Could the failure of a single hedge fund, or group of hedge funds, threaten U.S. financial stability? It is an important question, and one that is difficult to answer. Take for instance the rapid decline of Long-Term Capital Management (LTCM) in 1998, which threatened to take down many of LTCM’s creditors and derivatives counterparties. To avoid the financial panic that would have followed LTCM’s failure, the New York Federal Reserve stepped in and organized a private sector bailout of the fund. But in 2006, when the much larger hedge fund Amaranth Advisors shut down due to significant trading losses, the markets didn’t even blink.
Ever since LTCM’s demise, regulators and academics have been trying to understand the factors and conditions that could result in a hedge fund’s failure having a destabilizing impact on the financial system. A consensus view has yet to emerge, but it is widely understood that too much debt, i.e., leverage, is a primary—if not the primary—factor in assessing a hedge fund’s systemic risk potential. Part of the challenge in assessing hedge fund risks is the lack of available data, owing primarily to the fact that hedge funds are essentially unregulated.
The Financial Stability Oversight Council (FSOC or Council), created by the Dodd-Frank Act, is ideally situated to study this problem and develop solutions. Their mandate is to identify risks across the financial system and respond to emerging threats to financial stability. This is why last April, the Council created the interagency hedge fund working group to ascertain “whether certain hedge fund activities might pose potential risks to financial stability.” Unfortunately, the working group has made little progress in advancing the collective understanding of these risks, and with a new administration in place that is filled with veterans from the hedge fund industry, it looks like the working group will be put on ice. This means a significant portion of the so-called shadow banking sector will go unexamined, and the consequences could be severe.
LTCM’s Use of Leverage:
The collapse of LTCM alerted regulators, and market participants, to potential financial stability risks associated with a highly levered hedge fund. At the beginning of 1998, LTCM had borrowed over $125 billion with only $5 billion in equity, and the notional amount of LTCM’s total OTC derivatives position was $1.3 trillion. LTCM was able to mask a balance-sheet leverage ratio of more than 25 to 1 because it relied on multiple counterparties, none of whom had a complete view of the risks that had built up on the firm’s balance sheet. When the Russian government defaulted on its debt in August 1998, it was the spark that lit the fuse, and as the value of LTCM’s positions plummeted, the firm found itself unable to meet counterparty calls for additional collateral. Once LTCM’s counterparties became aware of the size and scale of the problem, they quickly realized the fund’s failure could saddle them with destabilizing losses. To avoid these losses, most of LTCM’s counterparties became willing participants in the fund’s Fed orchestrated bailout.
LTCM is the classic example of systemic risk caused by too much leverage. Chan, Getmansky, Haas, and Lo provide an excellent description of the relationship between leverage and systemic risk:
“Leverage has the effect of a magnifying glass, expanding small profit opportunities into larger ones but also expanding small losses into larger losses. And when adverse changes in market prices reduce the market value of collateral, credit is withdrawn quickly, and the subsequent forced liquidation of large positions over short periods of time can lead to widespread financial panic, as in the aftermath of the default of Russian government debt in August 1998. The more illiquid the portfolio, the larger the price impact of a forced liquidation, which erodes the fund’s risk capital that much more quickly. Now if many funds face the same “death spiral” at a given point in time—that is, if they become more highly correlated during times of distress and if those funds are obligors of a small number of major financial institutions—then a market event like August 1998 can cascade quickly into a global financial crisis.”
After LTCM’s failure, the government issued a report that zeroed in on the fund’s use of leverage as the cause of the crisis, and the report provided a number of recommendations “designed to constrain excessive leverage.” Most of these recommendations focused on enhancing transparency in the hedge fund industry by requiring funds to disclose pertinent financial information. The logic was that such disclosures would prevent hedge funds from acquiring an excessive amount of leverage unbeknownst to counterparties and regulators. However, Congress ignored most of the report’s recommendations, and the hedge fund sector remained largely outside the regulatory perimeter.
