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Study: Hedge Funds Could Contribute to Disruptions of the U.S. Financial System

New York (HedgeCo.Net) – According to a new study from the RAND Corporation, “Hedge Funds and Systemic Risk,” hedge funds were not a leading cause of the recent financial crisis, but they do have the potential to contribute to disruptions of the U.S. financial system.

Hedge funds, private investment pools open to high-asset individuals and institutions, until recently have been exempt from many of the reporting and regulatory requirements imposed on public investment pools such as mutual funds. Because hedge fund operations have been opaque despite accounting for a growing proportion of financial market activity, the funds have come under increasing scrutiny over the last 15 years.

The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 imposed greater regulations on the industry and additional rules are being considered. These recent regulations effectively address some, but not all of the the risks that hedge funds pose to the U.S. financial system, according to the study from RAND, a nonprofit research organization.

The RAND study examined whether hedge funds contributed to the global financial crisis of 2008 and whether such operations could destabilize the U.S. financial system in the future. To help overcome the scarcity of information about the hedge fund industry, researchers conducted extensive interviews with 45 hedge fund managers and lawyers, prime brokers, institutional investors, congressional staff, financial regulators and others connected with the industry.

Although hedge funds worsened the financial crisis in certain ways, the industry did not play a pivotal role compared to other agents, such as credit rating agencies, mortgage lenders and issuers of credit default swaps.

“We found little evidence that hedge funds contributed to the housing bubble,” said Lloyd Dixon, lead author of the study and a senior economist at RAND, a nonprofit research organization. “In contrast to banks, which invested heavily in subprime mortgages, hedge funds invested on both sides of the market. By betting that assets based on subprime mortgages and the banks that invested in them would decline in value, hedge funds called attention to the growing bubble.”

Researchers also found little evidence that short-selling of financial stocks (basically, betting that the price would go down) was a major contributing factor to the financial crisis. More significant factors were banks’ exposure to toxic mortgage assets and the financial market’s response to that vulnerability.

However, hedge funds did play a role in the crisis, Dixon says. Hedge funds destabilized financial markets by withdrawing billions of dollars from prime brokers and their parent investment banks out of fear that those assets could be frozen if the banks declared bankruptcy, which is what happened in September 2008 with Lehman Brothers Holdings. Although there were valid reasons for these withdrawals, the action was essentially a run on the bank, much like the actions of individual depositors during the Great Depression.

Looking to the future, RAND researchers identified six ways in which hedge funds could pose systemic risk to the U.S. financial system. Dixon and his colleagues define systemic risk as the potential that failure of one or more financial firms or a segment of the financial system could create cascading failures and disrupt a core function of the financial system.

It appears that three of these concerns–lack of information on hedge fund operations, lack of appropriate margin in derivatives trading and runs on prime brokers–are being effectively addressed by new regulations imposed by the Dodd-Frank Act, Dixon said.

Recent reforms also make considerable progress in addressing two other concerns–short selling and compromised risk-management incentives–although some questions remain about the effectiveness and comprehensiveness of the regulations.

In one key area, however, the study finds continued vulnerability.

“It is not clear that the reforms will do much to change the potential for hedge funds to build highly leveraged portfolios that turn out to be illiquid in periods of financial turmoil,” Dixon said.

He said it appears that few hedge funds will exceed a size threshold that triggers direct regulation. That means that control of leverage and portfolio liquidity will have to depend on market discipline and government oversight of prime brokers, who in turn oversee hedge funds. These may not result in meaningful restraint, particularly as memories of the financial crisis fade.

The study did not assess whether direct regulation of leverage and liquidity should be extended to a broader set of hedge funds. Rather, it identifies the leverage and liquidity of hedge fund portfolios as an area that policymakers and regulators should continue to follow.

The study also suggests that Dodd-Frank and other reforms, which are focused on the largest hedge funds, may not be sufficient to address the risks posed by large numbers of small- and medium-sized hedge funds that pursue similar strategies. Regulations also should be better coordinated across national jurisdictions.

The study can be found at www.rand.org. Other authors are Noreen Clancy and Krishna B. Kumar.

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