Ghosts of Black Monday come a calling

(UPDATE: In case it’s not obvious, I wrote this post Thursday morning over my first cup of coffee, well before the market opened, and posted it just as prices were starting to drop…)

Long term interest rates had risen some months earlier, the dollar was weak and getting weaker and financing for a leveraged buyout boom started to look shaky. Sound familiar? Is 2007 setting up as 1987 all over again? A report from Barclays Capital back in May foresaw some similarities. And I have to say that the hair on the back of my neck stood up a little this morning as I read about investors rejecting bonds offered to finance already completed leveraged buyouts of Chrysler and Alliance Boots. It’s undeniable that the vast pools of capital sitting in the coffers of private equity firms have acted as a floor under many of the weakest parts of the stock market. Just yesterday, I looked at the restaurant sector where buyout hopes are helping keep afloat share prices of some of the biggest players. It’s the same in newspapers, real estate, finance and on and on. Removing that floor, or even the perception of removing it, could turn a market swoon into a full blown rout.

Of course, not everything is the same as 20 years ago. One big difference is the role of hedge funds in today’s markets. With assets fast approaching $2 trillion, hedge funds can easily move markets – and do with great speed – when they sense an opportunity or an oncoming calamity. Which makes a new study out today from three researchers at the New York Fed all the more timely. The 31-page report, written in the style of a white paper, examines the growing influence of hedge funds and starts to address the question of how this influence might be felt during a major financial crisis. At bottom, the three authors conclude that the current discipline imposed by other market players is the best way to limit the damage of a major fund failure, not more regulation. In recent years, the market has functioned to contain problems, like when natural gas trading fund Amaranth and more recently subprime funds of Bear Stearns blew up. But there’s less here than meets eye since the three authors did no primary research of their own.

In some ways, hedge funds have improved and stabilized the markets by acting as buyers when others are selling, or providing liquidity in the jargon of finance, the report notes. But as seen in the 1998 failure of Long Term Capital Management (the really, really beating-a-dead-horse hedge fund blow up of all time), huge amounts of borrowing done by hedge funds can also cause problems to spill over to banks and other institutions if a fund runs into trouble. And such a spill-over could cause problems for the wider economy if banks had to pull back on lending to ordinary businesses, for example.

Unlike mutual funds or pensions funds, hedge funds operate without much regulation limiting their risk taking or investment strategies. The real check on a hedge fund is the market. Investors and lenders, primarily, have huge incentives to pressure funds not to go too far. The Fed researchers focus on those who lend to or otherwise enter financial contracts with hedge funds, their counterparties, as the main check on excessive risk taking that could destabilize the larger economy. At least one study cited by the authors found that the potential exposure of major financial firms to hedge funds was at most equal to 10% of their primary, or “Tier I,” capital, far too little to cause a major disruption.

“A key lesson from the collapse of [Long Term Capital Management] is that market participants may not be sufficiently cognizant of the risks they face and therefore not vigilant enough in constraining counterparty risk,” the author’s write. “Since LTCM, however, [counter-party credit risk management] has greatly improved.”

They then cite studies finding improved risk management techniques by counterparties; improved supervision; more effective disclosure and transparency; strengthened financial infrastructure; and more effective hedging and risk distribution techniques. Very reassuring. Ultimately, they conclude that this market discipline appraoch is “imperfect” but “remains the best line of defense.”

Still, they also include this little ditty: “More research on the role of hedge funds of funds as both a stabilizing force (through increased discipline and reallocation of capital to better performers) and a destabilizing force (as a source of ‘hot money’) would likely be fruitful.” It sure would. Think it will be completed by October 19? It could be a great 20th anniversary present.

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