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Introduction
Financial crises are an unavoidable aspect of capitalism as a consequence of the dichotomy between hard-wired human behavior and the ability to compete and innovate. Since the 18th century, the western European countries have been experiencing financial crises due to various reasons, such as financial bubbles and bank failures. In the past century, sound financial policies and regulations have reduced the frequency of financial crises, from an average of two per decade in the 1870s - 1910s, to around one per decade in the 1910s – 2010s (Clement, James, & Wee, 2015). The reduction in the frequency of financial crises in the past century, however, was accompanied by the emergence and rise of hedge funds.
The term “hedge funds” was first used to describe funds in the 1940s that combined long and short positions to hedge market risk, in order to provide stable returns for their investors. Over time, the types and nature of the hedging concepts expanded, as well as the different types of investment strategies. Hedge funds, which are investment pools open to high net-worth individuals and institutions, have been excluded from many of the disclosure and regulatory requirements that govern investment pools available to other investors (Markham, 2011). Because of the loose regulatory nature of hedge funds, hedge funds are not required under the Securities and Exchange Act of 1934 to report annually to the SEC and are free to pursue whatever investment strategy they choose, including investing in complex financial instruments such as derivatives and mortgage-backed securities (Eechoud, Hamersma, Sieling, & Young, 2010). As a result, they are able to evolve their strategies in a timely manner and take advantage of opportunities to make profit as they arise.
This paper examines the relationship between hedge funds and financial crises. In particular, it analyses the role hedge funds played in the period leading up to financial crises and the effect hedge funds had on the financial markets at the height of the financial crises. In addition, it explores how hedge funds could in turn be affected by financial crises. It argues that hedge funds have not played major role in past financial crises directly, even though some accuse hedge funds with a high degree of leverage of manipulating prices by making speculative attacks on, certain companies, sectors or currencies. Nonetheless, they appeared to contribute to the systemic risk in the period leading up to the crises and have the potential to cause financial crises in the future.
The paper also discusses the view that hedge funds are the potential victims of financial crises. Because of the fact that hedge funds pursue aggressive and high-risk strategies, financial crises could cause the demise of hedge funds. Additionally, regulatory changes as a result of financial crises have also influenced and limited hedge funds’ operations and strategies. To support these arguments, the paper draws evidence and examples from several financial crises and bubbles, such as the Long-Term Capital Management (“LTCM”) Fund Crisis, the Dot-com bubble, and the 2007-2008 Financial Crisis.
Speculation on European Currencies
One case study critics of hedge funds have often cited arguing that hedge funds manipulate asset prices to their advantage and deliberately attack the health and stability of financial systems was the currency speculation by George Soros and his Quantum Fund on European currencies in the early 1990s (Singh, 2017). The Quantum Fund was a global macro fund and Soros speculated against fixed European exchange rates because George Soros believed that they did not correspond with the macroeconomic conditions in the countries. In the fall of 1992, the Quantum Fund sold large amounts of the British pound and the Swedish krona against the forward rate of the dollar.
The respective central banks ' attempts to defend their fixed currency exchange rates became too expensive and they were forced to abandon them. Consequently, there was a rapid decline in currency value and a significant profit was made by the Quantum Fund. The Quantum Fund, according to Fung and Hsieh (2000), profited one billion pounds from its shorting of British pound alone. Soros was heavily criticized for his actions but responded that since currencies were obviously wrongly valued, sooner or later a price adjustment would be necessary.
The Bank of England was forced on September 16 to abandon the fixed exchange rate of the pound. The Quantum Fund had a 25 percent return that month and the return of the fund continued to be positive in the months ahead (Burnside, Eichenbaum, & Rebelo, 2000). On November 19, the Riksbank took the decision to allow the crown to float, resulting in the crown losing 20 percent against the dollar. In this situation, it is certain that markets were significantly affected by a particular hedge fund's speculative attacks on currencies.
