2008: The Great Hedge-Fund Run

The two comments on the previous post inspired this post. First a comment on "bank runs" and then a link to "fintag", a hedge fund news site that is rather fun. To the right is an image from that site (re-used without permission :)

Hedge-funds are exploding. With all the leverage they had, debt being senior to equity, a 30x leverage means 3% is equity, and a 3% variation in assets means THE EQUITY IS WIPED OUT?

So the banks are running on the hedge-funds, almost mechanically to shore up their balance sheets and the investors are getting screwed and so they run even faster to redeem. The hedgies unwind highly illiquid positions in a shitty market, making it shittier and looping back. This is clearly a downward spiral of the "bad kind" (see previous post for "downward spirals" of the good kind).

The FED system was set up to provide ample liquidity to the bank system to avoid the bank-run phenomena where "temporary bankruptcy" isn't materialized by redemptions resulting in systemic breakdown. So some of the banks are safe, but who is there to help the hedge funds? No-one.

The banks, the very entities that provide liquidity to the hedge-funds are running on them with a vengeance, they have no safety net. Hedge-funds had become increasingly important in the last few years because they managed so much leverage, they had become a force in the markets. Their un-winding is hitting the markets with the same force. The first market hickups in August was already attributed to hedge-funds strategies unwinding in some academic litterature (google: Andrew Lo, MIT, "What happened to the quants in August 2007?"). It is now accelerating and the end-run of this particular 'death spiral' of a run is the implosion of the hedge fund industry. Who gets hurt? the investors in the hedge funds, private money, large pension funds, everyone. As the cartoon describes, the guy who ran the hedge fund can now afford to take a break after having wreaked havoc on the whole system. Clearly the compensation structure is off in the hedge fund industry and performance fees should only be paid at exit, or something that actually track the *real* performance of the funds not just temporary snapshots that do not reflect the long term risks associated with the portfolio.