indirect counterparty exposure risks
Stress testing the hedge fund sector
By Gillian Tett
Published: May 24 2007 17:33 | Last updated: May 24 2007 17:33
Imagine for a moment that you were suddenly told that 700 hedge funds had collapsed. Would you react with merely a nonchalant shrug of the shoulders? Or experience a sense of panic?
It is not a hypothetical question. Last weekend the Financial Stability Forum – a committee of international policy makers – released its most comprehensive analysis of the hedge fund sector since 2000 (or when the world was still reeling from the implosion of Long Term Capital Management fund). This provides a fascinating snapshot of the explosive growth seen in this sector this decade. But it also highlights a fascinating fact: namely that while 1,518 new funds were apparently created last year, another 717 were liquidated too. That represents a death rate equivalent to about one 12th of all funds.
To be sure, not all of these funds necessarily “collapsed”. Some may have died because their managers retired to the beach; others quietly shrivelled as bets went wrong. But some funds undoubtedly imploded too: just remember Amaranth’s $6bn losses on natural gas bets. Yet what is striking is that the financial sector absorbed not just the Amaranth debacle – but another 700 deaths too. Moreover, it did this with barely even a minor tremor, let alone the type of panic that the media normally associates with hedge fund deaths.
To a certain extent, this simply reflects the fact that market conditions are extraordinarily benign, while the majority of these funds were undoubtedly also very small. But the trend also highlights another point: namely just how much the financial world has quietly matured since LTCM.
After all, if you step into any large fund in Mayfair or Greenwich these days, you will see a veritable army of compliance officers, risk managers and technology staff. Or talk to a prime broker, and you will be regaled with tales about how they now track credit lines to hedge funds more accurately than ever before. The type of scenario that unfolded in LTCM, in other words, seems difficult to imagine today.
Yet, just as generals have a nasty habit of fighting the last war, there is a constant danger that risk managers will focus on yesterday’s traps. And the FSF report points out that while banks have made amazing strides in managing their direct counterparty exposures to hedge funds, it is still far from clear that they are properly aware of all indirect exposures.
This second point matters because as the hedge fund industry has exploded in size, indirect links between banks and funds have grown too. Banks, in other words, do not simply lend to funds, but trade with them, and offload risky assets to them, on a massive scale. Indeed – and amazingly – the FSF suggests that prime brokerage now accounts for only a fifth of all bank revenue from hedge funds.
That, the FSF suggests, creates large indirect counterparty exposure risks – and it urges the banks to spend more time analysing this issue. Still, amid all the exhortations for extra number crunching, there is one other tactic that risk managers and regulators might also consider: embracing a little anthropology (or micro-level cultural analysis).
After all, the history of financial crises shows that when these erupt, human beings rarely behave precisely as models predict; instead, they have a nasty habit of panicking in ways that can seem unpleasantly irrational to the egg-heads. (In the case of LTCM, for example, some of its former managers are still startled that when the crunch came, their counterparties panicked in an “irrational manner not forseen by the LTCM models”.)
So if the banks respond to the FSF report by producing better stress testing models, they wlll certainly deserve at least one cheer. Indeed, that would rise to two cheers if they started properly addressing indirect exposures too. But what would be better still would be if regulators and bankers grabbed a clipboard as well – and analysed the micro-level incentives and stories playing out in the hedge fund world. Not simply at the disasters such as LTCM – but also at the 700-odd other funds that died last year without ever causing a panic.
Copyright The Financial Times Limited 2007