The Truth About Hedge Funds and the Financial Crisis
Separating economic fact from economic myth
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GoogleEditor’s Note: Reason columnist Veronique de Rugy appears weekly on Bloomberg TV to separate economic fact from economic myth.
Myth 1: Hedge funds are highly leveraged.
Fact 1: The market exposure of most hedge funds is less than twice the percentage of assets under management.
Contrary to commonly-held belief, highly-leveraged hedge funds are the exception rather than the rule. Hedge funds use short sales and derivatives to manage risk and reduce losses when the market is performing poorly. In addition, hedge funds often borrow funds or use other forms of leverage to magnify gains.
Furthermore, hedge funds take no part in the process of underwriting new securities. Nor do they serve as brokers or dealers of securities and derivatives. These funds have a single line of business—asset management—and they typically use relatively small amounts of leverage to finance and profit from their investment activities.
A 2007 study of hedge fund leverage by Adrian Blundell-Wignall, a deputy director of the Organization for Economic Co-operation and Development (OECD), which included leverage from borrowed funds and implicit leverage from derivatives, estimated that average hedge fund leverage was 3.9-to-1 (which means that for every $3.9 in hedge fund assets, $1 was equity and the rest was borrowed (or the economic equivalent of borrowing was achieved by using derivatives), with the bulk of the leverage coming from derivatives. In 2008, the International Monetary Fund (IMF) estimated that average global hedge fund leverage from borrowed funds had a ratio of 1.4-to-1.
The chart above is based on data from the McKinsey Global Institute; note that it measures leverage in a slightly different way than the OECD does (gross leverage here is assets plus liabilities divided by assets) but the overall outcome is quite similar. As you can see, even at its peak, total leverage in the hedge fund industry was not more that 3.5 times the level of assets under management—far below the leverage ratio of banks.
For context, consider that banks are typically leveraged at least 10-to-1 and investment banks are usually leveraged at least 20-to-1. In the case of investment banks, this means that for every dollar actually held by the investment bank, it had borrowed between $20 and $30.
More interestingly, as New York Law School professor Houman Shadab notes in his article “Hedge Funds and the Financial Crisis,” the contrast between the levels of leverage in these different components of the financial sector became even more pronounced in the lead-up to the financial crisis. For example, banking sector leverage usually ranged from 12-to-1 to 17-to-1 while major U.S. investment bank leverage became as high as 33-to-1 in recent years.
Myth 2: The hedge fund industry’s tendency to take excessive risks, combined with a lack of regulation, was an important cause of the financial crisis.
Fact 2: Not only did hedge funds not precipitate the financial crisis, they did nothing to exacerbate it. If anything, hedge funds have helped the economy to recover more quickly.
It is a fact that hedge funds are not as heavily regulated as other financial institutions. Also, they are not required to register with investment authorities or report on their activities. As a result, it is often alleged that hedge funds played a role in the emergence of the credit crisis, contributing to volatility through short-selling and by selling shares as a result of de-leveraging and redemptions.
Editor's Note: We invite comments and request that they be civil and on-topic. We do not moderate or assume any responsibility for comments, which are owned by the readers who post them. Comments do not represent the views of Reason.com or Reason Foundation. We reserve the right to delete any comment for any reason at any time.
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I'd like to leverage Veronique's hedge fund, if you know what I mean.
Even if she does pronounce "ratio" like a foreigner.
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Veronique seems to have been very libertarian about cocaine before this interview.
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This is a good article but it does leave out one fact that many who are critical of hedge funds complain about -- the managers are paid on the "carried interest" method instead of normal income tax rules and thus avoid billions in income taxes.
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Re: shrike,
the managers are paid on the "carried interest" method instead of normal income tax rules and thus avoid billions in income taxes.
Oh, the humanity! I shred my garmets! People avoiding being robbed!What has the world come to when State thieves cannot be successful???
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What has the world come to when State thieves cannot be successful???
So when a certain class of people gets to exempt themselves from the income tax system, you're OK with it, even if it means more of the burden falls on everyone else with earned income to pick up the slack.
Your logic only makes sense if:
1) You believe that less revenue will cause less spending, which can't be farther from the truth.
or
2) You think social engineering is awesome when you relate to the beneficiaries. -
So am I evil for contributing to a 401k and IRA, claming my children and deducting my son's tution from my taxes last year?
Before you answer that IS EXACTLY YOUR ARGUMENT. My deductions increased the tax burden for someone else.
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Oh hell, I just noticed the Soros picture...
In will come the Beckerhead conspiracy idiots who will insist the great communist-fighting capitalist is a "socialist" simply because Beck said so and he fought creeping GOP fascism 2001-08.
