The Hindu Business Line : Looking over the hedge

The systemic risk caused by hedge funds whose operations are "private" and unregulated is rising. This should cause as much worry for the IMF as for India, where hedge funds have made their entry through participatory notes.

THEY talked about the acumen of those at the helm of the Long Term Capital Management Fund (LTCM) in whispers. Its management team included Nobel Laureates, famous stockbrokers and others. By 1998, it was bankrupt. A massive bailout package had to be arranged by the Federal Reserve to keep it afloat.

Justifying the bailout, the Federal Reserve Chairman, Mr Alan Greenspan, said that if LTCM had failed, it could have impaired the economies of many nations. Soon, the episode was forgotten. Later years saw the mushrooming of hedge funds. Recent implosions of the Bayou and KL groups and investigations into such others as Refco have cast a shadow over them.

What are these hedge funds? There are now around 8,000 funds handling over one trillion dollars. There is no definition of hedge funds. However, as with elephants, you can spot them when you see them. Generally, they are structured as partnerships, mostly registered in offshore havens such as Cayman Island, and the Mauritius.

This means they are barely regulated. Not even by major regulators such as the Securities and Exchange Commission (SEC) of the US and the Financial Services Agency (FSA) of the UK. On date, they do not have or secure regular information about the operations of the funds.

The operations of the funds are `private' and there are no details about their funding sources. The assumption is that the money comes from high net worth individuals. The allegation that these funds handle `tainted' money from money-launderers, drug-peddlers, arms dealers, and so on, has often been denied but not strongly rebutted.

As investments are by high net worth individuals, the assumption is that they do not require the kind of regulatory protection necessary for small holders.

The other assumption is that fund managers do not destabilise markets. Rather, as some explain, they act as arbitrageurs and not as speculators. They claim, like Mr Greenspan that hedge funds provide liquidity to the market.

The premise is that such funds look for assets whose prices are out of line with their fundamental values, that is, selling those they deem expensive and buying those they think are cheap, which is the essence of `hedging'. Fund managers act as `contrarians' who smoothen prices over time and make markets more efficient.

There were reports of hedge funds offering high (alpha) returns to investors. Perhaps, this was so when the market was less crowded. A crowded market is now beating down its earnings. Recent reports suggest that earnings of hedge funds are not better than S&P 500 returns. In 2004, hedge funds returned 8.3 per cent as against 10.87 per cent for S&P 500.

Interestingly, these averages include only the successful ones. It is common for `bad' funds to close down and start another immediately. In June, Mr Greenspan cautioned the investors saying, "the funds had already picked the `low-hanging fruit' and were likely to find fewer good investments."

BusinessWeek (January 24, 2005) was more explicit: "The plethora of hedge funds trying to take advantage of the same sort of short-term arbitrage opportunities is also making it harder to profit from strategies that worked well in the past." Surprisingly, even as analysts were predicting a grim future, they received fresh blood from unexpected quarters.

With the bursting of the stock bubble, investments in equity ceased to be attractive. The low interest rate regime pursued by the Fed made investors move away from bank deposits and government bonds. Individual and institutional investors, such as pension plans, endowments and foundations, began to desert conventional avenues and take the high-risk road to get high returns.

The base of hedge funds, which was earlier confined to high net worth individuals, was widened. Also, a new vehicle named "fund of funds" — funds which collect money to invest in hedge funds — emerged to cater to the new entrants. Thus, there was `retailisation' of hedge funds at one level and `institutionalisation' at another. These were fuelled by exaggerated reports of returns declared by hedge funds.

A staff report of the SEC, "The implications of the Growth of Hedge Funds" (www.sec.gov/news/press/2003-125.htm), noted these developments and expressed concern over them. The Economist (June 30, 2005) reported that 32 per cent of European institutions invested in hedge funds in 2004, up from 23 per cent in 2003. No doubt, they tried to mimic the success stories of the Yale and Harvard Endowments. Sadly, the marriage of convenience did not bring lasting bliss for many other institutions. Strains developed due to the conflict of interests between hedge funds and institutions.

Prof Andrew Lo of the MIT Sloan School of Management narrated the tensions brewing between them in an early paper, "Risk Management for Hedge Funds: Introduction and Overview," in Financial Analysts Journal, December 2001. Institutions began to worry over "alternative investments" sought by hedge funds. These comprise a menagerie of products such as private equity, risk arbitrage, emerging equities and many other strategies, securities and styles.

