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In order to better understand how hedge funds played a role in the recent crisis affecting the financial market, it is important to first understand how hedge funds work. Hedge funds are similar to mutual funds in that money is pooled from investors and then invested in selected financial instruments in order to gain a positive return. Hedge funds however are not monitored by the Securities and Exchange Commission since the securities they issue are considered as private offerings. In order to get the maximum return for their investors, hedge funds often employ strategies like investing in ventures that have high risk.
One way of doing this is through derivatives. Derivatives are financial instruments that gets if values from the value of a particular underlying asset like bonds, exchange rates and commercial real estate loans. Another way that hedge funds obtain good returns is by employing the strategy of arbitrage. This is actually just exploiting the pricing inefficiencies with respect to certain related assets. A hedge fund for example can buy shares of a company from one exchange and then sell them to another which ensures profit.
Aside from the strategies it implements, hedge funds typically face large risks themselves. This is because hedge funds are highly leveraged. Hedge funds borrow money that is greater than what was originally invested. It is not unusual therefore for a hedge fund to borrow $20 for every $5 that it gets from an investor. So how does all this fit in the recent crisis faced by the financial market? In order to answer that, one has to look at how subprime lending works. The basic premise of subprime lending is to provide loans to people who are not qualified to obtain them in the first place.
These borrowers did not qualify due to some factors like credit history and income level, to name a few. In the past, when banks loaned money, it was the one who faced the possibility of default termed as a credit risk. Current practices in the financial market however have allowed banks to sell these mortgage payments as well as the credit risk involved to investors. This method is known as securitization. As a result, instead of having to face the credit risk alone, banks are now able to “spread” these risks to a large number of investors.
The problem arose when lenders, who had initially obtained loans on the idea that they would be able to refinance them on more favorable terms, were now faced with higher interest rates. Consequently, prices of real estate dropped which lead to foreclosures and defaults. As a result, banks and other financial institutions were faced with losses leading to the financial crisis. Now as the banks continued to distribute the credit risks, these investment were considered high risk and high yield. Which of course made them lucrative for hedge funds.
Thus as the risks related to these securities increased, it made them more viable to be placed with investors that had high leverage. Hedge funds became a likely source of investors since being unregulated, they had no need for capital requirements. Thus when these funds were unable to sell the subprime mortagages, especially since they were hoping to only hold it for a short time, they went out of business which actually contributed to the crisis. To get a better picture, let us look at two strategies employed by hedge funds already mentioned earlier. First is derivatives, particularly credit default swaps.
Credit default swaps, or CDS as they are often called, are insurance contracts that are used to protect bondholders in the likelihood of default. CDS are considered as two-party contracts since a company that incurs a loss will be able to gain a profit somewhere else ensuring that there is no actual loss. Recent market practices however have allowed CDS to be used either speculatively or even as insurance to a specific credit risk. The problem thus arose when there was uncertainty as to who would pay for these losses. Such was the case with Lehman Brothers.
Hedge funds, which are highly leveraged to start with, put investments in Lehman. It is possible that due to these investments, Lehman was also able to invest in CDS. When Lehman was unable to sell its CDS, it was eventually forced to file for bankruptcy. Another practice of hedge funds that could have contributed to the crisis is securitization. The market practice of allowing securitization also allowed the banks to put the debt that is associated with these same securities into SIVs or structured investment vehicles. SIVs are considered as entities that are in off-balance sheets.
Because of these status, the increase in risk meant and increase in yield. Hedge funds therefore were drawn to these since by not being in the books, the requirement for capital reserve was circumvented. Former Federal Reserve Chairman Alan Greenspan is even quoted to have said that it was the securitization and not the loan that was the cause of the crisis. While we can conclude that hedge funds contributed to the current financial crisis, they are not the sole factor and possibly not the originator. Hedge funds by themselves also have positive impacts on the market.
Because of their strategy of having arbitrage, they are actually helping reduce or even eliminate the mispricing that is currently prevalent in the markets. Despite being highly leveraged, hedge funds can actually provide the needed liquidity for companies. This was seen when the hedge fund Cerberus bought the ailing Chrysler company allowing for jobs to be saved. The practice of hedge funds investing in high risk investment have become a good source of risk transfer as well as diversification. While the crisis may not signal the end of hedge funds, only time will tell if they are truly a help to the market or a mistake.
References: U. S. Securities and Exchange Commission. Hedging Your Bets: A Heads Up on Hedge Funds and Funds of Hedge Funds. Retrieved November 8, 2008, from http://www. sec. gov/answers/hedge. htm Research RECAP. (2007, December 21). Role of Hedge Funds in Subprime Crisis Examined. Retrieved November 8, 2008, from http://www. researchrecap. com/index. php/2007/12/21/role-of-hedge-funds-in-subprime-crisis-examined/ Federal Reserve Bank of New York. (2004, November 17). Hedge Funds and Their Implications for the Financial System. Retrieved November 8, 2008, from http://www. ny. frb. org/newsevents/speeches/2004/gei041117. html/