ECB on Hedge Fund "Risky Business"

Ok, I admit it. I'm obsessed with the possibility of systemic breakdown led by too many (some deemed "too big to fail") playing too risky games in hedge funds. New Economist reports (as adapted with a "hat tip") :

Friday's Financial Times has this front page headline: "ECB warns of hedge funds risk to stability" [S]. Here is an excerpt from Ralph Atkins and Chris Giles' page one piece:

Hedge funds have created a "major risk" to global financial stability for which there are no obvious remedies, the European Central Bank warned yesterday in one of the bluntest official statements yet on the rapidly growing sector.

In a clear hint of rising official nervousness about the multi-billion-dollar industry, the ECB ranked an "idiosyncratic collapse of a key hedge fund or a cluster of smaller funds" in the same category as a possible bird flu pandemic as the type of shock that could trigger fresh disruption in financial markets.

The ECB's remarks will play to the hostility felt by some European political leaders over the growing influence of hedge funds. Last year, they were described as "locusts" by Franz Müntefering, now the German deputy chancellor. They come amid a debate among financial regulators around the world over the regulation of hedge funds.

The ECB's concern contrasts with a more relaxed attitude at the International Monetary Fund and the Bank of England, both of which have stressed the positive role of hedge funds while acknowledging possible dangers.

The ECB's comments came in the Frankfurt-based central bank's latest "financial stability review", which, for the first time, included a special section on hedge funds. The review highlighted an increasing tendency by funds to mimic strategies followed by others. It noted that the correlation of hedge fund returns had "surpassed levels seen just before the near collapse of Long Term Capital Management in 1998".

...Presenting the report, Lucas Papademos, ECB vice-president, said that if business conditions changed and many hedge funds reacted in a similar way, "because of the similarity of strategies, the implications for asset prices are going to be more pronounced". He stepped up ECB demands for greater transparency.

Here is the ECB media release for the report, and a link to the June 2006 Financial Stability Review [2.5Mb PDF]. (The section on hedge funds starts at page 133.) Here is the 'overall assessment' from that section. It's quite a stark warning, accompanied by some compelling analysis:

As the hedge fund industry keeps on growing, its expansion continues to raise questions about capacity constraints and the impact of hedge funds’ largely unconstrained investment strategies on financial markets. In addition to potentially high leverage, the increasingly similar positioning of individual hedge funds within broad hedge fund investment strategies is another major risk for financial stability which warrants close monitoring despite the essential lack of any possible remedies. This risk is further magnified by evidence that broad hedge fund investment strategies have also become increasingly correlated, thereby further increasing the potential adverse effects of disorderly exits from crowded trades.

It is difficult to gauge what could cause correlated sell-offs and how damaging these could be, but one possible trigger could be an abrupt end of the recent global search for yield possibly induced by the tightening of global liquidity conditions. A further slowdown of inflows into hedge funds or even widespread redemptions could also exert pressures on individual hedge funds to liquidate increasingly less liquid holdings, as more hedge funds seem to be venturing into less liquid markets in order to earn the associated liquidity premium. Since the valuation of such investments is often arbitrary, investors may not always be presented with an accurate picture of fund positions and performance.

Comments

[bailey]

It may be curious but it's certainly understandable that pension fund Advisors aren't DEMANDING risk managers reduce their leveraging AND outlandish derivatives. Remember TWA's Tillinghast rationalization to switch over to 747s long after everyone knew they were a bust?

[Dave]

bailey,

Since you and I seem somewhat unique among bloggers and "commenters," at least to our focus on "contagains" and "systemic risk," I thought I'd mention that Roubini's latest list of 12 (posted here yesterday)includes one that warns on "systemic financial crisis."

And last night while reading Stephen Roach's latest http://www.morganstanley.com/GEFdata/digests/20060612-mon.html, I noticed this reference to Naill Ferguson (historian), who (at recent forum):

"... had little to say on the financial risk issue, but he raised his eyebrows a bit when presented with arguments that the advent of derivatives makes the world a safer place by diffusing the distribution of risks. He asked if any of us had heard of an incident not all that long ago (1998) involving Long-Term Capital Management."

I keep going back to a favorite quote from sci-fi author Robert Heinlein, paraphrasing: "People don't learn from the mistakes of others. They seldom learn from their own mistakes. Never underestimate the power of human stupidity." Leaving these words here in this blog will give someone a chance, at some future moment, to make me eat my words. Or not!