In all funds, the entire management of affairs is left to the discretion of individuals while institutions need transparency, structure, stability and a well-defined process, which cannot be left to individuals. The gap in perception widened over time and was exacerbated by scandals, `creative accounting', bankruptcy, and so on.

An analyst captured this dilemma thus: "Hedge funds want to be institutionalised — that is, they want to look like institutions whose money they seek. But many do not have the needed controls. And when the money disappears, investors want the protections that an institution offers" (The New York Times, September 9). The FSA had also concerns over these developments. At the Reuters Corporate Finance Summit held on October 12, Mr Huertas of the FSA warned that institutions such as pension funds should carefully check out the hedge funds they invest in and "recognise that they are at risk for the entire amount of their investment."

Unfortunately, the current policies that pension funds should be `marketised' do not offer any other recourse. Most of the pension funds of corporations and endowments are deeply embedded into hedge funds in a complex web of contracts and agreements. These are opaque and it is difficult to value them. It may not be feasible to disentangle them unless there is a meltdown, which could come about when the hedge funds over-reach themselves through their arcane strategies played through credit derivatives (CD).

CDs are credit mitigating financial instruments to transfer credit risk from one party to another. Over the years, they have grown complex. Even as banks and other lenders sought new ways of hedging against risks, they found it easier to cosy up with hedge funds through CDs. The good old simple CD is dead and now the market consists of CD swaps (CDS), collateralised debt obligations (CDO), which is a bundle of CDS, and synthetic CDO, which include many other risks.

Some of these are "toxic wastes", as The Economist described them, and include the debt debris from the Asian, Russian and Latin American crises and defaults. The CD market has grown from around $600 billion in 1999 to an astronomical $12,430 billion till June 2005. Hedge funds form one-third of this.

It is common knowledge that the growth of credit derivatives reflects a radical change in the financial system. Banks and investors use them to move risk off their balance-sheets and into the hands of others.

Partly, this is an attempt to circumvent the Basel Guidelines and make balance-sheet adjustments. More important, it is a strategy to face a volatile financial market. They securitise risks and shift them to others.

The larger question is, how far can risks be shifted and who will ultimately bear them? Some economists take the view that credit derivatives help the financial markets meet the challenges posed by bankruptcies such as that of Enron and WorldCom. The other side of the picture is that the ballooning of CDs creates unsustainable imbalances in the market.

The problem with credit derivatives is that trading occurs in private deals rather than in exchanges. Thus, the sector is opaque and difficult to monitor. The valuation of assets is questionable. Many banks and corporations may hide such assets behind synthetic bundles and clean up their balance-sheets.

One analyst captured the situation thus: "... the financial system looks increasingly like a giant Enron: What is happening on the balance-sheet of public entities provides less and less of a guide to the distribution of risks." (Financial Times, October 20) As on date, regulators have no authority to monitor or control them. The FSA issued a discussion paper in June outlining some of the risks hedge funds pose to financial markets, including erosion of confidence, disruption of liquidity and challenges in valuing portfolios.

In its quarterly report released on September 5, the Bank for International Settlements (BIS) warned that "the complexity of some products and associated risk management systems, the growing presence of leverage players in credit markets and the possibility that investment strategies may be less diverse than anticipated may make it difficult to predict how markets will function under more stressful conditions."

The IMF Chief Economist, Mr Raghuram Rajan, also suggested that the risk of systemic crises is rising. Some other economists call it the intersection between fancy financial engineering, greed and underestimated "tail risk". Issues on systemic risk and hedge funds were analysed by Prof. Andrew Lo of the MIT Sloan School and three of his students (Systemic risk and hedge funds, August 1).

They took note of the symbiotic relationship of hedge funds with the banking sector, creating opportunities for earnings by banks through brokerage, etc. As many banks now operate proprietary trading units, which are organised much like hedge funds, the risk exposures of the hedge fund industry may have a material impact on the banking sector, creating new sources of systemic risk.

Those in the IMF and elsewhere, busy with the creation of "New Financial Architecture" should be more than worried over these improvised explosive devices getting inserted into their edifices.

India, on its part, has reason to worry over the invasion of hedge funds. through participatory notes in close collaboration with foreign banks and FIIs. That is another story.

(The author, a former Finance Ministry official, has experience in international, financial and trade issues.)

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