Chapter 12. Hedge Funds
“Note how easy it is to show a short-term profit in a financial institution: you have only to take on risk.”
David Beim and Charles Calomiris of Columbia University
Loosely regulated hedge funds have many advantages: they can move freely among markets, they can profit from prices going down as well as up, and they can increase their returns by using borrowed money. The meltdown of Long-Term Capital Management (LTCM) in September 1998 showed that they compelled markets to move in alignment; its rescue stoked moral hazard.
If banks appear logically doomed to decline, the same logic points to the rise of hedge funds. LTCM was the biggest and most ambitious, but it has become the perfect exemplar of the hedge fund model’s dangers. Its fall in 1998 cost its founders, including two Nobel laureate economists, some $1.9 billion of their personal wealth1 and caused the world’s biggest financial crisis since the war. Beyond its human drama, the episode demonstrated that hedge funds had the power to drive markets to move together. The response to its near-collapse was an easy money policy that was still having painful consequences a decade later.
The term “hedge fund” is a loose one. Any fund that does not obey the restrictions that regulators put on investments aimed at the general public, such as a mutual fund, is technically a hedge fund. In return for this permissive treatment, they are required not to advertise and may only take money from the very wealthy (generally those with at least $1 million to spare) who are investing money they can afford to lose. The advantages are enormous—they can keep their holdings confidential, they can charge more in fees, they can bet with borrowed money, and they can sell short.
As with mutual funds, the structure of hedge fund fees creates perverse incentives. The standard model is known in industry vernacular as “two and twenty”—managers get 2 percent of the assets they manage, plus 20 percent of the profits they make in any given year. The exact numbers vary, and the performance fee often only clicks in after the fund has beaten some predetermined threshold, but this still creates asymmetric incentives. If you come up with a way to win big in a given year, you take home a big chunk of the profits; if you lose big, you still keep your 2 percent management fee. This is a form of moral hazard. The incentive is to take big risks in return for good performance that will last at least until the end of the year. If hedge funds can latch on to a trend, therefore, they want to make that trend last longer (or possibly, to turn overpriced markets into bubbles). They have the tools to help this happen.
One big weapon is short-selling, a maneuver that profits from prices going down and hence inspires much animosity. A fund borrows a stock (generally from a big index fund that has to hold the stock and can benefit from the interest it charges on the loan) and then sells it. If its price falls, the short-seller can buy it back, return the stock to its owner, and pocket the difference in price. The ability to profit from downward moves helps manage risks, but also creates new ones. The gains from selling short are limited to 100 percent, while potential losses are infinite. Buy a stock at $10 and the most you can make is $10 (if it goes bust). If it goes up, there is no limit on the amount you could lose. This is why regulators make it hard for mainstream firms to sell short.
The most important weapon is borrowed money, or leverage, which allows funds to multiply returns many times over. Take this simple example: Invest $100 of your own money in a stock that rises to $110 and you make 10 percent. Invest $100 plus $900 of borrowed money in the same stock, for a total of $1,000 invested, and you make $100. You double your money (although you do then have to pay your lender some interest). The problem arises when your investment goes wrong. If the stock drops by 10 percent, then you have wiped out all your own money and still have to pay the interest.
Thus leverage is best left for trades that have a very high probability of making a small amount. In this case, the leverage makes worthwhile an investment that would not otherwise be worth making. Along with chasing trends, the other key job of hedge funds is finding pricing discrepancies and attacking them using leveraged money. This can be a force for making markets more efficient—but if the funds try to keep it going too long, it can create fresh inefficiencies.
As hedge funds evolved, they tended to be small investment vehicles for clubs of wealthy investors run by self-confident managers. Usually, they would have one very specific strategy for making money in particular asset classes—either by attempting to exploit specific inefficiencies and discrepancies in market prices or by following a trend. But then they got bigger.
LTCM had visions of transcending this model. John Meriwether, its founder, had previously been the chief bond trader at Salomon Brothers, giving him a starring role in Michael Lewis’s Liar’s Poker. Apart from other successful traders, bankers, and a former Federal Reserve governor, Meriwether also recruited Myron Scholes and Robert Merton, who had shared a Nobel prize for their part in formulating the Black-Scholes theorem, which made it possible to put a value on options. This team had great credibility and easily raised lots of capital and leverage. Merton was explicit that LTCM was a new kind of “financial intermediary” that would take over roles from banks by borrowing and lending in the capital markets.2
Its strategy was to use mathematical models to find securities that were mispriced and then use its money to eliminate the mispricing. When the spread in valuation between two bonds was too wide, according to its models, it would short the expensive one, and buy the cheap one. This way, it could be sure to profit one way or another when the prices moved closer together. At first, it concentrated on technical differences between U.S. government bonds, but as it grew bigger, it needed to look further afield. Roger Lowenstein’s classic book When Genius Failed details how eventually it held more than half the market for Danish mortgage bonds and had exposures in Brazil, Argentina, Mexico, Venezuela, Korea, Poland, China, Taiwan, Thailand, Malaysia and the Philippines.3 As with Magellan before it, once it grew big, it had to start treading in areas beyond its traditional remit.
