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.

Geithner Gone by June?

Not everyone has been pleased with Treasury Secretary Timothy Geithner's performance. Though he inherited a financial system in chaos, some would like to have seen more leadership from what is arguably the US' second most important financial position.

So with growing outrage over executive bonuses, limited mortgage relief, bailouts with limited transparency etc., what odd would you assign to the probability that Geithner will be relieved of his duties by June? 20%, 40%, 60%?

Well, according to Intrade, a futres site that allows speculation on a variety of outcomes, there is 15% likelihood Geithner will be fired.

If it were not so thinly traded, and I didn't think it improper to bet on the success of our leaders, I might consider placing a long position on this bet. The futures are priced at $15 and would pay $100 if he were fired or resigned by June.


Some other interesting futures bets from Intrade :

• Chance US GDP to decline by 10.0% or more from its peak value between Q4 2008 and Q4 2009: 19.5%

• Dow to close above 7000 on March 31: 83.4%
  

• Dow to close 2009 above 6500: 67%

• Any country currently using the Euro to announce their intention to drop it on/before 31 Dec 2010: 25%

• Richard Fuld (ex-Ceo of Lehman) to be indicted by US Federal Govt on any felony charge on/before 31 Dec 2009: 24%

• Angelo Mozilo (Countrywide) to be indicted by US Federal Govt on any felony charge on/before 31 Dec 2009: 42%
  

SEC Commissioner Supporting Hedge Fund Regulation

SEC Commissioner Elisse Walt, is supporting greater regulation of US hedge funds, an issue supported by democrats in Congress, particularly after the recent Ponzi scheme involving Bernard Madoff.

"I generally do support that notion (of hedge fund registration)," Walter told Reuters in an interview. "But the devil is in the details. Registration has to be meaningful."

Treasury Secretary Timothy Geithner and SEC Chairman Mary Schapiro also have recently expressed their support for legislation regulating hedge funds and other private pools of capital.

However, given that Madoff's firm was in fact an SEC regulated fund, it is not clear who should have regulating authority nor whether it will be effective.