Last Updated: March 7, 2008: 7:50 AM EST
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Anatomy of a hedge fund collapse

When big banks have multibillion-dollar holes on their balance sheets, they make harsh margin calls even to their healthier clients. Here's how one fund got crunched by the credit crisis.

By Roddy Boyd, writer

NEW YORK (Fortune) -- In this market, even when a hedge fund is doing well, the wolf can be right outside the front door.

Exhibit A: The recent collapse of the $150 million Tequesta Mortgage fund. Like much larger and higher-profile rivals that have imploded in recent weeks, Tequesta collapsed when it couldn't meet demands for more collateral from its prime broker - in Tequesta's case, Citigroup (C, Fortune 500).

Unlike other hedge funds that cratered from bad housing-related bets, Tequesta steered clear of the mortgage- and asset-backed credit markets now getting walloped by the real estate bust. In fact, Tequesta's investment strategy of avoiding credit risk was paying off, according to bond salesmen and rival fund managers who bought the Tequesta positions seized by Citigroup.

What's more, unlike many managers of now-defunct hedge funds, Tequesta general partner Ivan Ross specialized in mortgage-related investing and had successfully navigated ugly mortgage-market crises in 1994 and in 1998.

The cause of the Tequesta fund's death: The balance sheet problems of the commercial and investment banks that dominate Wall Street's bond trading. Its untimely demise offers a case study in how the credit squeeze is forcing big players like Citigroup to pull lines of credit from otherwise healthy investors.

Granted, Tequesta wasn't a knockout in the hedge fund world, where stratospheric returns were the norm in recent years. The fund's returns were steady, if unspectacular, according to Hedgefund.net: 8.82% in 2003, 7.9% in 2004, 2.92% in 2005 and 8.74% in 2006.

The bonds seemed safe

The Tequesta fund traded in bonds carved from so-called prime jumbo mortgage loans. These are loans made to higher net-worth borrowers, generally in the amounts of $500,000 or more, who tend to have better credit. Tequesta's portfolio of triple-A loans continued to have low levels of default and delinquency as of earlier this year, according to a Fortune review of fund marketing materials and letters to investors.

In short, the prime jumbo mortgage bond market proved to be the exact opposite of the collateralized debt obligation (CDO) market, where billions of dollars worth of bonds were found to have been backed by problematic collateral. But when the market for triple-A rated bonds evaporated in recent months, so did the market for Tequesta's holdings of otherwise stable jumbo mortgage investments.

Tequesta was known for avoiding the use of credit to increase the size and risk of its investments; indeed, it had to work hard to convince investors that its aversion to credit risk - Ross had written to investors as early as 2005 that he saw major problems with the credit cycle - would not preclude handsome returns. The fund was also known to be scrupulous in its hedging practices, in order to guard against declines in the prices of its bonds.

Investors clamored for a more aggressive approach. "They were facing investor questions in early 2007 because [Tequesta's] hedges left too much carry on the table," said a bond salesman who covered the fund. By "carry," the salesman is referring to the difference between what a hedge fund receives in bond interest and what it pays to its prime broker to finance the position.

Last year, Ross yielded and opened another fund that used slightly more leverage - but only, he told Fortune, to two times capital, which is sharply below the industry average. The move pleased some of the fund's investors who quickly shifted their investments to the new portfolio.

Markets dry up

His timing couldn't have been worse. In July and August of last year, and then again in October and November, the secondary market for jumbo mortgage bonds came to a standstill. At the same time, Tequesta's primary brokers - including Bear Stearns (BSC, Fortune 500), Citigroup, Credit Suisse (CS) and UBS (UBS) - were grappling with balance sheets loaded with billions of dollars worth of subprime mortgages, CDOs and other fixed-income derivatives and loans.

This, in turn, created problems for smaller, less-liquid markets. Jumbo mortgage bonds, for instance, saw valuations drop as dealers and rival mortgage hedge funds refused to indicate at what price they would be willing to buy this paper. Lacking bidders, Tequesta's bonds fell in value.

So began a vicious cycle.

Tequesta's portfolio managers watched on the sidelines as banks dumped billions of dollars worth of mortgage bonds to free up capital. Even bonds backed by loans to the wealthiest Americans traded lower.

This raised alarms among Tequesta's lenders. Executives at investment-bank prime brokerage operations saw the sharp drop in the value of Tequesta's holdings and demanded additional collateral. In turn, they forced the fund to make additional sales to meet the margin calls.

Last year, after months of grappling with - and meeting - margin calls, the Tequesta fund posted a 19.63% decline. Though alarming, Ross and his colleagues soldiered on, reckoning that the historically low valuations of their portfolio - "money good" triple-A securities that were now offering unprecedented yields well into the double-digits - would be irresistible to investors.

They were wrong. In February, according to a Tequesta executive, trading in the jumbo mortgage markets virtually stopped. Prompted by massive trades in other mortgage bond markets that forced bond prices to historical lows, the margin calls from its trading counter-parties and its prime-broker Citigroup, all of whom were coping with their own balance sheet problems - started around the third week of the month.

Making matters worse: Unlike other lenders making margin calls, Citigroup was willing to liquidate inventory below loan values - the value it had assigned the bond when they initially provided the fund its margin - and recognize losses just to get the bonds off its books. A Citigroup spokeswoman declined comment.

In one case, Citigroup seized collateral from Tequesta and put it up for sale in a bid-list auction. According to a trader at another firm, however, Citigroup's mortgage trading desk offered to sell Tequesta's bonds to regional brokerage firms at prices even lower than listed prices. In another instance, Tequesta's portfolio managers were told by Citigroup rivals that its seized bonds had been offered to other hedge funds for more than $25 below where they had been trading in the previous days.

Under that kind of pressure, Tequesta decided by early March that they'd have to shut the mortgage fund down. Tequesta, according to a firm executive, still has several portfolios open. Ross declined comment to Fortune.com on his future plans. But as long as the credit markets remain in their current miserable state, there are going to be more stories like Tequesta's.  To top of page