On the other hand, it is hard to accuse the Quantum Fund of manipulating prices or contributing to the financial bubble growth. This bubble was the consequence of a flawed economic policy and a price correction was therefore inevitable (Smith, 1996). Nonetheless, the argument that can be made is that due to the Quantum Fund's speculation, this price adjustment happened sooner and more drastically than would otherwise have been the case. Although a more organized adjustment of prices could have been carried out at a lower economic expense, this could have delayed the necessary structural transformation of the financial markets in the countries.
2001 Dot-com Bubble
In other cases, although hedge funds did not engage in predatory speculation and thus might not be the direct cause of the bursting of financial bubbles, they contributed to the expansion and rise of the bubbles. In contrast to the speculative attack on European currencies in 1992, it is suggested that amid the Dot-com Bubble in 2001, hedge funds chose to invest in technology stocks despite the fact that they believed that there was a bubble. Hedge funds held long positions in technology stocks during the bubble, and then began to close those positions before the crash occurred, according to Brunnermeier and Nagel (2004). Hedge funds were aware of a bubble and decided that the optimal strategy was to ride the wave instead of correcting prices. Hedge funds helped drive up prices by purchasing IT-related stocks and acted as a price destabilizer.
In the period 1998 to 2000, hedge fund portfolios were heavily tilted toward highly priced technology stocks. The proportion of their overall stock holdings dedicated to this segment was higher than the market portfolio's corresponding weight of technology stocks. The technology exposure of hedge funds relative to market portfolio weights peaked in September 1999, about 6 months before the bubble height (Wang & Wang, 2008). Hedge fund returns data show that short positions or options did not counteract this long-sided exposure.
Additionally, hedge funds skillfully anticipated the price peaks of individual technology stocks. On a stock-by-stock basis, before markets collapsed, they began to cut their investments, switching to stocks that still experienced rising prices. As a result, hedge fund managers captured the upturn, but avoided much of the downturn. This is reflected in the fact that hedge funds in the NASDAQ's technology segment received large excess returns. The claim that hedge funds capitalized on the bubble was backed by the fact that hedge funds’ outperformance during the 1999 to 2001 period was limited to the technology sector and did not occur in other market segments. Since the technology exposure of hedge funds cannot simply be explained by unawareness of the bubble, it is believed that the hedge fund managers were able to predict some of the investor sentiment that was behind the wild fluctuations in valuations of technology stocks at the time (Valliere & Peterson, 2004).
While hedge funds rode on the bubble, it was unlikely that they started the drastic fall in prices by selling their IT stocks. The equity market was a relatively liquid market and large volumes had to be traded to influence the general price trends. In the early 2000s, the capital of the biggest hedge funds rarely surpassed $20 billion. This is rather small compared to a total market capitalization of all NASDAQ shares in excess of $5 trillion, despite taking into account hedge funds’ ability to use leverage (Kalra, 2005). If hedge funds realized that there was a bubble, the fact that they chose to ride the wave showed that they did not believe they had enough influence on the financial markets to be able to burst the bubble themselves.
Possible role in future crisis
Besides the aforementioned channels, the third way hedge funds can possibly destabilize the financial markets is through posing systemic risk to the financial system. As such, they may trigger the initial failure of one or more financial firms or a segment of the financial system, undermining a core function of the financial system (Huertas, 2009). One factor of their systemic risk stems from the lack of supervision by the relevant authorities. Since regulators only have incomplete information on hedge funds’ positions, leverage, and asset values, they may not be able to determine the balance sheets and investors inflows and outflows of these funds. The speed and extent at which hedge fund portfolios and strategies change adds to the difficulty of assessing their risk.
In addition, the compensation structure of hedge funds incentivizes their managers to pursue disproportionately high risks investment opportunities in their management strategies, which can translate into proportional systemic risks (Smith & Gupta, 2017). During financial crises, hedge fund investors tend to liquidate their capital from the funds, in turn forcing hedge funds to withdraw their cash from their prime brokers. At the height of the financial crisis in September 2008, hedge funds withdrew billions of dollars from prime brokers, which are divisions of banks that provide services and extend credit to hedge funds, and their parent investment banks out of fear that their liquid assets could be frozen and they would be unable to fulfil redemption requests from their investors. Although these withdrawals were justified, they were essentially a run on the bank, like the actions of individual depositors during the Great Depression.
