Hedge Funds & the Global Economic Crisis - Willing Culprits or Easy Scapegoats?

October 2nd, 2012
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Contributed by: Shane Brett, Global Perspectives
The summer of 2012 marked 5 years since the slow onset of an economic crisis that first became known as the Credit Crunch and then the half decade that became known as the Great Recession.

At the time and over the last few years, Hedge Funds have received a large portion of the blame for the economic crash. They have often been portrayed as one of the main culprits responsible for causing the global financial crisis.

With the benefit and hindsight of recent history we can now look back with some perspective and see if the crisis really was the fault of the Hedge Fund Industry. Is there some basis to the claim that the industry was significantly responsible for the worst economic crash since the Great Depression; or were they merely a scapegoat for a seething public and outraged politicians and media?

Willing Culprits?

The first really significant event to signal a coming financial storm occurred in the UK on August 9th 2007, when BNP Paribas halted redemptions from 3 of its Hedge Funds due to a disappearance of liquidity in the market.

This led to panic from many investors as they tried to get their capital back from financial institutions. Hedge Funds liquidated their holdings from many Prime Brokers, making them more susceptible to financial collapse.

After the failure of Long Term Capital Management in 1997 the Hedge Fund industry had shown that the failure of a large fund had the potential to pull down one of the leading investment banks and lead to a wider systemic crash by also pulling down larger commercial banks.

In the recent crisis Hedge Funds who acted as short-sellers have been accused of contributing to the collapse of bank shares and the exacerbation of the financial panic (Short selling of course sees investors borrow and sell shares in a company in the hope of buying them back cheaper in the future for a profit).

We should be clear about this, while Short Selling is an important part of market activity and some would say an essential tool in restoring market equilibrium of inflated valuations (having helped expose multiple frauds including Enron), massive volumes of short selling right in the middle of an economic crisis does not help financial stability.

If the Hedge Fund industry has one charge against them that will stick it is this. Especially when it became known that some Hedge Funds were making massive Funds (e.g. Odey), by shorting UK banks – that later had to be bailed out with public money.
Huge Short Selling of banking stocks in 2008 certainly served to accelerate the general speed of economic collapse.

As the effects of the Lehman collapse in Sept 2008 reverberated throughout the financial system, the end of the year brought further evidence to some that the Hedge Fund industry was rotten and at the heart of the economic crash. Bernie Madoff admitted that the Hedge Funds he had been running for over two decades were in fact gigantic Ponzi schemes and that he had defrauded investors of $65 Billion – the largest fraud in world history. This merely served to reinforce the negative image of the Hedge Fund industry in the eyes of the regulators, politicians and the general population.

Hedge Funds seemed to have brushed aside basic checks of investment and operation due diligence to invest colossal sums of money with this incredible confidence trickster. Everyone from the regulators to the investors to his Feeder Fund managers came across looking foolish and hopelessly outwitted. But it was the Hedge Fund industry that deservedly took most of the blame.

Elementary oversight and basic due diligence was systematically ignored. Despite screaming red flags and plenty of whispering, the industry was content to let sleeping dogs lie, as long as the smooth, stable long term returns continued year after year.

Another charge against Hedge Funds is that it was their use of Excess leverage which contributed to the scale of the financial losses. There is certainly some truth in this, as leverage was used across the board particularly to amplify investment returns.

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Related People: Bernard Madoff
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