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What role did Hedge Funds play in the credit crisis?

July 3, 2011 2 comments

I have been asked numerous times questions along the lines of “What was the role of hedge funds in precipitating the credit crisis?”

The short and simple answer is: They are NOT responsible for the credit crunch. (If anything, Hedge Funds as unregulated investment vehicles probably help keep the markets in check).

Below is the long answer I posted on a discussion forum which attracted recommendations and interests; as such, I am reposting here.

If you have to draw the line somewhere, like with all market cycles, then post-dot-com crash or 9-11 in 2001 would be a good arbitrary starting point. The key points to remember are:

1) Greenspan kept interest rates for far too low after 9-11 and the dot-com crash – fuelling a credit bubble.

2) This cheap credit meant a housing bubble, as low rates = low mortgage = let’s all buy a house! Happy days!

3) As house prices went up, banks ran out of people to loan money to, they went to subprime or Alt-A (alternative to A-paper).

4) From subprime/Alt-A, greed led us to NINJA loans. No income, no jobs and no asset. These people can’t even prove their income but they can get a mortgage. Happy days!

5) House prices were going up, banks kept lending at record low rates, paying themselves huge bonuses. Everyone was doing it. Can’t beat ’em join ’em mentality. Risk was perceived to be low as everyone believed this housing boom was going to continue. Therefore, banks can easily repossess and sell the houses on, fuelling predatory lending.

6) The loans were packaged up, sliced up and sold on worldwide (e.g. European/Japanese pension funds/institutions).

7) ‘Experts’ argue that never in the US history has there been a NATIONWIDE simultaneous fall in the housing market. (Blackswan event, God I hate that word.) This led to the belief that securitized mortgages are relatively ‘safe’.

8) Pension funds can only buy triple A or AAA rated investments. Investment banks got around that problem by mixing up subprime loans with top rated ones. Paid good money to Moodys and S&P to rate them triple A. The rationale was that not everyone is going to default at the same time (see no. 7). The CDOs (Collateralized Debt Obligations) spread the risk around…

9) Hedge funds act like vultures. They are like the market vigilante. Some of the top guys like Michael Burry, John Paulson, Andrew Lahde (my favorite because he knew when to call it quits) begin to explore ways to short housing.

10) This proved to be almost impossible. They could short firms like NATIONWIDE or homebuilders but naked short selling = their losses can be unlimited and the market can remain irrational then we can remain solvent. (Some managers who correctly foresaw the crash lost money because they bet too early and the market still kept going up.)

11) So smart guys like Paulson found a way to bet against housing by buying Credit Default Swaps (CDS). It is sort of like an insurance policy in case the loan goes bad. His line of reasoning is that, when the shit hits the fan, everyone will be scrambling to buy insurance because their loans will be worthless.

12) As Nouriel Roubini puts it: “It is weird that these CDSs (insurance policy) can be traded around freely. For example if you own a house, only YOU can buy fire insurance for it. But in the case of this credit crunch, I or anyone can buy insurance for your house insuring it multiple times, and then sell it on later, essentially betting on your house burning down.”

13) On a sideshow, Goldman Sachs got hauled up to Congress to explain the fact that they helped Paulson & co pick the worst tranches to bet against. GS later turned around and bet against housing themselves.

14) Those that did not bet against housing were geared and long – and as it turns out they were also ‘long and wrong’. Banks were highly leveraged: 30:1 for Lehman 42:1 in Bear Stearns’ case. It was a case of the sausage makers keeping all the sausages on their books despite knowing what went into them.

15) It was only a matter of time when homeowners started defaulting. It became a snowball effect. When half your neighbourhood is being foreclosed, the value of your home plummets. You bought your house for 500k, now it is worth 300k. You hand in the keys and walk away. So more defaults again!

16) Now all the banks are scrambling to buy CDS. House is on fire! CDS shot through the roof. Guess who is holding it? The hedge funds who correctly bet on them like Paulson.

17) AIG (yup, US taxpayers money bailed them out) wrote most of the CDS and sold it dirt cheap. In traders’ lingo – you have AIG making money paying huge bonuses selling insurance policy for houses built from flammable material next to a pyrotechnic factory located on an earthquake fault line. It was a case of ‘picking up nickels and dimes in front of a steamroller/freight train’.

18) No problem – when AIG was about to go down, we have TOO BIG TO FAIL. Lehman was Goldman Sachs’ number one competitor but they were allowed to fail. If AIG went down, Goldman Sachs was on the hook. But no problem, the then Secretary Hank Paulson was former CEO of Goldman Sachs (conflict of interest?). Hank played a key role in bailing out AIG. AIG straight away paid back Goldman.  Make of this what you will. “It is Government Sachs mate. GS is a branch of the US government.” (That was what a friend said to me.)

19) When the market tanked, a lot of institutions started pulling funds from hedge funds. Some of which were geared/leveraged. They then had to unload their positions in a thin market, causing a death spiral. The liquidity problem killed them.

20) So do hedge funds have a role in causing the crash? Answer = NO!  They were as much a casualty as a profiteer.

So what caused the credit crunch? Well, no simple answer. I tried to keep it to 20 sentences. I guess it is a case of pluralistic ignorance, greed, hubris and regulation (or the lack of it)?

“If I had known I was going to fall down, I would have sat down” old Polish proverb.

 

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