The discrepancies it could identify were often tiny, but with enough leverage they could be profitable. LTCM called this “hoovering up nickels.” But few understood just how powerful a vacuum LTCM was using. By its peak in 1998, it had $4.8 billion in its own capital—but it had borrowed so much that it had invested $200 billion. That money came from big banks, who built ever closer and more lucrative relations with hedge funds as regulations eased. Banks profit by holding hedge funds’ assets and by lending them money.
LTCM hit problems in the summer of 1998 when Russia defaulted on its debt, as the ripples continued spreading from the previous year’s Asia crisis. That default forced losses on many investors and took away their appetite for risk. Risky assets thus tended to fall, relative to safer investments. But LTCM’s trades made the opposite bet—that over time different investments would converge. When the world suffered a big enough shock, suddenly all its bets, placed in different markets and countries, became the same thing.
Only small percentage losses would be enough to wipe the fund out because it had so much leverage and it was soon paralyzed. If it failed, it would have to sell $200 billion worth of investments as quickly as possible—and that could have been a disaster. People in the market knew that it was desperate and bet on its investments to keep going down.
Had it fallen, LTCM would have taken others down with it. The market knew that many banks had made big loans to LTCM and stood to lose, or even fail, if the fund failed. No bank felt like lending to another while there was a risk that they stood to suffer such losses, so the corporate credit market dried up. Nobody wanted to trade.
“I’ve never seen anything like this,” admitted Alan Greenspan. “What is occurring is a broad area of uncertainty or fear. When human beings are confronted with uncertainty, meaning they do not understand the rules or the terms of particular types of engagement they’re having in the real world, they disengage.”4
The solution was a meeting at the New York Federal Reserve, where regulators banged together the heads of enough senior bankers to get a deal. All had lent to LTCM and stood to lose. So 14 big banks clubbed together to put $3.5 billion into the fund and in exchange would take it over. The one prominent bank to refuse to join was Bear Stearns.
Did this stoke moral hazard? No taxpayers’ funds were used. The LTCM partners themselves were ruined (although most of them bounced back in the next decade). And the money came only from those who had been so foolish as to lend to LTCM in the first place; it was in their self-interest to avert disaster. But Paul Volcker, who usually refrained from criticizing his successor, did not see it that way. He publicly questioned whether it was appropriate for the Fed to “sponsor” a bailout of a private investor that was not a bank.
But if arranging the fund’s rescue did not stoke moral hazard, the next act in the drama certainly did. With markets still frozen even after the bailout, Greenspan called an emergency meeting and announced a cut in interest rates an hour before trading closed on a Thursday afternoon. The move, which surprised virtually everyone, ended the crisis and ignited a rally. Bank shares shot up 10 percent within minutes. The incident convinced traders that Greenspan had given up on stamping out “irrational exuberance,” and would instead help them if asset prices tumbled.
At least four lessons should have been taken from LTCM. First, even the best mathematical models of markets are prone to break down, so investors should not bet too much borrowed money that they will continue to work. Instead, the models created overconfidence.
Second, any investment strategy devoted to correcting market anomalies has a limited capacity—once enough money has been thrown at correcting a mispricing, the chances are that it will go away. So the more money attempts to follow that strategy, or the longer managers try to make it last, the less successful that strategy will be.
Third, diversification is not what it seems. Given a big enough shock, many apparently different investments can move the same way at once.
And finally, hedge funds cannot work in a vacuum. They have an effect on the environment around them, which affects their capability to take profits.
Thus LTCM should have led to a world of small, highly specialized hedge funds, using little leverage, and returning investors’ money to them once their strategy could no longer make profits. Instead, as we will see, almost the opposite happened. And the rate cut that followed to rescue the banks instead prompted investors to dive into the best available opportunity to make a profit. They were about to create the biggest bubble in history—in Internet stocks.
In Summary
• The LTCM rescue was the pivotal event in turning the 1990s bull market into an historic speculative bubble. It led rates lower when they should have been rising and created the belief that governments would always bail out the stock market.
• Hedge funds can use leverage and short-selling to eliminate market inefficiencies, but their fee structure gives them an incentive to exaggerate trends and pile into special situations, making markets more inefficient. By spreading across different markets, they become an extreme force for correlation.