Changes Post Financial-Crisis
The Dodd-Frank Act included several provisions designed to give regulators more insights into the hedge fund sector. Specifically, it required private fund advisers with over $150 million assets to register with the SEC. It also authorized the SEC to collect data from private funds for the purposes of assisting the FSOC in assessing systemic risk. In October 2011, the Commission voted unanimously to adopt Rule 204(b)-1 under the Investment Advisors Act of 1940. The rule required registered investment advisors with at least $150 in assets under management (AUM) to file periodic information with the SEC on what is known as Form PF, with reporting requirements tiered by the amount of AUM. The most onerous requirements are reserved for hedge fund advisors with at least $1.5 billion in AUM, who must also report additional information for each qualifying hedge fund with over $500 million in net asset value (NAV). As of the first quarter of 2016, there were 1,597 qualifying hedge funds.
Each qualifying hedge fund is required to submit Form PF on a quarterly basis using monthly data. Some of the more pertinent data – for the purposes of assessing systemic risk – that gets reported include: the value of borrowings by type of borrowing, the aggregate value of derivatives positions, and exposure to specific asset types. The SEC does publicly release aggregated Form PF data in their quarterly Private Fund Statistics report, but the real value in PF data comes from its ability to help regulators identify individual hedge funds that have taken outsized risks. Unfortunately, as we shall see, Form PF data suffers from a number of data quality issues, and is not sufficient to provide an adequate understanding of hedge fund systemic risk.
FSOC Asset Management Review
Form PF data was utilized in the FSOC’s review of the asset management industry, which kicked off in May 2014 with a public conference on the topic. In December 2014, the FSOC published a notice seeking public comment on “whether and how certain asset management products and activities could pose potential risks to the U.S. financial system in the areas of liquidity and redemptions, leverage, operational functions, and resolution, or in other areas.”
Last April, the Council provided an update on their review, which incorporated their own analysis and much of the feedback they received from the public and industry. The update highlighted “areas of potential financial stability risks” and provided thoughts on “key areas of focus and next steps.” When it came to hedge fund risks, the Council’s update centered on hedge funds’ use of leverage, and much of their analysis mirrored what was said in the government’s report in the aftermath of LTCM’s failure over fifteen years prior. However, this time, regulators had the added benefit of Form PF data, which provided further insights into hedge funds’ use of leverage.
Form PF data allows regulators to calculate hedge fund leverage using multiple metrics, however none of these metrics alone are “sufficient to identify whether the use of leverage by hedge funds may present financial stability risks” Part of the challenge is that hedge funds can obtain leverage from a variety of sources, and the metric used to measure leverage will largely be influenced by the source of leverage. Take for instance the balance sheet measure of leverage, which divides the amount of borrowings by the fund’s net asset value (NAV). This leverage metric would capture how much a hedge fund is borrowing via repurchase agreements (repo) or through their prime brokers, but would ignore leverage obtained through the use of derivatives. You can incorporate the market value of derivatives in the leverage metric by dividing gross asset value (GAV) by NAV, but this may still undercount leverage because the value of a hedge fund’s derivatives positions could change in such a way that it would increase leverage. Thus, the most expansive measure of leverage would divide gross notional exposure (GNE) by NAV, but of course this could overstate leverage because it does not account for offsetting derivatives positions.
Based upon the above leverage metrics calculated using PF data, the Council found that most hedge funds use modest amounts of leverage. But the Council also found that a select group of the largest funds, as measured by gross asset value, utilized significantly more leverage than their peers:
“For instance, as of the second quarter of 2015, for all qualifying hedge funds (QHFs), the weighted averages for the three ratios —GAV/NAV, GNE/NAV, and borrowing/NAV—were approximately 1.8x, 5.5x, and 0.7x, respectively. In contrast, for the 10 largest hedge funds, the weighted averages for the three ratios were 6.1x, 23.3x, and 4.6x.”
Risk Factors Besides Leverage
Just because the ten largest hedge funds appear to be highly levered compared to all other funds, does not mean that they pose a threat to financial stability. In their April update, the Council acknowledged the murky relationship between leverage and systemic risk: “Leverage is not a perfect proxy for risk, but there is ample evidence that the use of leverage, in combination with other factors, can contribute to risks to financial stability.”
