A V Rajwade: Hedge funds and systemic risk

Unless dollar interest rates shoot up far more sharply, a systemic risk looks unlikely

In an earlier article on dollar interest rates (World Money, April 18), I had referred to the possibility of downgrading of General Motors' (GM) debt to junk grade, which has since happened.

In another recent article (World Money, February 21), I had discussed the increasingly complex derivatives being traded in the credit markets, and the difficulty in monitoring their risks. The downgrade of two large borrowers, GM and Ford, has impacted both bond and credit derivatives markets in various ways:

Investors who are prohibited by policy or statute from investing in junk bonds have started to liquidate their holdings in the bonds of the two car manufacturers.

Consequent on the downgrade, GM and Ford bonds have also been removed from investment grade bond indices, and index funds or other investors tracking such indices are also having to restructure their portfolios.

Given the size of the two companies' issues, they are inevitably part of many collateralised debt obligations transactions, and the rating and pricing of tranches containing GM or Ford bonds have been affected.

The first segment to be hit by the uncertainties has been the hedge funds, some of which are reported to have incurred losses in complex trades involving credit derivatives.

The overall situation, of course, is nowhere near, even potentially, as large a systemic risk as the Long Term Credit Management (LTCM) affair of 1998, but still seems to have started worrying the regulators.

Banks have been asked to review their exposures to hedge funds and the president of the New York Federal Reserve has cautioned about "an increase in product complexity" and raised questions about how structured credit products will behave in the event of a major shock.

The chairman of the Securities and Exchange Commission in the US has also warned of the possibility of "disasters" as hedge funds search for ever more complex strategies for earning well-above-market returns to justify their fees.

Lately, hedge funds have also been attracting considerable criticism from other sources, particularly in Europe. John Sunderland, president of the Confederation of British Industry , criticised hedge funds for their short-term investment strategies and lack of transparency.

Many are advocating the wider use of a French practice under which investors holding shares for a minimum of two years have double the voting rights of short-term investors. The criticism is particularly virulent in Germany where a British hedge fund recently succeeded in forcing change in the management of Deutsche Börse, the stock exchange.

German politicians are also on the offensive. The chairman of the ruling Social Democratic Party recently compared hedge funds to locusts "who destroy everything and then move on".

The German economics minister has also joined the criticism, and the Chancellor has called for a thorough review of the operation of hedge funds in the German market. At the heart of the debate is shareholder capitalism to which the UK and US subscribe, versus the stakeholder capitalism which much of Europe prefers.

Should companies be managed solely for the benefit of the shareholders or for the benefit of all stakeholders including the employees, the suppliers and the consumers? The current criticism stems from cases of some hedge funds taking over companies, sending workers home and selling the bits and pieces to earn obscene returns.

Private equity investors are also attracting their share of criticism, and not only in Germany. In South Korea, for instance, private equity investors have earned a bad name after earning billion dollar profits through taking over sick banks and later re-floating them on the stock market.

The Koreans are feeling even more cheated as these transactions were so structured that the investors got away without paying a cent of tax. The central bank is also incenced: it has advised the government against selling banks to private equity funds.

Both hedge and private equity funds have grown rapidly in recent years "" and, increasingly, the dividing line between the two is becoming thinner as both are equally active in purchase of distressed debt and other assets, sometimes in partnership with each other. There is another common thread: the fund managers face the same "moral hazard".

They make tonnes of money if the strategy works (in the aggregate, the hedge fund managers pocketed a bigger fee than fund managers in the much, much larger mutual fund industry), but have little to lose in the event it fails. And, it often does "" a majority of the hedge funds active in 1996 have since closed down "" but the LTCM managers are back in business.

Some other financial intermediaries have also become increasingly dependent on the 7,000-odd hedge funds managing an aggregate of a trillion dollars. A third or more of the transaction volumes on the New York and London stock exchanges is generated by hedge funds.

Investment banks depend on the industry for as much as an eighth of their aggregate revenue through offering prime broking, stock lending and other services. Many hedge fund managers are former traders with investment banks. The banks not only provide various services to the funds but often make investments in them.

But to come back to where I started: would the current situation lead to a systemic risk? Unlikely, unless dollar interest rates shoot up far more sharply. This is not to be ruled out if there is a precipitate fall of the US currency. On the positive side, the estimated leverage of the industry now is much lower "" between two and four, as against 10 in 1998, and 28 for LTCM itself.

Email: avrco@vsnl.com