Hedge Fund Worries

New York Fed president Tim Geithner is worried that market failures such as "lack of information, incentive conflicts and moral hazard" are causing risk levels in hedge fund markets to grow and, if the growth of risk continues, increased regulation of the markets may be required. He's cautious because, "With too much government intervention, innovation is constrained and the system is stifled." However, "With too little, the probability of systemic crisis may rise to levels that are unacceptably high":

NY Fed chief warns on hedge funds, by David Wighton and Peter Thal Larsen, Financial Times: Hedge funds may need to be regulated because of the increasing risk they could pose to the financial system, according to the head of the New York Federal Reserve... Geithner ... said supervision of core banks and investment banks had encouraged the transfer of risk to unregulated institutions such as hedge funds.

Their growth was now increasing the risk that if they ran into problems, it could damage the regulated core. ... Mr Geithner said that, for the moment, regulators should continue to focus on encouraging the banks and brokers that lend to hedge funds to improve their “counterparty discipline” of the funds.

But, over time, the growth in hedge funds “will force us to consider how to adapt the design and scope of the supervisory framework to achieve the protection against systemic risk that is so important to economic growth and stability.” ...

Mr Geithner ... [said] ... the ... effectiveness of this market discipline may be compromised by “market failures” such as lack of information, incentive conflicts and moral hazard. “Supervision and regulation have the potential to help mitigate these sources of market failure,” he said.

We don't know enough about these markets, particularly their vulnerability to large shocks. [Update: The WSJ's Greg Ip has more].

Comments

[reason]

I have said before, that there is something else that worries me about hedge funds. They are a misuse of limited liability. They allow rich individuals to limit their exposure to very risky leveraged positions.

[reason]

One thing I should add, this misuse of the limited liability status is not limited to hedge funds. Enron was another example - or is it. Maybe Enron was just another hedge fund after all.-) Limited liability companies shouldn't make highly leveraged bets full stop.

[a]

"We don't know enough about these markets, particularly their vulnerability to large shocks."

I guess we know about traditional banks and their vulnerability to large shocks. Or do we?

[Steve Waldman]

Concurring strongly with reason's point above, limited liability investment funds have every incentive to take on leverage recklessly, so long as they can find a counterparty foolish enough to lend the money. (More here)

In an era where huge funds of money are lent by the official sector for reasons other than maximizing direct return, and where the most foolish lender sets the price of securitized credit, economists should not be surprised when fund managers respond rationally by making large gambles with other people's money. This applies both to much maligned hedge-funds, as well as to often lionized private equity.

I prefer changes in market structure and technology to regulation, but the problem seems to me quite real.

[Richard]

Not coindidentally, there's been a huge proliferation in exotic derivative products which cater to hedge funds and assist in taking on large levels of systemic risk.

The "2 and 20" reward structure of most hedge funds also reeks of moral hazard, as it provides a very large incentive to go and get today, while the LLC structure shelters earlier gains.

Perhaps removing the LLC designation for hedge funds is in order; failing that, perhaps the requirement of reserves. Yes, that goes against the nature of the business (they are not insurance companies), but providing an incentive for one-way bets which cannot fall below zero cannot end well.

[anne]

http://www.nytimes.com/2006/09/19/business/19hedge.html?ex=1316318400&en=2732df5d691f1629&ei=5090&partner=rssuserland&emc=rss

September 19, 2006

A Hedge Fund's Loss Rattles Nerves
By GRETCHEN MORGENSON and JENNY ANDERSON

Enormous losses at one of the nation's largest hedge funds resurrected worries yesterday that major bets by these secretive, unregulated investment partnerships could create widespread financial disruptions.

The hedge fund, Amaranth Advisors, based in Greenwich, Conn., made an estimated $1 billion on rising energy prices last year. Yesterday, the fund told its investors that it had lost more than $3 billion in the recent downturn in natural gas and that it was working with its lenders and selling its holdings "to protect our investors."

Amaranth's investors include pension funds, endowments and large financial firms like banks, insurance companies and brokerage firms. The Institutional Fund of Hedge Funds at Morgan Stanley was an investor in Amaranth; as of June 30, it had a stake valued at $124 million. The turnabout in the fortunes of the $9.25 billion fund reflects the decline in energy prices recently; natural gas prices fell 12 percent just last week.

Yet also last week, Charles H. Winkler, chief operating officer at Amaranth, had met with prospective investors at the Four Seasons restaurant in Manhattan and reported that his fund was up 25 percent for the year, according to a meeting participant. Days later, rumors began circulating that Amaranth was losing money in one of its natural gas bets, a trade that had generated enormous profits for the fund in recent years.

Late in the week, the fund's traders began dumping large stakes in convertible bonds and high-yield corporate debt, securities that could be sold without disrupting the market.

Mr. Winkler did not return a phone call seeking comment.

The scale of Amaranth's losses — and how quickly they appear to have mounted — was the talk of Wall Street yesterday, as was speculation on how much the bet was leveraged, or made on borrowed money. Still, there were no signs of ripples on the financial markets as a result....

[Cassandra]

Many of us in the business were stunnned by Amaranth's +13% month (in April, I believe it was) when the average fund was up a "just a bit". For the risk exposure &/or leverage required to generate such an outsized return frequently cuts both ways.

There are rare occasions where the moons align and "everything goes right large" reflecting a positive tail-event when one is positioned correctly, hedged well and not assuming excessive risk and or leverage. But such occasions are - it must be said irrespective of what anyone tells or pitches you - incredibly few and far between. Such an event may indeed reflect an investor's prescience and perfection, but more often than not it is a tell-tale. But greed and peer-pressure often prevents even the most intelligent and savvy of investors from paying heed to the most blatant flashing red lights and asking the tough question: am I prepared to accept the outsized risk in exchange for the outsized return?

[Richard]

I seem to remember a demonstration showing that a "fund" based upon parallel processes, all using the St. Petersburg Paradox (your bet doubles your money half the time, half the time you lose all. The expected return of this strategy is infinite). The returns are exceptional - until it crashes.

I suspect that hedge funds and their ilk achieve healthy returns and higher Sharpe ratios only by taking on higher skew and kurtosis (i.e., the risks are reflected only in the higher moments). It also seems likely that they are taking on an unknown amount of systemic risk.

[Ferocious_Imbecile]

Don't worry about the $500 trillion derivatives market...the Plunge Protection Team will get Bernanke to print trainloads of US dollars to dump into the hedge funds to keep them afloat...lol...sure they will.