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May 10, 2005
Are Worries About Hedge Funds Overblown?
What started out as a story in today's Wall Street Journal about how hedge funds haven't been so hot lately quickly snowballed into rumors in the bond pits about hedge fund liquidations in the U.S. and in Europe. Stock investors got spooked.
Here's an explanation from economic research outfit Action Economics: "The crux of the matter appears to be the GM/Ford downgrades last week, that gave rise to speculation that some leveraged credit default swap or derivatives positions were at risk."
The WSJ report said that hedge funds had been caught on the wrong side of a long debt/short equity trade on GM that was undermined by the Kerkorian bid for an 8.8% stake in GM stock and Standard & Poor's subsequent credit downgrade on the auto maker. Action Economics says there was also talk that collateralized debt obligations (CDO) spreads were blowing out amid deleveraging following the GM/Ford episodes. In addition, there was talk of a large UK-based hedge fund that had been investigated earlier in the year for its pre-marketing practices, says Action Economics.
I wonder if these concerns are overblown. When I tried to find if any blogs were covering this, the only one I found so far was from John Rutledge. What do you think?
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Even though investors aren't as worried today about potential hedge fund blowups from problems at GM and Ford, I think there is still potential for major problems at some point due to derivatives.
The hedge fund industry is huge and growing. Yet returns are weak. Managers must be getting desperate for gains, which may lead them to take more risk and try to use complex derivatives to manage the risk. That's what led to the Long-Term Capital mess in the 1990s and it could happen again.
Posted by: Amey at May 11, 2005 01:53 PM
I think the law of large numbers and the lack of transparency will inevitably cause a shock to the hedge fund industry. It's just a matter of time...
Believe it or not, most hedge funds run pretty simple strategies. Many of them use little, if any, leverage. But, there will be someone out there who will lever up beyond reason... and ultimately make the wrong move.
The people running LTCM were extremely smart, well-educated people who got caught with their pants down at just the wrong time, thanks to the Russians defaulting.
This time, I'm afraid the culprits will not be as smart, but the effects could be just as great. But this time, I wonder if the Fed will be able to bail us out of the next mess the way they did with LTCM...
Posted by: The Assetman at May 14, 2005 01:44 AM