In my earlier “bubbles” diaries, I’ve written both about the real estate bubble and the hedge fund worries in the markets. The conversation in the comments has focused more on the housing topic, which is more familiar to most, so I’d like to dedicate a specific diary to the hedge funds story, which is just as scary as the housing stuff, and could hurt us all just as badly.

A hedge fund is just an investment fund, and what individual funds do shouldn’t matter. Plus, as their names indicate, they supposedly “hedge” their risks by the use of sophisticated financial insturments and their investments are not necessarily riskier than other investment funds, quite often the opposite.

Hedge funds are unregulated, highly levarage, prone to herd like behaviors, and they have been pushed by absurdly cheap money to seek ever riskier ways to invest their money.

The problem with hedge funds is that

  • they are not regulated, so it is hard to have information about what they do and what’s their real financial situation at any time;
  • they are highly leveraged (they invest a lot more than the actual funds they have raised, as they borrow a lot of money as well);
  • they seem to move in herds, all piling in into similar instruments or strategies at the same time, and causing massive shifts in financial markets that can present systemic risk. Many of these instruments, like CDOs, are untested in times of crises.

Most of all, in their quest for high short term returns at a time of high liquidity (thanks to the Fed’s incredibly lax monetary policy which has flooded the markets with cheap money), they are driven to take increasingly risky bets to improve their income.

Last week, I pointed out to this piece by Steve Rattner, a very senior banker (former deputy CEO of Lazard), in the Financial Times, which is worth quoting again:

Hedge funds will have to kick the junk habit

we need to give equal attention to a more basic problem: the vast quantity of old-fashioned imprudent lending that has gone almost unnoticed over the past two years.

Junk bonds have become dramatically junkier.

(…)

When the tide goes out, the size of the investment losses may prove staggering. Following record high-yield issuance last year of $147bn (€117bn), there are now nearly $1,000bn of outstanding high-yield bonds. In 1990-1991 and 2002, default rates exceeded 10 per cent. The amount of outstanding paper was lower then, so a high default rate today would be much more costly. Today’s low default rate – only about 1.6 per cent in April, compared with a historic average of around 5 per cent – has lulled high-yield bond buyers into a false sense of security.

There is an old saying: “rising tides lift all boats”. This is precisely what has been happening in the financial world. Easy, extremely cheap money has made it possible to borrow more at no apparent extra cost, and thus to put more money on the table for asset purchases, fuelling price rises. What is true for houses is also true for financial paper. Rising prices for debt effectively means that remuneration for the risk goes down (interest rates go down), which means that if you are an investor and want better returns, you need to invest in ever riskier stuff.

And that’s what’s happening.

Staggering amounts of money have been invested in increasingly risky paper – one trillion dollars worth of junk debt, which only looks safe in a context of cheap money and expensive assets.

Quoting again Steve Rattner:

Even paper that does not default carries risks for the holders. In 2004, a frothy market squeezed the difference in yield between high yield bonds and US Treasuries down to 3.14 per cent, the lowest ever. Now the market has begun to realise its folly but despite recent interest rate increases by the US Federal Reserve, lots of low quality paper is still trading with single-digit yields – not much of a return for a double-digit chance of a bankruptcy.

In their desperate quest for returns, anything that paid a little bit more than Treasuries was purchased, and prices do not reflect the underlying risk anymore.

As I have written previously, and as Mr Rattner also pointed out in his piece, CDOs and other such exotic instruments are essentially untested in crisis scenarios, and the ripples from the GM and Ford downgrades to “junk” debt status have been pretty worrying. Goldman Sachs has come up with an estimate of 1 billion dollar losses for hedge funds from that episode, and this is widely seen as a conservative estimate. And that was just on the basis of news from two companies (admittedly big borrowers), not macro-economic news like Fed rates or growth prospects.

Other believers take refuge in the strong US economy that has powered corporate profits, which in turn have generated the cash needed to meet debt obligations. But high-yield borrowings often take years to repay and the dicier credits need everything to go right.

AGAIN, that same story: only hope, of wishful thinking, makes these investments look sane in any long term perspective.

Timing a big turn in the credit markets is as difficult as predicting the next recession. An economic downturn would certainly trigger trouble, as might a few high profile defaults. Lending to highly leveraged companies would probably dry up, sparking a cascade of defaults.

The problems that appear here is that:

  • with little information coming from the funds, it is hard to know what risks they are taking (this is a big difference with banks which are a lot more tightly regulated);
  • the new instruments like CDOs are distributing financial assets and risks in totally new ways around the financial markets. While this is supposed to make it possible to allocate risks better to those that are the best positioned to carry them, the complexity of these instruments, and the sheer amounts out there make it very likely that some spectacular losses will appear in unexpected places when corporate defaults take place (as they will), and the follow on effects will be totally unpredictable. For instance, banks are reducing their exposure to certain kinds of risks by repackaging them and reselling them in various tranches to investment funds. But as they are financing the leverage of these funds at the same time, they may be taking on indirectly the very risk they thought they had sold. Again, the lack of information coming from the hedge funds makes that difficult to assess, even for their banks.
  • the short term focus of the funds makes it more likely that they come in and out of markets very quickly, with little attention to long term consequences. For instance, as I noted in another recent diary, hedge funds seem to be the main buyers of dollars and US Treasuries these days, and they do not have the strategic reasons that entities like the Centrla Banks of Japan and China have to hold dollars. If they start selling, the effcts could be quite brutal. (And if you think the euro is not a threat anymore, read this again. And again).
  • an additional issue which was raised in yesterday’s Financial Times is that hedge funds have grown so fast that they are apparently having trouble finding enough competent administrators, vital players in the industry:

Fears over workload of hedge fund staff

Administrators overseeing about a third of global hedge fund assets are so overloaded they risk mispricing complex credit instruments, giving rise to concerns about financial stability, London bankers warn.

Bankers say the Dublin-based teams, which look after global hedge fund assets totalling some $300bn, are finding it tough to attract and retain vital staff.

The pressures come at a critical time in the hedge fund industry as administrators value complex financial instruments in which there is no liquid market.

Credit default swaps and collateralised debt obligations in particular have been under the spotlight because hedge funds are believed to have got on the wrong side of a downgrade of debt early last month.

“You have the combination of strained resources among administrators combined with a lack of expertise in valuing these complex securities. That is putting a lot of strain on the system,” said Rod Barker, head of prime brokerage at CSFB in London.

Hedge fund administrators are critical, if low-profile, intermediaries in the fund administration business, providing independent valuations to investors.

(…)

The processes involved in valuing the positions of some hedge funds were difficult to automate, particularly if they were not exchange-traded, she said. Automation was also more difficult if a fund was multi-currency.

(That’s the people in charge ok assessing exactly what the fund’s positions are worth. Pretty important, you’d think?)

The most recently reported numbers seem to suggest that hedge funds have survived the GM downgrade storm:

according to Merrill Lynch’s global hedge fund monitor, published yesterday, the average diversified fund was flat at -0.01 per cent in May and was down by less than 2 per cent in the year to date.

Elsewhere, five of six largely US hedge fund benchmarks covered by Dow Jones posted gains last month. For the year to date, four of six indices monitored by Dow Jones – merger arbitrage, distressed securities trading, equity market neutral and event-driven – were up. Convertible bond arbitrage traders had the worst losses, Dow Jones and Merrill Lynch said.

The returns are not those usually sought by hedge fund investors and do not justify the fees charged by managers, but they will allay fears that hedge funds will have to sell from a position of weakness into declining markets.

But, although I bring that up in the interests of objective reporting, I don’t believe it is significant. The GM downgrade was one of the most expected moves on the markets (even if its exact date was a surprise) and it should not have created such panic (it WAs panic, for a while) and such worries about the health of the financial system. Now imagine what could happen if a serious – and unexpected – crisis arises. say an ew acocunting scandal at a big firm that goes bankrupt. Or a major disruption (for whatever causes, including innocuous ones like the weather) to the oil production facilities of any big oil producing country. or a big terrorist attack. Or a big earthquake in the US. Or a big political scandal engulfing the White House (one can dream…)

The financial system is unusually vulnerable today. As written above, a lot of the current investments make sense only if everything goes well. The crisis could come in one of the following ways:

  • a run on the dollar of the funds suddenly jump out of the positions they have accumulated;
  • a banking crisis if a major corporate goes bankrupt, and its debts are found to be held in unexpected places that cannot cope, and pass the burden back to the banks that thought they had downloaded the risk, amplified by leverage effects;
  • a brutal rise in interest rates as inflation fears suddenly cause a bond crash.

As a final note, one of the most striking elements of today’s markets is precisely the fact that long term interest rates as so low (instead of creeping up as my last scenario would suggest). As Big Time Patriot pointed out in this diary, even “Bubbles” Greenspan cannot explain it. Dallasdoc has a suggestion in a comment in my previous financial diary, which is to say that this represents a flight to quality by the hedge funds (or the smarter ones anyway) – i.e. the people that realise that the current situation is unsustainable and are putting their money in the least risky place possible.

The consequence, as I wrote in that diary, is that the yield curved has flattened, which is always an ominous sign of bad things to come (usually, recessions).

Again, this is the quandary Bubbles Greenspan has put us in:

  • low interest rates have created financial asset price inflation, which force fund managers to invest in increasingly risky paper to get the returns investors have grown used to and require
  • new financial instruments have made such riskier bets a lot easier to make, and they have shifted risks around the system, for vast amounts,  in unknown ways
  • the inflation threat (seeping from these asset bubbles, and from the oil price increases) forces the Fed to increase its short term rates, threatening the riskier investments and the whole house of cards
  • paradoxically, the smart money is piling into US Treasuries, keeping long term interest rates low and maintaining the appearance that all is well for the US economy.

With the oil prices still increasing, and Europe’s current political crisis making the US economy an apparently better bet (despite its record breaking budget and trade deficits), pressure is building on all sides, and is probably beyond the control of anyone to stave off. What will ultimately trigger the crisis? Who knows, but it’s getting closer.