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I'm reading "The Big Short" right now, which barely mentions hedge funds. It was the big banks appetite for creating mortgage backed bonds, built on loans they didn't understand. They'd extend bad loans (indeed created entire industries to collect them) so that they could bundle and sell the bonds. Then they started doing credit swaps, so they could create another layer of profit on top of the same loans. AIG was dumb enough to insure the swaps that it didn't understand, and when the loans started defaulting (as housing prices levelled) the resulting need to pay off those huge bets resulted in a cash crunch that caused the whole thing to go tilt. I've explained it poorly, but it is a great read.
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Indipolitic|3.18.11 @ 7:26PM|#
"I'm reading "The Big Short" right now, which barely mentions hedge funds."That's not all it doesn't mention.
From a review:
"But Lewis does not use his 264-page book to even apply one word - not one single utterance - against the malignant government policies behind much of this malaise."
http://www.amazon.com/Big-Shor.....233&sr=1-1 -
Quite true, and the book would be better with a policy discussion. However, it should be read anyway, he's provided an educated template -- you can insert the policy failings of your choice.
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I predict this will be over 400 comments.
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No. This is something we can all agree upon.
You need something about Palin, gay marriage, or the Ground Zero Mosque to rile up those kind of numbers.
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Eat something, Veronique, and keep it down.
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Like what I would do with Obama's man seed.
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i like
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Interesting.
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great posting.its worth reading.
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Agree that this is a great post.
Whenever I read Veronique's posts on fiscal conservatism, I'm reminded of a post from yesteryear by one of our resident Team Red trolls.
Enjoy
Karl|4.12.08 @ 8:05AM|#
Veronique de Rugy - who is this clown, must be French with a name like that. Crawl back into your institutional echo chamber with your theory's and numbers. Talk about Hit and Run, come back to me when the US has been attacked again but this time by Iranian made dirty bombs after the Democratic Surrender Monkeys have left Iraq. Sadly these events will probably take place in big cities like LA,Philli, NYC, DC, Boston, filled with unexpecting people and mostly of liberals. Us gun toting, bitter church goers with pray for you. I certainly don't need numbers and charts to identify who the enemy is and what they want to our country. -
That oldie-but-baddie was both funny and yet also left me bereft of several IQ points.
Though it is a relief to see Team Red admit that it has little regard/penchant for annoying numbers-n-charts-n-facts-n-stuff (which are evil al Qaeda inventions designed to convert our Christian children to homosexuality or some such).
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The only thing that needed to be said is that no hedge fund was bailed out by the federal government.
That is proof enough that they had nothing to do with it.
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Golly gosh,
It wasn't fault of the hedge funds,
Wall Street, Fannie, Freddie, & the banks weren't at fault either. They all say so.So nobody's at fault. It all just happened, like a meteor strike....
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The primary cause of the crises was wanton printing of debt by world central banks. Hedge funds egged this on by lobbying for more printing of credit, so they could borrow it cheaply.
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I don't know where to post this but when is Reason going to publish an article supporting the bombing of Libya? I know that's not an opportunity that fake libertarians would pass up... I guess it's related to this article considering the amount of taxpayer money wasted on it that we could just give back to the people that earned it which would help with the economy.
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The richer get richer and the poor get poorer. Nobody cares. It's all about survival of the fittest.
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Spoken like a true progressive.
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http://online.wsj.com/article/.....7884e.html
Yeah ok Hedge funds are so good! What a load of bull! They short commodities meanwhile driving them up to make them more profit! Who do you think is contributing to up tick in oil prices! The measly 1.5 million barrels exported from Libya is just a capitalization market!
http://money.cnn.com/magazines...../index.htm
Fools! -
How exactly do you short something and drive up the price? You're out of your element. Also, completely ignore that the BRIC economies were raging in mid ’08 and merely slowed down but did not recess (also it was not clear that the US was in big trouble at the point). Speculators can only artificially support a price for so long before it corrects.
Also, what is a "capitalization market"?
As for VDR. “Basically, it is a myth that hedge fund managers are risk takers who seek to maximize returns.” No it’s not. That describes every capitalist (even mom and pop). I believe you meant that it’s a myth that they seek to maximize returns without regard to risk. It’s minor but there are a few spots where your points are not quite clear (in the nuke article too). I’m just suggesting a little more thoughtfulness in your arguments.
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Last quote heard from Toni’s dad after abruptly leaving for good upon hearing that his wife was pregnant with their one and only child.
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very nice article on hedge funds and interesting too..
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