Hedge Funds Hoard $600 Billion in Cash

This post first appeared on Minyanville.

While they’re not deviously plotting the demise of the worlds’ most powerful financial institutions, hedge funds are loading up on another popular trade: Cash.

According to the Financial Times, Citigroup estimates hedge funds have recently squirreled away as much as $600 billion in cash, of which $100 billion is held in money market funds - those same money market funds Washington so graciously propped up last week.

With good risk-reward investment opportunities in short supply, hedge funds -- paid handsomely to manage risk -- are relying heavily on the safety of cash to ride out recent market turmoil. It’s telling that for those whose livelihoods depend on beating the market, the investment du jour is no investment at all.

Money market funds, which offer a superior return to most traditional bank accounts, hold more than $3 trillion dollars for retail and institutional investors alike. The funds are offered by private wealth managers, as well as big financial institutions like JPMorgan (JPM), Charles Schwabb (SCHW) and even General Electric (GE).

Managers are supposed to invest in safe financial instruments that yield their clients a moderate but secure return. Since there's no chance for principal appreciation, funds compete on this return alone. During the credit boom, certain funds stretched for yield on the back of cheap leverage, investing in riskier and riskier assets, including the now-infamous mortgage-backed securities and other structured debt.

Last week, as if markets needed any more problems, the Reserve Primary Fund announced it had become only the second fund in history to “break the buck.” It turns out that in order to earn investors a higher yield, the fund had purchased debt backed by Lehman Brothers. When Lehman folded, the fund was forced to write off more than $785 million and halt redemptions as clients clamored for cash.

As uncertainty spread about which fund could be next, investors raced to withdraw money from what were feared to be the “next shoe.” That is, until the Treasury Department stepped in to prevent what could have been the bank run to end all bank runs.

Money markets don’t just act as a savings account on steroids; large financial institutions use them to maximize the cash they use to run day-to-day operations. Their willingness to sock away precious dollars at competing banks represents a healthy level of trust, that when they wake up in the morning the money will be right where they left it.

The past week has witnessed an evaporation of that trust, as banks are literally hoarding cash, forgoing returns in the interest of keeping their money close to home. Despite hopes the $700 billion bailout plan will defeat partisan politics in time to rescue the financial system, banks still won’t part with their cash. The recent spike in the London interbank offered rate, or Libor, is evidence of just how pervasive fear is.

Risk, as Mr. Practical is apt to say, is high.