Subprime casualties provide feast for canny credit vultures (FT.com)

It is a golden rule of finance that whenever a bloodbath occurs, vultures with a sharp eye on cheap assets start circling. So too with the credit world.

So, while rumours have flooded around the markets in recent days that some institutions are nursing massive losses from the recent turmoil, some hedge funds and investment banks have amassed large gains.

Moreover, as credit prices started to recover on Tuesday, some investment groups prepared to swoop on cheap assets. On Monday, for example, Citadel Investments, the Chicago-based hedge fund run by billionaire Kenneth Griffin, said it would acquire credit portfolios of Sowood Capital Management, a medium-sized Boston-based hedge fund, which has recently suffered devastating losses linked to credit positions.

Market observers said the deal was worth several hundred million dollars. The mere fact that the Chicago-based hedge fund is willing to make any bid at all significantly boosted confidence in the financial markets on Tuesday and is likely to leave other investors eyeing new value trades.

According to Sowood, its losses in June resulted from sharply wider corporate credit spreads unaccompanied by any concomitant move in equities, and exacerbated by a decline in liquidity.

Some observers predict the market may have seen the worst of the turmoil, leading to an acceleration of the fight for cheap assets.

"End-of-month buying in equity markets is helping to fuel the view that the worst of the credit market weakness is now behind us. If this view takes hold, then we are likely to see more of the 'value-grab' trades that have so far been tempered by the fear that credit could go materially wider," says Geraud Charpin of UBS.

Indeed, bankers at Goldman Sachs are already creating a special new fund to invest in distressed credit products. Other Wall Street groups, such as JPMorgan, are believed to be mulling similar steps.

However, even before the vultures swoop, there are signs that some investment groups have done well by exploiting the pain of others. Prudential Investment Management's Alpha Fund, for example, enjoyed a strong performance in its fixed-income funds in the first half of this year by shorting the subprime sector.

Separately, some hedge funds saw stellar results last month, demonstrating that nimble credit-focused managers have been able to negotiate recent market turmoil successfully.

MKP Capital Management's flagship $400m credit fund of MKP, run by three former Salomon Brothers fixed-income executives, is up 22.6 per cent over the year to July 27.

Brigadier Capital's structured credit fund was up over 8 per for the month to mid-July according to people in the market and the Pursuit Opportunity fund, which specialises in asset-backed securities, was up 5 per cent in June and is said to have extended gains further.

But for every winner, there are many losers. Aside from Sowood, a clutch of other funds already admitted to serious problems, ranging from Basis Capital in Australia to the now-infamous Bear Stearns-linked funds in New York.

Other losers include Braddock Financial, which is closing its $300m Galena fund due to losses on subprime. The Horizon Fund was down 32.9 per cent in June and sources close to the fund suggested it may have endured more problems in July, while the Eidos Structured credit fund was down 8 per cent in June.

Another fund said to have suffered is Higland Capital's special opportunities fund, which was down 17.5 per cent in June and is also expected to report falls for July in the coming days.

More surprising still, the list of recent victims is now extending well beyond US shores - or the hedge fund world. On Monday, IKB - a specialised German lender - issued a surprise profit warning due to losses on subprime securities.

The problems in US credit markets broadly are also affecting ordinary retail investors who thought they were in safe, steady products.

Late on Tuesday Australia's Macquarie Bank announced that investors in one of its mutual funds could lose up to 25 per cent of their money.

Separately, Axa insurance group has also warned that two of its funds have been badly dented. "AXA's recent decision to purchase additional subprime exposure to support liquidity at two of its mutual funds has underlined potential contamination from this issue," said Deutsche bank analysts in a recent research note.

There are concerns that some other European investment vehicles, such as collateralised debt obligations, could be nursing similar losses. The sheer breadth of names offers comfort to some observers, since it may suggest that the process of risk-dispersal is helping the financial system to absorb the credit shock.

However, while volatility remains high, the vultures who are sharpening their credit claws will have plenty of meat to chase in the coming months.