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The causes of financial panic are almost never ones we expect. After all, if regulators expected a bank or hedge fund to collapse, they could cause it to raise capital or take remedial steps to close it on a precautionary basis. In fact, financial markets are repeatedly taken by surprise as in the case of Bear Stearns, which announced it had sufficient liquidity just two days before it collapsed.

Systemic risk - that is, risk to the entire financial system not just one institution - is even harder to diagnose because most regulators use models that misapprehend the statistical properties of risk. The few analysts using proper models based on complexity theory understand that forecasting ability is limited. This is due to the huge number of variables involved and their extreme sensitivity to minute changes in initial conditions. Large complex systems are, in fact, impossible to model except at a theoretical level for this reason.

Seismology is a good analogue for understanding risk and complexity in financial markets. Seismologists have no ability to predict earthquakes. This does not make seismology worthless. We understand that it's a bad idea to build large cities on known fault lines. We understand that when large populations are near major fault lines earthquake-resistant buildings should be required.

Which brings us to the Panic of 2008 and one fault line that did not crack - hedge funds. After the spectacular collapse of hedge fund LTCM in 1998, in which I was personally involved, regulators and other market participants spent the next ten years fretting that even larger hedge funds that emerged in the early 2000's would cause another financial catastrophe. In fact, the cause of the Panic of 2008 was an unholy alliance of government sponsored enterprises, greedy bankers, reckless borrowers, blind rating agencies and lax regulators caught together in the housing bubble caused by the Fed's cheap money policies. Hedge funds were more victim than villain in the events of 2008. Instead, banks were very much to blame.

Since 2008 all eyes have been on the banks. They have been subjected to stress tests, increased capital requirements, Dodd-Frank and the stringencies of the Volcker Rule that bans most proprietary trading. Yet while the largest banks are still the main source of systemic risk through their derivatives trading operations, could it be that hedge funds once again haunt the financial landscape and pose a new kind of systemic risk?

In 2008, hedge funds faced enormous redemption requests from frightened investors. Many hedge fund investors are fund-of-funds that have investors of their own. When the top-tier of investors want their money back, the fund-of funds have to get it from the hedge funds who in turn have to get it from the markets through fire sales of stocks and bonds. These fire sales cause more losses that trigger more redemptions, and so on. In effect, everyone in the world wants her money back and the markets are not liquid enough to answer the call.

In these conditions, hedge fund managers often resort to provisions in their documents that allow them to suspend redemptions. This is like a bank closing its doors when the depositors are lined up around the block. While it may be unpleasant for investors, it does serve a purpose. If a hedge fund manager had to dump assets to meet redemptions, the first investors to ask for their money would get a relatively good deal while the last investors would get the dregs. Suspension is a way to treat all investors fairly by selling assets in an orderly manner over time as the panic subsides. On the whole, suspensions work well as a kind of circuit breaker to smooth out the immediate impact of financial panic.

Today the situation has changed materially. Investors chastened by the experience of 2008 are insisting on new terms for their hedge fund investment dollars. Some are insisting on managed accounts that are not part of the regular commingled hedge fund but are kept in separate custody subject to same day liquidation. Other investors are offering structured deals in which the hedge fund manager bears the first loss in the event of any downturn. Still others are insisting that all "gates" and other suspension provisions be removed from the documents and that lock-up and redemption notice provisions be shortened or eliminated.

Hedge fund managers often agree to these demands as the price of getting launched. At the individual fund level these voluntary bargains between investor and fund manager make sense. But at the systemic level a darker picture is emerging in which the entire hedge fund industry is now a loaded gun with a hair trigger.

When a 2008-style panic happens again, investors will rush for the exits in order not to be victimized by the markets. This time the results may be catastrophic. If hedge fund managers must sell assets instead of suspending redemptions, the markets will not be able to absorb the selling. Instead of individual funds freezing up the markets themselves will freeze up.

Risk never evaporates, it simply moves from place to place. Regulators and investors are forever fighting the last war. The next financial war will be bloodier and harder to stop.

Source: Hedge Funds And Financial Panic