What part did Hedge funds play in the crash of 2008?

July 15, 2011
Ziad K. Abdelnour

Insights into Investment Strategies and Opportunities

The blog examines the role of hedge funds in the 2008 financial crisis. It discusses how these funds were both impacted by and contributors to the market conditions that led to the crash. The analysis includes an exploration of the investment strategies that exacerbated the crisis, as well as the subsequent regulatory changes aimed at preventing future financial disasters.

When Brooksley Born was interviewed on an episode of the PBS documentary series, Frontline, in October of 2009, it was the first time many viewers had ever heard of AIG’s involvement with credit default swaps. It was definitely the first time the majority of the American people had ever heard anyone quantify the depth of the abyss upon the edge of which Wall Street was teetering.

“We had no regulation,” testified the former chairman of the Commodity Futures Trading Commission (CFTC), who in 1998 had dared to cross swords with the Great and Powerful Greenspan. “No federal or state public official had any idea what was going on in those markets, so enormous leverage was permitted, enormous borrowing. There was also little or no capital being put up as collateral for the transactions. All the players in the marketplace were participants and counterparties to one another’s contracts. This market had gotten to be over $680 trillion in notional value as of June 2008 when it topped up. I think that was the peak. And that is an enormous market. That’s more than 10 times the gross national product of all the countries in the world.”

Not all derivatives are evil and destructive, but it is very crucial to understand the risks associated with these sophisticated products. This requires specialized high tech knowledge by professionals who have the necessary insight and expertise to know what tool to use and when it is appropriate.

The vast majority of hedge funds did not suffer significant damage due to the meltdown, although all of them certainly felt the shock waves. The ones that were most exposed and most leveraged are no longer with us.

Why has this gone on so long with no end in sight?

Because the Media has created and perpetuated the general perception that only people with money to burn invest in hedge funds. It is generally believed that the SEC has the opinion that if these rich people are so dumb as to give their money to Wild West fly-by-night money slingers, then they deserve to lose it. If it were the regular public that were losing their life savings, they say, it would be different story.

This is typical bureaucratic perception of financial reality.

The sad reality that everyone except the bureaucrats seems to have learned is that when all of the stupid rich people lose their money, the rest of the world economy suffers as well. This is why something real needs to be done about the more questionable hedge funds. I believe we need to have some regulation of the market, but it must be regulation that is well-thought out and anticipates unintended consequences.

I personally believe the SEC should require all hedge funds to operate in a true market-neutral mode, or not be allowed to call themselves hedge funds. It would be true capitalist caveat emptor (let the buyer beware) at its best.

As people put more and more money into hedge funds, another 1998 Long-term Capital Management debacle is just waiting around the corner to ignite another global financial crisis, requiring taxpayers to spend billions bailing out all of the firms that shouldn’t have been investing in them in the first place.

LTCM’s issue was ironically very similar to the issues that plagued Citibank most recently. The problem was not in what the fund traded nor in the strategies they followed, but in the size of their books and the fact that they had no limits on the overall volume of their arbitrage trades. They effectively became the market and couldn’t get out when things turned against them; and in the exposure of lenders to them, which no one was watching. It was therefore a question of unsupervised leverage and that is where the problem is in that sub-sector of the hedge fund industry. It is where the largest regulatory loophole is located.

This is what happened to Citibank and others more recently when the overall size of all of these deals went unchecked. This is where the regulators must find a way to measure the systemic risk of any particular fund. It is also why former SEC Chairman William Donaldson, CFA, has said this is the most distressing period since 1929.

“As hedge funds struggle to achieve returns,” he lamented. “I think there’s a tendency to skate on thinner and thinner ice, and it’s kind of an accident waiting to happen. ”

Bottom line on hedge funds

It is a fact that allocating a certain percentage of your investments to alternative investments does lower the volatility and risk of the traditional portfolio; but there is one very crucial difference between hedge funds and mutual funds.

Hedge funds are not infinitely scalable. Hedge fund managers cannot and do not accept unlimited amounts of capital. They all top out at some point and stop accepting additional investments as the capital available starts diluting their returns. Hedge fund managers rely instead on a small but steady inflow of investment capital that can be managed easier.

In the last few years, there has been an average of 2,000 new hedge funds start per year with about 1,500 closing within that time frame. This is not just due to losses. There are other factors, too; one of the main culprits is the inability to raise enough capital to sustain the operation. In general, allocators need at least two years of a successful track record before the may allocate money to a new fund. Many mangers cannot survive the costs alone and join with other funds. This also includes managers retiring after a long run. The bottom line is that the net number of funds is increasing, not decreasing, as a direct function of demand and the limited capacity of existing funds.

This increased demand for additional hedge funds to handle the amount of capital coming into the market has led, in the past, to unqualified and incompetent people setting themselves up as hedge fund managers. This is a very powerful incentive for literally thousands of people to set up new fake hedge funds every year – and most have no experience running money whatsoever. The Securities and Exchange Commission has done a less than stellar job of supervising and registering hedge fund managers. Commodities traders and managers whose funds deal with investing in any type of futures market must be registered with and are regulated by the CFTC.

What’s important is to close any regulatory loopholes that could cause a systemic problem due to the actions of one or more funds. The shenanigans of Bernie Madoff hurt not only his investors but also the hedge fund industry at large although he was NOT running a hedge fund operation. It did not help that the media failed to serve their primary mandate to inform and educate. Instead, they over-dramatized, sensationalized and misrepresented the issues; exacerbating the damage caused to the honest and innocent managers by Madoff’s actions.

The point is not to predict the future, but it is possible, for example, to identify trends. People need to understand the risks involved. There’s no such thing as a “riskless” investment.

Your feedback as always is greatly appreciated.

Thanks much for your consideration.

Sources

Born, Brooksley. Interview on Frontline. WGBH Educational Foundation. 20 October 2009. Retrieved from:

http://www.pbs.org/wgbh/pages/frontline/warning/interviews/born.html

Read more: http://www.pbs.org/wgbh/pages/frontline/warning/interviews/born.html#ixzz1PrXCELpb

Fulford, Mike (2010) Opinion on the Usage of Hedge Funds. Tools For Money website. Retrieved from:

http://toolsformoney.com/hedge_funds.htm

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