Chapter 6: Executive Summary – Hedge Funds in the Aftermath of the Financial Crisis

From the book “Restoring Financial Stability: How to Repair a Failed System”. Section II: Financial Institutions

Background

The available data show a remarkable diversity of management styles under the “hedge fund” banner.  Hedge funds are major participants in the so-called shadow banking system, which runs parallel to the more standard banking system.  Hedge funds have the ability to short sell assets, which allows them to use leverage, and leverage means that their equity value, absent limited liability, can go negative.  Hedge funds add value to the financial system in a number of ways: (i) by providing liquidity to the market; (ii) by correcting fundamental mispricing in the market; (iii) through their trading, by increasing price discovery; and (iv) by providing investors access to leverage and to investment strategies that perform well.

Hedge funds have certainly been in the thick of the current financial crisis. For example, it was the collapse of two highly levered Bear Stearns hedge funds that initiated the collapse of the subprime-backed collateralized debt obligations (CDOs). But hedge funds didn’t cause the growth in the subprime mortgage market, or make housing prices collapse so that subprime loans would default, or force financial institutions (GSEs, commercial banks and broker-dealers) to hold $785 billion worth of CDOs on their books. In fact, there is very little evidence to suggest that hedge funds caused the financial crisis or that they contributed to its severity in any significant way. That being said, hedge funds, or subsets of hedge funds, may still generate systemic risk that imposes externalities on the financial system.  A fund that is sufficiently large and levered (like Long Term Capital Management [LTCM] in 1998) could generate systemic risk.

The Issues

Hedge funds are, for the most part, unregulated.

At first glance, not regulating hedge funds seems patently unfair, as it allows them to take advantage of regulatory arbitrage, namely the ability to offer intermediation services in direct competition with regulated institutions like banks.  However, this ignores the substantive advantage that banks have through either the explicit guarantee of deposit insurance or the implicit “too-big-to-fail” guarantee.

The immediate policy issues are the following:

  • Should hedge funds be exempted from any of the financial system regulations aimed at managing the systemic risk in the financial system (and the associated externalities)?
  • Under what circumstances should hedge funds be subject to additional regulation?
  • What forms should the additional regulation (if any) take?

Policy Recommendations

  1. By the proprietary nature of their trading, hedge funds are not very transparent to the market. Lack of transparency of financial institutions can magnify financial crises due to counterparty concerns. A minimal condition would be that, in order to help regulators measure and manage possible systemic risk, hedge funds (of sufficient size) should be required to provide regulators with regular and timely information about both their asset positions and leverage levels.
  2. Since hedge funds do not receive guarantees from the government and so are not subject to the moral hazard problems associated with such guarantees, any additional regulation of hedge funds over and above that advocated above is in general not warranted.  The exception is when hedge funds impose externalities on the financial system. For example, if a hedge fund falls into the class of large complex financial institutions, then that fund needs to be treated as a systemic institution to be regulated (and taxed) as such.  We also make several suggestions for cases in which a subset of funds (“systemic-risk” subset) together imposes externalities on the financial system.
  3. Managed funds (mutual funds, money market funds, SIVs, and hedge funds) are subject to bank-like runs on their assets. These runs can trigger systemic liquidity spirals. In the current crisis, both the commercial paper market (in August 2007) and money market (in September 2008) seized up when a managed fund in these markets stopped redemptions due to exposures to subprime AAA-rated CDOs and Lehman Brothers’ short-term debt, respectively. Hedge funds in a systemic-risk subset may need regulation that discourages investors from withdrawing funds after bad performance, since bad performance (and lack of transparency) by a fund may lead to a run on the fund’s assets under management. Any such regulation would impose costs on the hedge fund investors, which must be balanced against the benefits obtained from the systemic risk reduction. We propose a market-oriented solution that weighs this balance.
  4. A more controversial question is whether special regulation is needed for hedge funds with respect to public transparency of asset positions and leverage (e.g., along the lines of more Form 13F-like filings). This decision involves balancing the benefits and costs to hedge funds and investors. The largest concern relating to transparency is counterparty risk, and these counterparty issues are most relevant with OTC derivatives. It may be that by fixing the cracks elsewhere in the system, e.g., creating a clearing house/exchange structure for large OTC derivative markets,  the transparency goal can be reached without having to impose onerous regulation on the hedge fund community.

