Why Hedge Funds are NOT "Too Big To Fail"

Relative to Other Financial Institutions, Hedge Funds are Actually "Too Small NOT To Fail"

Timothy Geithner and other public officials have argued that large hedge funds are "too big to fail". Their collapse, they argue, could have widespread systemic impacts on the global financial system. However, their are legitimate questions as to whether the argument that hedge funds are too big to fail has any credible weight. In fact, relative to their regulated counterparts such as banking and insurance giants, hedge funds are actually too small not to fail.

Why Hedge Funds Are NOT "To Big to Fail":

1. The largest hedge fund (Bridgewater at under $40 billion in AUM) has less than 2% of the assets of Citigroup (Citi had 2008 assets of $2.2 trillion).

  • The entire hedge fund industry is estimated at about $1 trillion. By comparison, Citi had $1.1 trillion, in off-balance sheet assets alone. These off-balance SIVs often consisted of now toxic CDOs and other structured debt pools.

2. Hedge Funds Actually Operate with Less Leverage than Most Banks

  • Here are the 2008 leverage ratios for the largest US Banks: Citigroup (19.2x), JP Morgan (12.7x), Wells Fargo (12x), Bank od America (11.7X).
  • According to the Merrill Lynch Hedge Fund Manager Survey, 70% of hedge funds operated with less than 2x leverage in 2007. And 2007 was the most levered hedge funds had been in almost 10 years.
  • Currently, the average hedge fund has net leverage of less than 1.

3. Hedge Fund Collapse Does Not Markedly Effect Broader Markets

  • While a hedge fund collapse may have some detrimental effects on the financial markets in which the fund(s) operated, it is not likely to lead to widespread economic malaise.
  • By contrast, the failure of a large bank leads to tens of thousands of job losses (at least 35,000 from B of A a lone), massive decreases in consumer and business lending, and general liquidity issues.

4. Hedge Fund Failures are Just a Blip Compared to Regulated Financial Institutions

  • AIG losses in 2008 ($98 billion) were greater than all the hedge fund failures in history.
  • At the time of Lehman's bankruptcy, it still declared $639 billion in assets. This represents assets equal to more than half of the entire hedge fund industry and more than 10x larger than Madoff's fund. If Lehman can be permitted to fail, what logical rationale could be proposed for bailing out a hedge fund?

Hedge funds are not too big to fail. The entire industry represents fewer assets than individual global banks. Additionally, protecting hedge funds from failure creates an unnecessary moral hazard. Funds might be encouraged to take more risk, particularly risks with systemic impact, if they feel their size and breadth makes them impervious to failure.

Unfortunately, we have recently created such a moral hazard with the bailout of banks. However, the impact of moral hazard was deemed modest in comparision to the potential failure of the entire economic system. Given the much slighter impact posed by hedge funds, considering hedge funds to be too big to fail carries negative implications as well.

This is not to say hedge fund regulation can't be helpful; it can. However, considering hedge funds to be as dangerous as massive financial institutions is purely asinine.

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