Hedge Funds, Oil Prices and Resulting Recession

In 1997, some observers feared an impending global recession as a result of the headwinds stemming from the Asian financial crisis. However, within two years, those fears had dissipated and were replaced with new concerns of irrational exuberance.

In contrast, the U.S. economic downturn beginning in 2008 initially appeared to be relatively benign. Most observers believed that a moderation in U.S. economic growth was essential to prevent an over-heating of the global economy. It was further believed that the problems confronting the U.S. economy were of its own making and would have little effect on global economic growth.

To be sure, some economists did forecast a U.S. recession in 2008 as a result of mounting home foreclosures. Such forecasts were however widely dismissed as being unduly alarmist during the first quarter of 2008.

It is essential for policy makers to understand the key differences between the 1997 Asian financial crisis and the 2008 global recession.

First, during the Asian crisis, the prices of commodities, particularly oil, declined as a result of falling demand. In fact, the price of oil plummeted to nearly US$10.00.

Second, global policy makers preemptively stimulated their economies, through monetary easing, in order to mitigate the downside risks stemming from the Asian crisis.

By contrast, in 2008 the prices of commodities skyrocketed during the midst of the U.S. economic downturn. That is, prices increased as global demand weakened, which can only be described as irrational market behavior. The resulting commodity bubble fueled worldwide inflation concerns.

Further, global policy makers in 2008 were compelled to restrict the growth of their economies, through monetary tightening, in order to mitigate the downside risks of inflation.

To be sure, were it not for the irrational behavior of commodity prices, global policy makers would likely have stimulated their economies in 2008 to mitigate the downside risks stemming from the weakness in the U.S. economy. Moreover, lower commodity prices would have further boosted global economic growth.

Indeed, the U.S. consumer would have demonstrated far greater resilience to the numerous headwinds confronting the U.S. economy were it not for irrational behavior of commodity prices, particularly oil, which touched $150 during the middle of 2008.

What explains the divergence in the direction of commodity price movements in 2008 relative to 1997? In short, hedge funds. In 1997, the prices of commodities were largely set by supply and demand forces between producers and suppliers of commodities. However, in 2008, commodities had become asset classes which were widely available to investors through online exchange traded funds. During the first half of 2008, market participants attempted to reduce their exposure to assets denominated in U.S. dollars by selling U.S. equities and re-investing in commodities.

In short, the downward spiral of the U.S. economy and subsequent global recession was largely attributable to the (irrational) investment allocation decisions of market participants, particularly hedge fund managers.

Millions of jobs have been lost because market participants did not understand the wider impact of their investment decisions.

Going forward, policy makers will be well served in placing restrictions on the amount of speculative interest in commodity markets. Perhaps hedge funds should be restricted altogether from speculation in commodity markets? Or perhaps policy makers should set upper and lower limits for commodity prices? To be sure, the global recession of 2008 clearly demonstrates that the unbridled self-interest of market participants can no longer go unchecked.

Comments

[CaptainJJack:]

I agree with this, and in my view, the ONLY reason that hedge funds made so much difference is summed up in one word: leverage. I have not done the math, but I know that small changes in the margin requirements have a huge effect on returns.

SO... I would increase the margin requirements on the derivatives, and I would require banks to put up A LOT more capital when they lend to hedge funds to reflect the risk of lending to unrestricted, unregulated entities.

2008 Dec 31 08:07 AM

[john s. gordon:]

indeed 22/1 leverage was EXCESSIVE.
> jack

2008 Dec 31 09:31 AM

[scotty1560:]

Agree with all the comments.

Might help to put a few restrictions on lending practices as well, that
100% ltv creates a few issues down the trail, doesn't it.
Nothing like some good old fashioned gambling aka leverage to destroy
an economy.

Now the bad news: our "leadership" is joined at the hip with the financial
services monster..kinda like "Siamese twins", so don't hold your breath
on any real reform..each decade the system decays a little more from
those good old days of Tommy Jefferson and Andy Mellon. Those
expensive co-ops in Manhattan cost lots of dough, ditto a good lobbyist.

2008 Dec 31 10:56 AM

[JohnnyM:]

That commentary is scary. Many will buy it hook, line and sinker but it leaves many factors out of the picture. The commodity oil market was manipulated as we had a fast move from $115 to $130 bbl only months ago. Was it Hedge Fund managers who moved oil up? Not completely, they were mostly shorting oil at the time. It was the usual fraud through manipulated oil reserve figures which allowed some to make billions on the back of forced short covering by many managers around the globe. The $145 bbl level could not be sustained as it was driven mostly by short covering. Now with oil sub $40 bbl, we may wonder where a true value lies since $200 bbl seems to have been a GS pipe dream.

The market and commodity collapse came about due to an inflated housing market. That was created by Congress and the WS boys who were only too happy to keep Goldilocks in curls despite heavier downpours. Push more cash onto the public, provide homes to those who have no ability to pay, give them inflated rates which will surely fail in time, etc. Of course there was individual fraud taking place at desks all around the US as easy money was just too hard to turn away. They took advantage of the poor.

Global recession affected by the WS boys who concocted a method to sell risky junk mortgages with a bonus insurance plan to investors around the globe for high returns. Result, inability to cover the insurance claims (CDS) for the failed mortgages. Major global institutions go bankrupt, more borrowing good money after bad. A cash and then a credit crunch as cash becomes scarce as its just too risky to lend or help the weak.

I don't blame the Hedge Fund managers who also got caught in this perfect storm. They not unlike Mutual Fund managers must provide cash to their customers when asked to redeem their positions. So is it this selfish action that is creating more weakness in the markets in the last few months? How dare they take more $$$ out of our market when it is already too low! They have no choice and there is more to come.

Historically, it takes years to get to a market top. It only takes a few months to make those peaks vanish. Let's place blame closer to the WS crew who single handedly brought the world to a financial collapse on a high risk bet that crap mortgages would survive and not onto large and small investors who were attempting to make money on the impending downside of financials and commodities.

And some of us were concerned about terrorism? This is much worse.

2008 Dec 31 12:13 PM

[diego:]

I strongly disagree with this post. Today's problems are related to leverage in the OTC markets, not in the exchange traded instruments. CDS total 65 USD trillions and pretty much this is what has the world on its knees. In futures volume traded is about 600 trillion USD a year, ONLY for the CME; have you see the CME collapesed yet? No, only the dark OTC markets.

OTC's losess created a negative externalities because hedge funds and other speculators were forced to fliy to cash, either with or without a yearly positive return.

If you are going to blame the manipulation in the crude market for such volatility, then you should post about the index funds, not the hedge funds who, according to the CFTC, there is no evidence of price manipulation by those institutuions. So the finger should be pointed to index funds and not hedge funds.

Jan 01 07:40 PM