How Hedge Funds Created the Financial Crisis

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Deals based on trust soon capsized when housing prices fell. Photo: Fuse/Getty Images

Hedge funds caused the 2008 financial crisis by adding too much risk to the banking system. Their risks were more dangerous than other financial institutions because they used leverage. They used sophisticated derivatives to borrow money to make investments. That created higher returns in a good market, and greater losses in a bad one. As a result, the impact of any downturn was magnified. 

In 2001, the Federal Reserve lowered the Fed funds rate to 1.5% to fight the recession.

During the stock market downturn, investors sought out hedge funds to gain higher returns. Low interest rates meant bonds delivered lower results to pension fund managers. They were desperate to earn enough to cover their expected future payments. As a result, massive amounts of money poured into hedge funds.  

As the economy improved in 2003 and 2004, more money flowed into these funds. Managers created riskier investments to gain an edge in a very competitive market. They increased their use of exotic derivatives, such as mortgage-backed securities. These were based on bundles of mortgages and were very profitable. 

Low interest rates also made payments on interest-only loans affordable to many new homeowners. Many families who couldn't afford conventional mortgages flooded the housing markets. As demand for the mortgage-backed securities rose, so did demand for the underlying mortgages.

Banks had become big investors in hedge funds with their customers' deposits. The large banks created their own hedge funds. That had been illegal until Congress revoked the Glass-Steagall Act revoked in 1999. As a result, banks put pressure on their mortgage departments to lend to anyone and everyone.

They didn't care if the loans defaulted because they sold the mortgages to Fannie Mae and Freddie Mac. 

As the number of reasonable investment alternatives decreased, fund managers started piling into similar types of risky investments. That meant they were more likely to all fail together. Nervous investors were more likely to withdraw funds quickly at the first sign of trouble. As a result, many hedge funds were launched, and just as many failed. 

By 2004, the industry was unstable with high levels of volatility. A National Bureau of Economic Research study of the hedge fund industry revealed higher levels of risk. Those findings were supported with more research in 2005 and 2006. (Source: "Systemic Risk and Hedge Funds," National Bureau of Economic Research, March 2005.)

Also in 2004, the Federal Reserve raised rates to fight inflation. In 2005, rates rose to 4.25% and to 5.25% by June 2006. For more, see Past Fed Funds Rate.

As rates increased, demand for housing slowed. By 2006, prices started to decline. That affected homeowners who held subprime mortgage the most. They soon found their homes were worth less than what they paid for them. 

Higher interest rates meant that payments rose on interest-only loans.

Homeowners could not pay the mortgage, nor sell the home for a profit, and so they defaulted. ​No one really knew how that would affect the value of the derivatives based on them. As a result, banks that held these derivatives didn't know if they were holding good investments or bad ones. They tried to sell them as good ones, but other banks didn't want them. They also tried using them as collateral for loans. As a result, banks soon became reluctant to lend to each other.

In the first half of 2007, several prominent multi-billion-dollar hedge funds started to falter. They had invested in mortgage-backed securities. Their failure was because of desperate attempts by investors to reduce risk and raise cash to meet margin calls.

Bear Stearns was a bank brought down by two of its own hedge funds.

In 2007, Bear Stearns was told to write down the value of $20 billion in collateralized debt obligations (CDOs). They were, in turn, based on mortgage-backed securities. They had begun to lose value in September 2006 when housing prices fell. By the end of 2007, Bear wrote down $1.9 billion. By March 2008, it couldn't raise enough capital to survive. The Federal Reserve lent JP Morgan Chase the funds to purchase Bear and save it from bankruptcy. But that signaled markets that the hedge fund risk could destroy reputable banks.

In September 2008, Lehman Brothers went bankrupt for the same reason. Its investments in derivatives caused it to go bankrupt. No buyer could be found. 

The failure of these banks caused the Dow Jones Industrial Average to plummet. A market decline alone is enough to cause an economic downturn, by reducing the value of companies and their ability to raise new funds on the financial markets. Even worse, the fear of further defaults caused banks to refrain from loaning to each other, causing a liquidity crisis. This almost stopped businesses from raising short-term capital needed to keep their businesses running.

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