The highly leveraged nature of the portfolios held by hedge funds also contribute to their systemic risks. Traditionally, the hedge fund industry has been the most exposed to leverage among financial intermediaries. The sophisticated use of leverage is a defining characteristic of the industry as regulating the appropriate use of leverage plays a central role in the management of hedge funds (Chan, Getmansky, Haas, & Lo, 2012). Systemic risks associated with hedge funds’ use of leverage originates from its ability to amplify liquidity losses and contribute to the overvaluation of assets in bull markets. When hedge funds liquidate positions simultaneously and decrease leverage, a fire-sale can ensue and this poses systemic risk to other financial institutions, including mutual funds and investment banks. Such an externality could arise when a hedge fund needs to liquidate assets that it considers to be significantly undervalued but that it must liquidate in order to fulfill margin calls or redemption demands.
Long-Term Capital Management Fund
While we have shown in the above sections that hedge funds influence financial markets to a modest extent and in subtle and interesting ways, we now discuss how financial crises have the potential to bring down hedge funds or cause hedge funds to adjust their strategies. Although hedge funds are investment vehicles that use hedging strategies to aim to achieve stable returns even in volatile markets and during financial crises, they themselves are potential victims of financial crises when they utilize high leverages to pursue high returns.
One such example is the Long-Term Capital Management (“LTCM”) Fund, which was founded in early 1994 and was liquidated in 1998. Since its inception, LTCM held a prominent position in the hedge fund community, mainly because its partners included individuals with substantial reputations in the financial markets and economic theory, such as Myron Scholes and Robert Merton.
At the start of 1998, LTCM believed that there were arbitrage opportunities in the fixed-income securities market. In particular, models generated showed that the yield spread between the liquid and “high-quality” bonds (e.g. Treasury bonds) and the junk or more illiquid bonds (e.g. foreign bonds) was wider than what fundamentals suggested. This led LTCM to aggressively make leveraged convergence trades, taking advantage of arbitrage between securities (Jorion, 1999).
In the meantime, the balance-sheet leverage ratio of the LTCM Fund was more than 25-to-1. Although precise comparisons are difficult, the exposure of the LTCM Fund to emerging market risks was probably several times higher than that of the trading positions typically held by major broker firms (Hoffmann, 2017). The LTCM Fund’s scale and leverage, as well as the trading strategies that it utilized, made it vulnerable to the unprecedented financial market conditions that after the devaluation of the ruble by Russia and declaration of a debt moratorium on August 17, 1998.
The Russian financial crisis triggered a “flight to quality” in which investors minimized risk and sought out liquidity. Many investors, in particular, shifted their investments into the U.S. Treasury market. As a result, risk spreads and liquidity premiums in markets around the world increased sharply, contrary to the forecasts of the models used by LTCM (Jorion, 1999). The scale, magnitude, and pervasiveness of the widening of risk spreads undermined the risk management models employed by LTCM and it suffered losses in individual markets that greatly surpassed what traditional risk models suggested were probable.
In addition, the shocks to many markets at the same time undermined the expectations of relatively low market price correlations and invested realized that global trading portfolios like LTCM’s were less well diversified than anticipated. Ultimately, the “flight to quality” caused a considerable decrease in the liquidity of markets, which made it difficult to quickly minimize exposures without suffering further losses, contrary to the assumptions suggested in their models.
As a result, the LTCM Fund suffered losses of $1.8 billion in the month of August, bringing the loss of capital for the year to more than fifty percent, and found it difficult to minimize its positions due to the large size of those positions (Kabir & Hassan, 2005). In a short span of time, these liquidity pressures, along with continuing declines in the Fund’s capital, caused serious concerns among the LTCM’s principals about the fund’s ability to continue fulfilling its cash flow obligations. Bear Stearns, the prime brokerage firm for LTCM, had also demanded the fund to collateralize potential settlement exposures, further shrinking the fund’s overall liquidity resources. LTCM’s counterparties for repo and over-the-counter derivatives also sought as much collateral as possible due to the dire situation and these factors added to the liquidity pressures facing LTCM.
