Are Hedge Funds ‘Too Big to Fail’?

Date: Thursday, July 28, 2011
Author: Gregory Zuckerman, The Wall Street Journal

Who’s afraid of hedge funds?

A year after Dodd-Frank was signed into law, regulators still have not decided which large financial firms pose a risk to the financial system. Hedge funds want to be excluded.

They may have a point, according to a new paper by two academics at Columbia Business School and a Citigroup executive.

The average hedge fund is “modestly leveraged,” with borrowed money amounting to just over two times the fund’s equity, according to the research. What’s more, funds reduced their leverage ahead of the housing crisis, even as banks increased leverage. In the first quarter of 2009, the average fund was leveraged at 1.4 times its equity, even as leverage at investment banks topped 40 times, says the paper, which is based on data from various funds of hedge funds.

Hedge-fund leverage began falling in the middle of 2007, likely because fund managers were becoming nervous, say the authors, who claim their study is the first to examine actual hedge-fund borrowings, rather than leverage estimates.

So what about Long-Term Capital Management, the big hedge fund that regularly borrowed $30 for each $1 of equity, and saw leverage race to more than 100-to-1 as it melted down and brought financial markets to their knees in 1998? The academic paper only covers the December 2004 – October 2009 period.