Hedge Funds & the Global Economic Crisis: Willing Culprits or Easy Scapegoats?

By Shane Brett, Managing Director, Global Perspectives

The summer of 2012 marked 5 years since the slow onset of an economic crisis that first became known as the Credit Crunch and then the half decade that became known as the Great Recession.

At the time and over the last few years, Hedge Funds have received a large portion of the blame for the economic crash. They have often been portrayed as one of the main culprits responsible for causing the global financial crisis.

With the benefit and hindsight of recent history we can now look back with some perspective and see if the crisis really was the fault of the Hedge Fund Industry. Is there some basis to the claim that the industry was significantly responsible for the worst economic crash since the Great Depression; or were they merely a scapegoat for a seething public and outraged politicians and media?

Willing Culprits?

The first really significant event to signal a coming financial storm occurred in the UK on August 9 th 2007, when BNP Paribas halted redemptions from 3 of its Hedge Funds due to a disappearance of liquidity in the market.

This led to panic from many investors as they tried to get their capital back from financial institutions. Hedge Funds liquidated their holdings from many Prime Brokers, making them more susceptible to financial collapse.

After the failure of Long Term Capital Management in 1997 the Hedge Fund industry had shown that the failure of a large fund had the potential to pull down one of the leading investment banks and lead to a wider systemic crash by also pulling down larger commercial banks.

In the recent crisis Hedge Funds who acted as short-sellers have been accused of contributing to the collapse of bank shares and the exacerbation of the financial panic (Short selling of course sees investors borrow and sell shares in a company in the hope of buying them back cheaper in the future for a profit).

We should be clear about this, while Short Selling is an important part of market activity and some would say an essential tool in restoring market equilibrium of inflated valuations (having helped expose multiple frauds including Enron), massive volumes of short selling right in the middle of an economic crisis does not help financial stability.

If the Hedge Fund industry has one charge against them that will stick it is this. Especially when it became known that some Hedge Funds were making massive Funds (e.g. Odey), by shorting UK banks – that later had to be bailed out with public money.

Huge Short Selling of banking stocks in 2008 certainly served to accelerate the general speed of economic collapse.

As the effects of the Lehman collapse in Sept 2008 reverberated throughout the financial system, the end of the year brought further evidence to some that the Hedge Fund industry was rotten and at the heart of the economic crash. Bernie Madoff admitted that the Hedge Funds he had been running for over two decades were in fact gigantic Ponzi schemes and that he had defrauded investors of $65 Billion – the largest fraud in world history. This merely served to reinforce the negative image of the Hedge Fund industry in the eyes of the regulators, politicians and the general population.

Hedge Funds seemed to have brushed aside basic checks of investment and operation due diligence to invest colossal sums of money with this incredible confidence trickster. Everyone from the regulators to the investors to his Feeder Fund managers came across looking foolish and hopelessly outwitted. But it was the Hedge Fund industry that deservedly took most of the blame.

Elementary oversight and basic due diligence was systematically ignored. Despite screaming red flags and plenty of whispering, the industry was content to let sleeping dogs lie, as long as the smooth, stable long term returns continued year after year.

Another charge against Hedge Funds is that it was their use of Excess leverage which contributed to the scale of the financial losses. There is certainly some truth in this, as leverage was used across the board particularly to amplify investment returns.

That is fine when times are rosy and markets are growing but it simply magnifies the problem when liquidity dries up and there is an economic crash. This was illustrated clearly in the losses caused by mortgage back derivatives as the underlying loans went sour. The losses were far in excess of the mortgages themselves, because investors including Hedge Funds had borrowed significantly to take out synthetic positions through Credit Default Swaps.

Easy Scapegoats?

However from a wider viewpoint it is obvious that the crisis is the result of excessive worldwide debt. This was built up by both individuals (US, UK, Ireland), Governments (Greece, Portugal, France), as well as private debt being guaranteed by sovereign states (Ireland, US, UK).

The quarter century from 1982 known as the Great Moderation (characterised as it was by low inflation, low interest rates and rising employment) led to a loosening of financial regulation and an ensuing debt expansion and asset bubble.

While Hedge Funds certainly played their part in borrowing widely to finance investment (some would say speculation), they were just one sliver of a wider debt bubble that grew throughout the global economy over the past quarter century.

The banks created the global housing bubble by reducing the requirements for mortgage qualification and massively increasing their property lending.

The private market then took these loans and packaged them into tranches for sale to different investors. They were erroneously graded by the rating agencies and sold in every corner of the globe. The global purchase of these securitised assets meant the effects of the crisis was felt worldwide (e.g. as in the collapsed of exposed German Landesbanks).

It is also worth noting that in America the massive growth of Sub-Prime mortgage lending (through Freddie Mac and Fannie Mae) was partially caused by well intentioned but misguided government policies. aimed at making homeownership available to sections of the public who otherwise would never have qualified.

This combined with a long period of regulatory loosening by many governments (for example by the repeal of the Depression-era US Glass-Steagall Act separating investment and commercial banking) which paved the way for an explosion of bank lending.

Banks not only lent hugely in relation to their capital base (further reducing their Capital Ratios to historically low levels), they also became more dependent on short term financing in the money markets to finance this expansion. This was especially risky where this short term capital was being lent back out for long term loans (as Britain’s Northern Rock found out to its cost). This type of funding is exactly the sort of financing that dries up overnight in a credit crunch.

Conclusion

Looking back on this recent history we can now see fairly clearly it was the banks that caused this economic crisis. It was the excesses of the banking industry, through the accelerated growth of debt and lax lending criteria that planted the seeds of global economic collapse.

Hedge Fund did not contribute significantly to the global housing bubble nor did they play a pivotal or systemic role in the crisis. Other players such as mortgage lenders, the credit rating agencies and of course the banks themselves were to blame for causing the crisis.

While Hedge Funds may not have been substantially responsible for the global economic crisis, some of their activities definitely contributed to the scale of the collapse.

However it is worth remembering that unlike the banks, no Hedge Fund anywhere worldwide received any public money, nor did any have to be bailed out by a government.

Tellingly, after the financial crisis Oliver Stone changed the script of his movie “Wall Street 2” from focusing on the Hedge Fund industry to that of Investment Banking.

Nevertheless, the crisis that began 5 years ago has provided regulators worldwide with the pretext they wanted to regulate the Alternative Investment Industry far more closely.

The same regulators, who have been so sharply criticized for their failures in averting the crisis, have been enacting widespread legislation in the US and Europe to bring Hedge Funds firmly within their regulatory remit.

This means that whether Hedge Funds were responsible or not, the Global Economic Crisis will deeply change the nature and structure of the industry through increased global regulatory requirements.

Shane Brett is Managing Director of Global Perspectives. an alternative investment & asset management consultancy based in London & Dublin.