From Reuters:
NEW YORK (Reuters) - Hedge funds may now pose the biggest risk of a crisis since 1998, when the implosion of Long-Term Capital Management threatened the global financial system, the New York Federal Reserve said on Wednesday.
The statement represented the bank's sternest warning to date over the possible fate of the $1.4 trillion industry.
"Recent high correlations among hedge fund returns could suggest concentrations of risk comparable to those preceding the hedge fund crisis of 1998," according to a paper written by Tobias Adrian, capital markets economist at the central bank.
So I looked at the paper and the abstract says in part:
...A comparison of the current rise in correlations with the elevation before the 1998 event, however, reveals a key difference. The current increase stems mainly from a decline in the volatility of returns, while the earlier rise was driven by high covariances—an alternative measure of comovement in dollar terms. Because volatility and covariances are lower today, the current hedge fund environment differs from the 1998 environment.
I'm still concerned, but I'm not yet losing sleep over it.
I'm a neophyte in macro analysis; however I have a few questions that come to mind.
1. How is it that the successful hedge funds make that much money; specifically the projected earnings of the top 20 or so? Are they from short-term trading strategies or from derivative contracts that are highly leveraged? If they gain, who will lose - somebody must fall in this category...
2. Where are these hedge funds incorporated?
Are they alloted the protection should they fall under; whereas they take the risk/high-reward now knowing that they are covered?
With the industry termed "unregulated"; isn't a crisis like LTCM almost assured to happen?
Your thoughts and feedback is appreciated.
Thanks!
1. I am not an expert on their specific trading strategies, so I can't comment there. However, the typical hedge fund is quite heavily leveraged.
You ask who loses when they gain. There is no identifiable loser in the normal course of events--just like there is no identifiable winner in the event that the hedge fund loses. The fund is essentially taking on risk that would otherwise be spread among participants in the market. In that way, they play an important role in the system. In a sense, they are an arbitrager of risk. If their gamble pays off, they win at the expense of the vast number of financial players who each bet small amounts against them.
2. Many are offshore. They are not regulated in the same way as, say, a mutual fund is regulated. They are very different instruments. Hedge funds, by their very definition, are for a small number of large investors. (Whereas, a mutual fund is for a large number of small investors.) So they are organized more like a partnership and avoid the regulation of other funds. The investors in a hedge fund are people with a lot of risk capital.
If you have read a little bit about the LTCM crisis, you probably know how all that played out. I won't repeat it here, but there are, of course, many places to go to read that story. The bottom line is that something like that could happen again, and if it does it will, with almost certainty, be for a reason that no one (or nearly no one) saw coming. And it is for that reason that a large concentration of risk as alluded to in the paper is a bit of a concern.
But as the paper also points out, the last crisis was marked by high covariances while the current situation is being caused by lower volatility. High covariances are more worrisome because of the possibility of contagion, as we saw happen in the 1990s crisis. Hence, it's not as bad as the Reuters headline would lead you believe.
Furthermore, the main reason to be worried about hedge funds at all is because of the possibility of contagion and systemic risk. That is, if a hedge fund gets into trouble, it may fail to make payments to its creditors. This can cause its creditors to default on their creditors, and so on down the line. This is the sort of thing that can cripple a financial market as it cascades through the system. Everyone has an interest in making sure this doesn't happen. How best to do that is an unsettled question. Ben Bernanke gave a speech on the subject about a year ago:
http://www.federalreserve.gov/Boarddocs/speeches/2006/200605162/default.htm
You might also be interested in this piece by Christopher Neely who gives a blow-by-blow account of how the Fed reacts to crises like LTCM (as well as 9/11 and the 1987 market crash).
http://research.stlouisfed.org/econ/cneely/MarApr04Neely.pdf
Interesting "letter to the editor" write-in I had saw in the Financial Times yesterday (May 7)
By Janet Tavakoli, President, Tavakoli Structured Finance, Chicago, IL
"“Tavakoli’s law” states that if some hedge funds return soar above market averages. Then others must crash and burn. If one accepts that passive investors are indexed and reap average market returns, then active investors that reap extraordinary returns above the market average are offset by active investors who experience extraordinary losses in aggregate.
The current situation may indeed be different from that presented by LTCM, but it may be even more alarming not less alarming. Due to the use of structured products and derivatives, hedge funds can take on hidden leverage above and beyound that which can be explained by polling prime brokers. Furthermore illiquid structured products will experience a classical collateral crash when hedge funds try to liquidate these assets to meet margin calls or collateral “cures”"
I don't know if you prescribe to Tavakoli's law; this is the first I've heard of it; but I find myself agreeing in theory.
Thank you for the links.
Who are the "others"? Other hedge funds? I'd like to see the evidence. Certainly it's not a theoretical position. I suspect she means other "active investors" (next sentence). If so, then she's saying the same as I said here:
"If their gamble pays off, they win at the expense of the vast number of financial players who each bet small amounts against them."
The reader can decide which version is more descriptive.
As for the second part, I'm not sure if she is directly referencing the Fed paper to which I linked. That is, is she more worried about the current situation because of what she read in that paper, or because of how she assessed the situation beforehand? I suspect the latter, but am prepared to be corrected. Her "classic collateral crash" is my "systemic risk". So we're not worlds apart on this. But I confess to being a bit less worried than she. Contagion is more of a worry when covariances are high, so that is one thing to watch.
Good work Bill, I linked back to this because it ties in to Systemic Risk & Group Behaviour.
Thank you Bill for the comments -