com.

(11/24/06)