Role of Hedge Funds in Subprime Crisis Examined

The subprime mortgage market crisis and associated turbulence is as much about the breakdown of the structure of US financial markets as it is about bad debt, an analysis published by the International Monetary Fund argues.

The origins of the subprime mortgage crisis are dissected in an article in the IMF’s Finance and Development magazine by Randall Dodd, a Senior Financial Expert in the IMF’s Monetary and Capital Markets Department. The article provides a history of the evolution of the mortgage market and makes a useful companion to NERA Economic Consulting’s Subprime Mortgage Lending Primer

The article examines the role of hedge funds in the unfolding crisis, noting that Fitch ratings warned of the risks in 2005.

“Hedge funds have quickly become important sources of capital to the credit market,” but “there are legitimate concerns that these funds may end up inadvertently exacerbating risks.”

That is because hedge funds, which invest in largely high-risk ventures, are not transparent entities—their assets, liabilities, and trading activities are not disclosed publicly—and they are sometimes highly leveraged, using derivatives or borrowing large amounts to invest, Dodd writes. So other investors and regulators knew little of hedge funds’ activities, while, as FitchRatings put it, because of their leverage, their “impact in the global credit markets is greater than their assets under management would indicate.”

Dodd identifies several points of weakness that contributed to the market failure that allowed a 3 percentage point jump in serious delinquency rates on a subsection of US mortgages to throw a $57 trillion US financial system into turmoil and cause shudders across the globe:

• The market first broke down at the juncture where the highest-risk tranches of subprime debt were placed with highly leveraged investors. Hedge funds have no capital requirements (they are unregulated in this regard), and the industry practice of highly leveraged investing allowed for excessive risk taking.
• The market also ruptured because unregulated and undercapitalized financial institutions were liquidity providers to the OTC markets in subprime collateralized debt obligations and credit derivatives. As soon as those markets’ solvency troubles emerged, they became illiquid and trading essentially ceased.
• Unregulated and undercapitalized mortgage originators also contributed to the crunch. The originators, like the hedge funds, operated with too little capital and used short-term financing to fund the subprime mortgages they made and expected to hold only briefly. When they could not sell those mortgages to the firms that packaged them into securities, many unregulated originators were forced out of business.
• Lack of transparency in the OTC markets exacerbated the situation. The inability of market participants to identify the nature and location of the subprime mortgage risk led to a sudden shift in risk assessment. Once overly optimistic about the risks of the subprime market, scared and confused investors suddenly panicked and overestimated risk, shunning even senior, investment-grade tranches.
• OTC markets also suffered from a failure of liquidity. Instead of showing resilience in the face of greater price volatility, these markets ceased trading as counterparties became untrustworthy and buyers fled.

Among the potential remedies suggested by Dodd is “applying industry standards and any existing regulations pertaining to the use of collateral (margin) to OTC derivatives and hedge fund borrowing.”

Technorati Tags: financial-regulation, Hedge-Funds, IMF, subprime-mortgage

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Friday, December 21st, 2007 : Credit Research, Economic Research, Public Sector : 4 Comments

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