Hedge funds leaning too much on leverage

Not since the time of Long Term Capital Management in 1998 where it lost $4.6 billion in less than 4 months has leverage been at the all time high that it is at now.

Hedge funds are riding high on the abled use of leverage (also known as debt) and the arising concern regarding their debt financing is due to their lack of controls over risks that they take.  As of present, the hedge funds manage US$1.3 trillion (that’s approx the current total amount of China’s foreign reserves), and after including all the borrowings, the hedge funds total up to about US$2.6 trillion.

With the leverage further increased by placement of funds in derivatives, hedge funds has made it to the top issues that requires discussion in the Group-of-Eight nations (G8) together with fellow issue of the explosion in global derivatives trading.

The Business Times states that Deloitte’s survey found that only 60% of its hedge fund respondents monitor balance sheet leverage, and only 50% of them monitor off balance sheet leverage (the extent of derivatives position). That highlights many a red flag that risk management policies are inadequate or insufficient enough for the dealing with a possibility of a possible risk crisis (i.e counterparty risk and credit defaults).

Those who remembered the Long Term Capital Management (LTCM) debacle in 1998 will shiver at the thught that such a major crisis may repeat. The then fear that LTCM’s forced liquidation of its company would lead to drastic fall in prices and hence creating a vicious cycle where other companies would have to liquidate as well was so huge that even the Federal Reserve had to step in to mediate the potential losses.

This entire debacle was the result of the credit risks and default risks undertaken by LTCM; the Russian defaulting of their government bonds made what was supposed to be a huge gain in LTCM’s positions (had the spreads of the bonds actually converged) turn out to be the biggest loss by a hedge fund in the market.

It’s slightly worrying, all this debt that is carrying the financial markets around. Leverage is good, but where it starts to hit highs never before seen, it is justifiable for us to get more than just a little tingle of worry.