Oddly, this story, which runs in today’s Financial Times, does not seem to have been reported in the Wall Street Journal or the New York Times (and perhaps not on Bloomberg either, but I am less certain since its search tools for the great unwashed aren’t foolproof).
The findings, at least for the Fed, are pretty dramatic. On the one hand, it warns that according to some measures, hedge funds now pose as big a risk to the financial system as they did right before the Long Term Capital Management meltdown. On the other, the Fed argues that the causes for the risk metrics being so high this time come from different, less troubling causes.
The signal is high correlation of returns. Tobias Adrian, the economist who produced the study, concludes that the correlation this time is due to low volatility, while 10 years ago, more variable hedge fund returns nevertheless moved together.
The problem is that the presence of low volatility doesn’t necessarily prove that the hedge fund returns aren’t somehow correlated in ways that bode ill for financial stability. As we mentioned earlier, a recent analysis in Risk Magazine found that credit risks are more tightly linked than most observers believe (and recall that many hedge funds pursue credit-market trading strategies). Similarly, the recent Bank of England report on financial risk pointed to the central role of what it called large complex financial institutions. By implication, if any of them were seriously damaged, it would have widespead ramifications. And it was this very sort of institution that the Fed called together to cobble together a bail-out of LTCM. Why did they go along? Because they stood to lose a lot more if they didn’t.
From the Financial Times:
The risk hedge funds pose to the global financial system has reached levels by some measures comparable to those just before the Long Term Capital Management fund imploded in 1998, the Federal Reserve Bank of New York said yesterday.
But the New York Fed said the similarities – involving close correlation among hedge fund returns seen before the LTCM crisis and again recently – had different causes, making the current environment less alarming.
The bank’s study is the latest contribution to a debate that has seen regulators and analysts express concern over the risks and leverage taken on by hedge funds, the private investment vehicles that are increasingly influential in financial markets. The hedge fund industry has mushroomed in recent years and now accounts for an estimated $1,500bn (£749.7bn) of investments.
The study analysed the similarity between returns achieved by hedge funds with nominally different strategies. “Correlations were high prior to the LTCM crisis, and have been rising recently,” said study author Tobias Adrian, an economist in the capital markets research group at the New York Fed.
The increasing importance of hedge funds in capital markets made the study important, Mr Adrian said.
“While the funds are major liquidity providers in normal times, their use of leveraged trading strategies has raised concerns about their liquidity effects in times of market stress.”
He cited the LTCM experience as evidence that heavy hedge fund losses could drain trading liquidity from financial markets.
“If the returns of many funds are either high or low at the same time, the funds could record losses simultaneously, with possible adverse consequences for market liquidity and stability,” he said.
Mr Adrian said the recent high correlation of hedge fund returns stems mostly from their low volatility, a less reliable signal of future turbulence than a decade ago when the rise in correlation owed more to funds’ more volatile returns moving in lockstep.
Worries over the potential risks posed by hedge funds in financial markets have led to calls from regulators, including the New York Fed, for caution on the part of investment banks and others who lend to hedge funds.
Some policymakers are also pushing for more regulation of hedge funds, which are typically lightly supervised and tend not to disclose information on their trading positions.
LTCM delivered high returns for several years in the 1990s before it came close to collapse in the autumn of 1998 as its bets went bad following Russia’s default on its international bonds. Fearing for the broader financial system, the New York Fed organised a bail-out.
One of the figures associated with LTCM was Robert Merton, the Nobel prize-winning finance expert. Speaking at the CFA Institute’s annual conference in New York this week, he said the fund had been carefully managed from a risk perspective, but had been undermined by unforeseen risk-averse behaviour on the part of counterparties as losses mounted.
Update: The notion that this story is underreported appears valid. The New York Times’ Dealbook (a newsletter/online feature, not a part of the print edition) found the story only on Reuters via CNN and MarketWatch.
