Hedge funds may pose huge market risk: Fed

Date: Friday, May 4, 2007
Author: CNN Money/Reuters

Could be largest risk since Long-Term Capital Management crisis in 1998 says New York Federal Reserve

Hedge funds may now pose the biggest risk of a crisis since 1998, when the implosion of Long-Term Capital Management threatened the global financial system, the New York Federal Reserve said on Wednesday. The statement represented the bank's sternest warning to date over the possible fate of the $1.4 trillion industry.

Recent high correlations among hedge fund returns could suggest concentrations of risk comparable to those preceding the hedge fund crisis of 1998," according to a paper written by Tobias Adrian, capital markets economist at the central bank.

Back in 1998, the New York Fed helped bring together Wall Street tycoons who eventually cobbled together enough funds for an unprecedented $3.6 billion bailout.

The LTCM crisis was all the more shocking to investors because of the individuals involved, regarded highly for their market savvy and mathematical prowess.

But with the crisis averted, the hedge fund industry bounced back with a vengeance, increasingly rapidly over the last decade in both size and scope to an estimated $1.4 trillion.

Hedge funds, investment pools that are aimed primarily at wealthy investors and institutions, have been very lightly regulated, facing only vague registration requirements.

Their sheer immensity has raised some red flags from policy-makers, with New York Fed President Timothy Geithner among those sounding repeated warnings about the need for cautious lending.

The Fed's latest worry arose from what it described as a rising correlation between the actual returns of hedge funds, which could point to similar trading strategies that excessively concentrate risk on too few market positions.

"Similar trading strategies can heighten risk when funds have to close out comparable positions in response to a common shock," the economist Adrian wrote.

Still, many officials including Geithner have shied away from calling for explicit regulation, arguing instead that the large banks who lend to hedge funds should police themselves to make sure no one lender gets in too deep.

Hedge funds borrow large sums of money in order to take aggressive bets on financial markets. Many operate heavily in the derivatives market, estimated at around $17 trillion, raising fears about possible future shocks.