Why Are Hedge Funds Not Blowing Up All Over the Place?

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There are many things I do not understand about the financial crisis, but the one thing that currently puzzles me the most is how there have not been dozens of huge hedge-fund failures over the last few months.

I am sure there are plenty of hedge funds that are long mortgage-backed securities. Moreover, hedge funds are often highly leveraged.

Even if a hedge fund was just fully invested in equities — not mortgage-backed securities, but leveraged five times — it might have lost everything.

On top of this, the money in many hedge funds is “hot money.” In other words, if things start to go south at a particular hedge fund, many investors pull their money out as quickly as they can. This compounds the hedge fund’s problems, because it means it needs to liquidate positions to pay out the investors who withdraw their money.

I suspect there are two reasons why we have not yet seen massive hedge-fund failures. The first is that most hedge funds have “lock up” periods, so that investors can only get their money out with a lag of a few months or maybe up to a year.

My guess is that many hedge funds are facing huge redemptions; they just haven’t reached the end of lock-up periods yet so they haven’t had to pay out. A lot of lock-ups are probably timed quarterly, which means the next chance out is at the end of the calendar year.

The second reason that hedge funds might not yet be blowing up is that they are nearly unregulated, so they don’t face “mark to market” rules or required capital ratios. So these hedge funds could be in terrible shape, but might be able to hide that fact — at least until the redemptions hit.

My prediction: the next few months will see a string of huge hedge-fund failures, which will lead hedge-fund investors to pull their cash out of hedge funds en masse, triggering further hedge-fund blow ups.

I would not want to be holding the same assets that these hedge funds are holding, because they may have to liquidate at fire-sale prices.

[Addendum from Dubner: Levitt is such a smart guy that he doesn’t even have to read the newspaper. If he did, he’d have seen today’s front-page article in The Times about how hedge funds are blowing up all over the place, or at least will be soon.]


Hedge Fund Guy

Thanks a lot for directly contributing to a destructive run on hedge funds!

roberto

Hedge funds will start blowing up in the 4th quarter and 1st quarter of next year. Many are bleeding badly and on life support. They are screwed royally because the big pockets they depend on are bailing and worse there is not a single bank around that will even talk about lending them money. Some much for second Gilded Age. Didn't last long, did it hedge fund boys and girls.

Captain Obviousness

A good hedge fund would have been shorting and buying puts during the crash. Maybe not enough to come out positive overall, but enough to be down way less than the market. That said, yes the overleveraging and redemptions will lead to more failures.

leonard schneide

Since they are so heavily leveraged they are able to buy quality stocks . A small gain is magnified and the manager gets his 20 percent. As pointed out they can insure their main investments by shorting or buying put options. Or they can buy very conservative instruments like top rated bonds. This is profit and protection. If my bonds pay me $1,000 a year and I am granted 5x margin, I can buy enough to get $5000 a year. The managers of these funds are neither brilliant nor geniuses -- there are too much of them for that. They are merely capable guys into a good thing, most of them courtesy of a bull market.

Chris

As Ledbury notes, long equity funds are not 5x leveraged. Even in normal markets, that amount of leverage would make them too volatile and a poor fit for just about anyone's utility curve. A lot of the large equity funds are long/short funds -- in many cases, two parts long and one part short. If their beta is 1, their expected return is the S&P 500 +/- alpha (value added).

James

Um, I work in the industry, and actually . . . they are.

David Heigham

"Lock ins" have prevented many an investor from panicking out of hedge funds, sure. Come year end (which is probably the largest of the quarterly exit gates)these investors will mostly be over their panic and looking forward. The question will be whether a hedge fund or another form of investment will do better next year. I guess many investors will plump for hedge funds.

Of course, some investors will really need their money elsewhere because of other losses and risks. A good many hedge funds should go out of business, but as a group they will still be big, big billions.

BSK

I Read Books-

"Economics aims to explain how economies work and how economic agents interact."

Maybe I'm just a nut, but that quote from wikipedia would seem to imply that economists should have some understanding of the way that the economy works. Obviously, this is a complex situation with many layers. But, if you write an economics blog for the world's leading newspaper, you PROBABLY should have some expertise in major issues relating to the economy. Rather, these guys just write whatever, wholly admitting they have no idea what they are talking about yet attempting to draw erroneous conclusions anyway. This is yet another case, as the necessary addendum indicates.

Doc

Where have you been? Hedge funds are blowing up left and right from a combination of value compression and liquidity demands. 20% to 70% reduction in AUM was not uncommon the in the two weeks. Of course, they are not broadcasting these developments but there are a few web pages out there that show detailed changes and include some managers' investor letters. Hedgies are hurting just like the rest of us.

JG

Some have been:

http://hf-implode.com/

Barbara

Oh wait, scratch that, reverse.

Barbara

Am I wrong in my understanding that Levitt is the writer and Dubner is the economist? (not that they are mutually exclusive disciplines by any means, but that's how their partnership is specialized, right?).

Charles

My understanding was that a lot of hedge funds have limits so you can only take money out at specific times (e.g., at the end of each quarter). So, there may very well be a backlog of hedge funds that will collapse just as soon as investors are allowed to withdraw from them. Or, maybe, this will help them out, as investors will have gotten over their worst inclinations by the time they are actually able to withdraw.

Speedmaster

Because they ... wait for it ... hedge? ;-)

Joe Smith

"This kind of financial crisis defies what we have understood about market economies"

We have had a bubble followed by a bank run / panic. Seems to me that in reading my legal / economic history the first such event in modern economic history occurred in England in 1825. The only real difference now is that the world acts as one economy.

Each generation of teenagers thinks they are the first ones to ever discover sex and each generation of bankers thinks they are the first ones to discover leverage.

RJ

Sounds like hedge funds will prevent any sort of real market recovery until midway through 2009, which will give Obama ample time to FDR our economy.

Princess Leia

You have a good friend Steve D.'cause yeah, it was in the paper this morning how investors are pulling their $$$. So no surprise.

But what about private equity? Firms seem to be laying low, but I suspect they are hurting, too. Could someone please check?! Is this the end of private equity.

No one deserves to be making a killing, imho.

jt

I am continually confused how people can speak about 'hedge funds' as if they are all part of a single, homogenous entity. A hedge fund that sells CDS is nothing like a hedge fund that longs-shorts equities, which is nothing like a hedge fund that trades grain futures, etc.

Morris

The regulation argument is not valid. All hedge funds have a bank prime broker which holds their assets. The prime broker is taking the residual risk of the portfolio beyond the funds capital.

If a hedge fund is leveraged and the losses of the securities book held by the prime broker seems to come close to the fund's capital the prime broker will liquidate the assets in the market and give the hedge fund back the residual cash to hand back to investors after the lock up period is over.

I think that hedge fund leverage is zero at the moment as all banks have completely shut all new funding making it prohibitively expensive since the end of August. At the moment HFs are like real money mutual funds, in many cases running high cash levels to meet high expected redemptions. Clearly, if funds have to be closed because of outflow - which will happen over the next couple of months - there will be some more pain but it will not be extraordinary. Once this process is complete this will be the near term bottom for most assets - probably for the next 4-5 months.

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Peripatetic Entrepreneur

The Economist this week has an article on the subject:

http://www.economist.com/finance/displaystory.cfm?story_id=12465372