How Hedge Funds Created the Financial Crisis

The True Villians Behind the Financial Crisis

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Hedge funds caused the 2008 financial crisis by adding too much risk to the banking system. That's ironic, because investors use hedging to reduce risks. They use sophisticated, data-based investing strategies. It allows their analysts to find out more about individual companies than an average investor could. They exploit and take advantage of any unfairly priced stocks. That makes share prices more fairly valued. By reducing risk, hedge funds lower stock market volatility.

Many hedge funds are very active investors. They buy enough shares to get a vote on the company's board. They have such an influence on that company's stock that they can force the company to buy back stock and improve share prices. They can also make the company sell off low-producing assets or businesses, becoming more efficient and profitable.

Five Factors That Made Hedge Funds So Risky

Hedge funds also increase risk. First, their use of leverage allows them to control more securities than if they were simply buying long. 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. Hedge funds derivatives include options contracts that allow them to put down a small fee to buy or sell a stock at an agreed-upon price on or before a specified date.

They can short sell stocks, which means they borrow the stock from the broker to sell it, and promise to give it back in the future. They buy futures contracts that obligate them to either buy or sell a security, commodity, or currency, at an agreed-upon price on a certain date in the future. 

As a result, hedge funds' impact on the stock market has grown substantially in the last decade. According to some estimates, they control 10 percent of shares on U.S. stock exchanges. That includes the New York Stock Exchange, the NASDAQ and BATS. Credit Suisse estimates their impact could be even higher. They may control half of the New York and London Stock Exchanges. (Source:  "U.S. Regulators Grow Alarmed Over Hedge Fund Hotels,” International Herald Tribune, January 1, 2007.) 

Since they trade often, they are responsible for one-third of the total daily volume on the NYSE alone. An estimated 8,000 hedge funds are operating globally. Most are in the United States. There is a high concentration in the state of Connecticut. 

Researchers found that hedge funds contribute positively to the stock market. But when their sources of capital dry up, they can have a devastating negative impact. (Source: Charles Cao, Bing Liang, Andrew Lo, Lubomir Petrasek, "Hedge Fund Holdings and Stock Market Efficiency," Federal Reserve Board, May 2014.)

Second, they all use similar quantitative strategies. Their computer programs can reach similar conclusions about investment opportunities. They affect the market by buying the same product, like mortgage-backed securities, at the same time. As prices rise, other programs get triggered and create buying orders for the same product. 

Third, hedge funds rely heavily on short-term funding through money market instruments. These are normally very safe ways to raise cash, such as money market funds, commercial paper issued by high-credit corporations, and CDs. The hedge funds purchase and resell bundles of these instruments to investors to generate enough cash to keep their margin accounts active. The bundles are derivatives, such as asset-backed commercial paper.

Usually, this works fine. But during the financial crisis, many investors were so panicked they sold even these safe instruments to buy 100 percent guaranteed Treasury Bills. As a result, the hedge funds couldn't maintain their margin accounts, and were forced to sell securities at bargain-basement prices, thus worsening the stock market crash.  They helped create the September 17, 2008 run on money markets.

Fifth, hedge funds are still largely unregulated. They can make investments without scrutiny by the Securities and Exchange Commission. Unlike mutual funds, they don’t have to report quarterly on their holdings. That means no one knows what their investments are. 

How Hedge Funds Create Asset Bubbles

The world's richest hedge fund owner, George Soros, said that hedge funds actually influence markets in a feedback loop. If a few of their trading programs reach similar conclusions about investment opportunities, it triggers the others to react.

For example, say funds start buying U.S. dollars in the forex market, driving the dollar's value up a percent or two. Other programs pick up on the trend, and alert their analysts to buy. This trend can be accentuated if the computer models also pick up on supporting macro-economic trends, such as war in Ukraine, an election in Greece, and sanction on Russian oligarchs. The model takes all these things into account, and further alerts the analysts to sell euros and buy dollars. Although no one knows for certain, the dollar index did rise 15% in 2014, while the euro fell to a 12-year low.

 

Other recent asset bubbles were just as sudden and ferocious. The U.S. dollar rose 25 percent in 2014 and 2015.  The stock market rose nearly 30% in 2013, Treasury yields fell to a 200-year low in 2012, and gold rose to nearly $1,900 an ounce in 2011. Oil prices rose to an all-time high of $145 a barrel in 2008, even though demand had fallen thanks to the recession. The most damaging asset bubble of all was hedge fund trade in mortgage-backed securities in 2005. 

How They Caused the Financial Crisis

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.