In These New Times

Hedge funds could be next victim Montreal Gazette

PETER HADEKEL
Freelance

Friday, September 19, 2008

One wag at a financial conference here yesterday likened the current chaos in the markets to a TV reality show.

Working title: Survivor Wall Street.

Investors are wondering who will survive the brutal shakeout now under way and who will be voted down in the market panic that has spread over the last two weeks.

The next victim in the crisis may well be the hedge fund industry, said Donald Coxe, chief portfolio strategist for the BMO Financial Group.

After a speech to a Montreal conference on Governance and Financial Markets organized by the Institute of Corporate Directors, Coxe said leveraged hedge funds are dangerously exposed. These are private, unregulated pools of capital that use huge amounts of leverage to bet on the direction of financial markets.

The number of hedge funds has grown eight-fold this decade, to reach an estimated $6 trillion U.S. in assets. Many of its so-called assets may be in financial derivatives that are now under stress.

While commercial banks typically have $10 of investments backed by every dollar of capital, and investment banks like Goldman Sachs or Morgan Stanley may have $20 or $30 of financial bets backed by that same dollar, the ratio for hedge funds can be 50:1 or more.

“I believe this is going to be the next pressure point in the system,” Coxe said

A major market panic in the late 1990s was provoked by the collapse of hedge fund Long Term Capital Management. With the power of leverage, it had used $2.3 billion in capital to buy $125 billion in securities that went bust.

Two Nobel Prize-winning economists at the firm had supposedly come up with a fail-safe model to predict movements in financial markets. But their model was blown up by reality.

In a controversial move, the Federal Reserve under Alan Greenspan engineered a bailout of Long Term Capital, to prevent a global panic from getting worse.

That decision was “disastrous,” Coxe said, and surely won’t be repeated this time by policy-makers such as Ben Bernanke at the Federal Reserve and Henry Paulson at the U.S. Treasury.

“It now becomes messy, because we are losing the investment banks,” Coxe said, referring to the liquidation of Lehman Brothers and the fire sale of other Wall St. pillars such as Bear Stearns and Merrill Lynch.

“There’s no way that we can have the (Federal Reserve) bailing out hedge funds.”

The big question about the funds is: who lent them all that money? If they do go down, what collateral damage will they cause?

Coxe said yesterday that in many cases, the funds have borrowed money from each other so, to some extent, there would be a cancelling-out effect if they fail.

But banks and investment dealers also have financed them. Both Bear Stearns and Lehman Brothers did a lot of business with hedge funds, and it’s no coincidence that both have fallen.

One might be tempted to say good riddance to hedge funds. After all, they have speculated wildly in financial markets and created enormous volatility that has hurt individual investors.

But it may not prove so easy to untangle them from the rest of the financial system.

The Federal Reserve’s decision to bail out insurance giant AIG, for example, was intended in part to protect the $400-billion-market in insurance policies that cover bond defaults. These are known as credit default swaps.

Hedge funds in many cases were the ones writing such insurance policies for large commercial banks. So if hedge funds fail, banks would not be able to collect on those insurance policies.

That’s just one reason why this financial crisis is proving so hard to contain.

phadekel@videotron.ca

© The Gazette (Montreal) 2008