Fearing that the total collapse of LTCM would spark a larger global financial crisis, the Federal Reserve Bank of New York made a controversial decision to orchestrate the bailout of LTCM. The firms involved in the bailout invested around $3.6 billion into the fund, and in exchange received a 90 percent equity stake in the fund’s portfolio along with operational control (Kabir & Hassan, 2005). This helped LTCM to survive the market volatility and exit in an orderly manner in early 2000.
2008 Financial Crisis
In contrast to a single hedge fund being affected by a financial crisis, the 2008 financial crisis generally affected the hedge fund industry. Nearly 700 funds, which was 7 percent of the industry, liquidated in the first three quarters of 2008 and the average hedge fund lost 18 percent of its value in 2008. According to BarclayHedge, as many as 89 per cent of the hedge funds in the database reported a loss in September 2008 (Dai & Shawky, 2013).
One of the reasons why this crisis was detrimental to the hedge fund industry is that many different types of assets were adversely affected simultaneously and globally. Typically, hedge funds receive premiums in exchange for credit risk, duration risk and liquidity risk and these risk premiums constitute a large part of the profits of the hedge funds. However, in the 2008 crisis, a higher degree of risk taking did not lead to higher profits (Samarbakhsh, 2011). The fact that the crisis impacted many different asset classes and markets simultaneously also wiped out all of the previously gained profits from these premiums and hence the increased risk premiums did not compensate for the losses.
As investors became more reluctant to take risks during the recession, they reduced borrowing in their portfolios by selling assets. This forced the prices of virtually all asset types to drop, such as commodities and property, which undermined the positive effects of diversification. During the 2008 crisis, there was extreme volatility in both share and commodity prices, making the prediction of future movements in asset values extremely difficult (Samarbakhsh, 2011). For example, several hedge funds that had invested in a bearish equity market trend and bullish commodity prices experienced problems in July 2008 when the trend abruptly reversed with a significant increase in share prices and a substantial drop in commodity prices.
Tightening of Regulations
Another detriment a financial crisis posed to hedge funds was the tightening of regulations. In the aftermath of the 2008 financial crisis, the Securities and Exchange Commission, fearing that short sellers were speculating against some banks and brokers, banned shorting against roughly 800 financial sector stocks (Capocci, 2013). The decision to ban short-selling impacted hedge funds’ strategies to various degrees. There was a predominant adverse impact on some strategies, primarily those in which short-selling was a natural element or in which there was a high degree of exposure to the financial sector. Although the aim of the short-selling ban was to discourage hedge funds from using strategies that reinforce negative market movements, the ban also made it harder to defend long positions with short positions and utilize certain arbitrage strategies (Courtney, 2010). For example, Copper River Management, a short-selling hedge fund founded by David Rocker and run by Marc Cohodes, shut December 2008 after the short-selling ban added to problems stemming from the bankruptcy of Lehman Brothers (Boyd, 2008).
Conclusions
In conclusion, hedge funds and financial crises are closely related to each other. Hedge funds play a subtle and interesting role in the various financial crises, by influencing these crises in the period leading up to them and at the onset of them. Even though they have not been found to be the primary and direct cause of past financial crises, hedge funds manipulating prices with high degree of leverages could hasten the price corrections of certain companies, sectors or currencies, which could result in huge economic costs. In addition, they appear to contribute to the systemic risk in the period leading up to the crises and have the potential to cause financial crises in the future due to their use of leverages and their unique compensation structure.
On the other hand, hedge funds could in turn be affected by financial crises, regardless whether these crises are domestic or abroad. This is mainly due to the fact that hedge funds pursue aggressive and high-risk strategies. As the LTCM and 2008 Financial Crisis have shown, hedge funds, which supposedly employ strategies to hedge themselves from risks, can be victims of financial crises when the financial health a market rapidly deteriorates. Additionally, regulatory changes as a result of financial crises could also influence and limit hedge funds’ profits and strategies. Therefore, even though hedge funds do not seem to be major market players by capitalization and assets under their management, their use of high leverages combined with shorting strategies allow them to manipulate prices or ride on the bubble. However, this characteristic also leaves hedge funds more vulnerable to financial crises and the tightening of regulations.
Bibliography
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