Hedge fund crisis?

Although you frequently see "hedge funds" mentioned in many articles about the waves of crises overwhelming Wall Street over the past seven months, you rarely see any deeper explanation of the role that hedge funds have had in the various crises. In theory, hedge funds are ideally suited for exploiting crises because of their ability to arbitrage virtually any kind of pricing gap within or between markets. And all of these tend to be short-term trades.

Unfortunately, what happens is that once a hedge fund identifies an opportunity, other funds as well as the in-house proprietary trading desks at all of the financial firms begin to mimic that same "trade", squeezing the potential value of the trade down to zero or even negative. That is what markets do, so there is no problem there.

Two problems occur.

First, because the window of profitability for any trade may be small, funds leverage with borrowed money or options or futures, pushing their risk up towards the sky.

Second, they start chasing after lower-profit trades, possibly with even greater leverage.

But eventually even low-profit short-term trades become scarce, causing traders to lengthen their time horizon for a "trade" so that it may look more like a speculative position (months) or even an investment (years.) Hedge funds do not normally make long-term investments, but sometimes their trades go bad and turn a short-term "sure thing" into an investment-like position that they cannot dump either without a large loss or maybe even at all.

When leveraged hedge funds get into trouble, their brokers or "primes" (e.g., prime brokerages such as Bear Stearns) issue margin calls. Those margin calls can be quite painful for the hedge fund, but sometimes, as we have seen lately, even the securities held by the broker cannot be redily sold to satisfy the margin call, leaving the broker on the hook. That does happen on occasion, and in fact happens all of the time even in good markets, but it rarely happens simultaneously for a significant fraction of the broker's clients. And that is the problem we are experiencing might now on Wall Street, where hedge funds are falling like flies and unable to meet margin calls and repay loans, causing their brokers ("primes") to suffer as well.

The end result of all of this will be the purging of a significant number of hedge funds. There were too many of them chasing too few of the same trades and using ever-greater leveraging to exploit ever-narrower profits on fewer trades.

Lately commodities have been the last great refuge for hedge funds, but now it appears that even many of those profitable commodities positions will have to be sold off to satisfy margin calls.

Hedge funds are an important part of the financial ecosystem, but sometimes the do get carried away with their own over-inflated self-importance and think that somehow they are immune to the laws of supply and demand. Now, they are being forced to pay the piper.

I do wish that the media would do more in-depth coverage of the extent to which hedge funds were fueling the speculative exceses in both the mortgage and commodities markets and the extent to which hedge funds were in fact the primary cause of the current bout of crises fouling Wall Street and causing harm to consumers.

I would also like to see investigation into the extent to which banks which are supposed to have the interests of consumers at heart may have been fueling profits by catering to the excesses of hedge funds. And, the extent to which the banks themselves were engaging in the same risky  trades as hedge funds via their in-house proprietary trading desks.

In general, profits from hedge funds benefit primarily the wealthy (and pension funds as well), but it is especially shameful when the excesses of hedge funds (pushing commodities prices higher and literally destroying the mortgage and housing markets) are harming average consumers on Main Street. The media and Congress and state regulators should try to do a much better job of probing the roles of hedge funds and hedge fund-like activities and protecting the interests of consumers.

A strong and healthy consumer has to be considered the financial bedrock of our economy.

-- Jack Krupansky