Ideally, Form PF data would allow regulators to identify these “other factors.” One such factor would be a fund’s market exposures. Clearly there is a difference between a highly levered fund that is investing in S&P 500 equities, and one that is investing in high-yield debt. The Council’s update notes that Form PF does require filers to report Value-at-Risk (VaR) but that not all filers calculate and report VaR the same way, thus making market exposure comparisons difficult.
Another factor that could influence systemic risk is a hedge fund’s counterparty exposures. Recall how LTCM borrowed from many different counterparties, using little collateral, and that these counterparties were unaware of how much LTCM was borrowing from other counterparties. Unfortunately, Form PF data does not close this knowledge gap because it only requires funds to report the sum of mark-to-market net counterparty exposures for each of their top five counterparties. And because hedge funds receive funding from many different counterparties that are supervised by multiple agencies, there is “no single regulator [that] has a complete window into the risk profile of hedge funds.”
While Form PF data does grant regulators greater visibility into the potential buildup of risks within the hedge fund industry, it is clear that it suffers from many limitations. As the Council concluded in April:
“While the reporting of data on Form PF has increased transparency to regulators, the leverage metrics and broad strategy classifications available in Form PF do not provide sufficient insight into relevant risks, limiting the Council’s ability to assess potential risks to financial stability from the activities of leveraged hedge funds.”
Hedge Fund Working Group
Recognizing the need to dig deeper into hedge fund risks, the Council’s April update announced the creation of an interagency working group that “will share and analyze relevant regulatory information in order to better understand whether certain hedge fund activities might pose potential risks to financial stability.” The hope was that by bringing together the different federal agencies, and sharing the regulatory and supervisory data they collect, the Council would be able to arrive at a more complete view of hedge fund activities and the risks these activities may pose to financial stability.
The working group provided a progress report to the Council in November that focused on identifying the conditions under which “hedge funds’ use of leverage could pose potential risks to financial stability: (1) by causing or contributing to significant disruptions of key financial markets through forced selling, or (2) by transmitting stress to counterparties that are large, highly interconnected financial institutions.”
Unfortunately, the progress report offered little by way of fresh insights, and mostly reiterated many of the challenges that were highlighted in April’s update—the main challenge being that regulators still do not have access to sufficient data to assess threats to financial stability coming from the hedge fund sector. In fact, the November progress report listed “addressing data gaps and limitations” as one of two areas of focus for the next phase of the group’s work (the other being continued monitoring of potential financial stability risks). The progress report goes on to make specific recommendations for data points regulators would like to receive, including: hedge fund risk exposures, terms of financing received, and posted margin and unencumbered cash.
Still Flying Blind
Seven months after the hedge fund working group’s creation, and two-and-a-half years after launching their review of the asset management industry, the most significant recommendations the FSOC came up with for addressing hedge fund risks revolved around the need for better data. These are essentially the same recommendations regulators put forth in their 1999 report in the aftermath of LTCM’s demise.
Surely this result falls fall short of the working group’s promise, which according to Janet Yellen, was to “better assess potential systemic risks” from hedge funds. Yet here we are, no closer to understanding the set of conditions and factors that could cause the failure of a highly levered hedge fund to send shockwaves throughout the rest of the financial system.
Of course it is possible that no hedge fund is large enough to destabilize the financial system, and if a hedge fund were to fail, the worst that would happen is a bunch of rich people would lose some of their fortunes. But the point is that, right now, regulators have no way of making that determination. Nor does it look like they will have that capability anytime soon.
President Trump’s administration is filled with veterans from the hedge fund industry (Treasury Secretary nominee Steve Mnuchin used to run a hedge fund). And with President Trump’s appointees set to soon make up a large portion of the FSOC’s voting members, it is hard to imagine any of the hedge fund working group’s recommendations being taken seriously. Unfortunately, this means regulators, and the public, will continue to operate in the dark when it comes to hedge funds; and we may not see the next LTCM coming until it’s too late.
 Hedge fund advisors can manage multiple hedge funds. For example, Bridgewater Associates is a hedge fund advisor that runs three funds, Pure Alpha, Optimal Portfolio, and All Weather.