Hedge Funds

The 2007 – 2008 Global Credit Crisis
and Hedge Funds

The global credit crisis had its origins in a bubble of rising real estate prices, followed by a sharp fall in housing prices that began in 2007 and dropped roughly 20 percent on average nationwide by fall 2008. That led to an escalation of mortgage delinquency and default rates, which may ultimately result in losses exceeding $4 trillion.³⁹ Financial institutions pulled back on credit availability, “deleveraged” by selling off bad debts at heavy losses, and pursued quick foreclosures of delinquent mortgages.

A liquidity crisis ensued in the credit markets, spilling over into other markets, as some financial institutions became insolvent and others neared bankruptcy. Banks grew increasingly reluctant to lend to one another, as demonstrated by the wide gap that emerged between the London Interbank Offered Rate (LIBOR) and Treasury securities interest rates. Risk premiums for debt soared, making credit more scarce and costly. Markets froze worldwide in a vicious downward cycle of worsening liquidity. By fall 2008, losses on loans and securities from the financial turmoil and weakening economies had exceeded $1 trillion, according to International Monetary Fund estimates.⁴⁰ Lack of investor confidence and trust compounded the problem.

What role did hedge funds play?

Funds that owned subprime debt and related securities lost value amid the financial turmoil. As the former SEC Chairman David Ruder explained in testimony before a House panel in November 2008, “Although some hedge funds hedged CDO [collateralized debt obligation] risk and made substantial profits, many hedge funds suffered major losses when the CDOs lost value.”⁴¹

Maria Strömqvist with the Swedish Riksbank observed: “To simplify somewhat, we can say that the hedge funds have been affected more by the present financial crisis than they have affected it.”⁴²

SEC Commissioner Kathleen Casey, who chairs the IOSCO Technical Committee, made a similar point in releasing the IOSCO report Hedge Funds Oversight: Final Report in June 2009: “Securities regulators recognize that the current crisis in financial markets is not a hedge fund driven event. Hedge funds contribute to market liquidity, price efficiency, risk distribution and global market integration.”⁴³

The observation in April 2008 by Sebastian Mallaby of the Council on Foreign Relations remains valid today: Hedge fund “failures have stemmed mainly from errors that were not of their own making. Because banks have mismanaged themselves so thoroughly, they have had to mobilize capital by calling in loans to hedge funds, forcing the funds to sell off positions precipitously. Forced sales have driven down the value of the hedge funds’ remaining holdings, undermining their creditworthiness and triggering a further calling in of loans, further forced sales, and further losses. This vicious circle has caused a few funds to go bust. But the trigger was . . . subprime losses in the regulated banking system.”⁴⁴

A similar conclusion was reached by researchers at the Bank of International Settlements and the Bank of Canada: “[U]nregulated hedge funds have not been the main protagonists during the current crisis. Instead, the greatest systemic risk has come from large complex financial institutions that are subject to varying degrees of regulation.”⁴⁵

Another report on the global banking crisis by Lord Adair Turner, Chairman of the UK Financial Services Authority, found that “hedge funds did not play a significant role in the crisis.”⁴⁶ The de Larosière Group reached a similar conclusion in its study for the European Union.⁴⁷