Summary – In eighteen short, targeted and definitive White Papers – each tracing the core of a problem facing the financial sector, evaluating the policy alternatives, and recommending a specific course of action – members of the Stern Faculty apply sound principles and provide a blueprint for reconfiguring the financial architecture and regulation after the crisis. (In the following days these 18 Chapters will be published here at RGE Monitor)

4 Responses to "Chapter 6: Executive Summary – Hedge Funds in the Aftermath of the Financial Crisis"

  1. Andrew G. Bernhardt   February 7, 2009 at 12:23 pm

    I’d probably claim a hedge fund is a type of fund similar to an ETF (exchange traded fund), or mutual fund, that either does or does not have daily liquidity, dependent on how it’s setup by its owners and operators. It’s “collections,” the investment capital of its investors, can be invested in any number of strategies and/or allocaitons just like a mutual fund can, it’s important to review and examine the prospectus. Basically, a hedge fund costs significantly LESS to operate versus an ETF or mutual fund— due to fewer regulatory hoops to jump through. Additionally, rather than e.g. a mutual fund that charges about on average 1.47% per year of a management fee, the hedge fund charges about 2% mgmt fee, and also the fund manager gets to keep approximately 20% of all profits generated (essentially eroding the return from 100% gains to the investors to 80%). The fund’s performance is just as good as the fund manager can accomplish, just like a mutual fund mangaer, or ETF.

    • Andrew Bernhardt   February 7, 2009 at 12:25 pm

      Hopefully the fallout of the Bush Administration will not mean that the Securities markets, derivatives, hedge funds, mutual funds, ETFs, etc. hopefully they will not be regulated to kingdom come! Less hasty regulatory changes would be greatly appreciated.

  2. Guest   February 7, 2009 at 12:26 pm

    seems as though it’s every asset class that is deteriorating too, housey, commercial property, securities, currencies, everything. Hell, even my car is dropping in value.

  3. Andrew G. Bernhardt   March 2, 2009 at 11:51 pm

    What Wrecked the Economy and What Went Wrong:U.S. 110th Congress & Legislature has done the following:Implemented Rule Changes, Changes Regulations, and Devises New Rules including: (approx. dates)1. Generally Accepted Accounting Principles, 20002. Sarbanes-Oxley, 20013. Allows 0% down on real estate, 20024. Validates, ratifies, an approves of 8 HUGE Federal budget deficits 00-085. Abolishes the downtick rule, 2007 (a rule that never should have existed in the first place)6. Coerces New Mark-to-Market Accounting, of Level III assets on Balance Sheets of Large Entities, ’067. Validates the Constitution annually. Which is despicable! It includes shameful idiocy e.g. “the right to bear arms,” and other hoaxes, lies, and ridiculousness including “sovereign immunity,” “due process,” “checks & balances,” and other direct causes of the incoherence of the USA— Consequently there are on average 20,000 to 30,000 murders per year, giving the US an extremely high violent crime rate- including murder, homicide, armed criminal action, bank robbery, and aggravated battery.8. By not prohibiting IUDs, birth control pills, and “the shot” women delay marriage, and have fewer children, later in life, this ultimately strains social security, strains payrolls tax collections, and labor force figures— as well as causing directly demographic shifts that are and will be unprecedented and bad.The Executive Branch & The Legislature Are Effectively:Designing and implementing rule changes, and new rules that make the USA more chaotic than it already is, wrecking the solvency of financial institutions, and this challenges the coherence of society at large. They have destroyed the solvency of banks, brokerages, insurance, and reinsurance companies, sovereign entities globally, and consequently the economy and capital markets have suffered. Large amounts of investment capital has been lost globally, and the gap between the rich and the poor has unfortunately narrowed sharply. By borrowing trillions of dollars (for a war against a terrorist hiding in a cave in the mountains of afghanistan, and the sovereign state of iraq) they have crowed out borrowing, crowded out investment, and incited a credit crunch. They have diverted money away from good social causes like the currency, the stock market, the real estate, CMOs, and CDSs. They have incited two recessions. They are responsible for causing directly what I describe as “The Greater Depression.” The Congress and the current and previous administrations are a disgrace— in that they borrow more to solve problems induced from too much earlier borrowing! Economic development and economic activity has ground to a halt. Political and civil unrest has erupted abroad, and I wonder a lot why it has not in the USA. The economy is weakening substantially, and the credit markets have seized up, loans are difficult to obtain despite low interest rates. The people are losing on all fronts, including the securities markets and homes (real estate).So, ‘What Can I do?’ ‘What Should Happen?’ You may ask—On a behavioral economics note, everyone should act like those in L.A. California! They should pretend that their home is worth $15-million-dollars, and that it rises at +20% per year! Then speculators would re-emerge and good times would come out of the wood work. People could then act like their home is an ATM-machine, and they could effectively take money out of it, with some mortgage equity withdrawal for consumption! We need unfounded, unwarranted, baseless, silliness when it comes to real estate pricing and real estate speculation— to fuel consumption.Secondly, we can wait for the War to end! The war will be declared over on month number eighteen of the Obama administration (June of 2010). With real estate potentially reversing or holding steady starting roughly June of 2010, and with the war declared over and victorious in June of 2010, I see these two events, as potentially major catalysts for a bull run on the stock indices. At this hypothetical point in time though investors should re-examine the debt of the USA and its impact on the economy.~ Andrew G. Bernhardt, St. Louis, Mo.