Restoring Financial Stability Chapter 6 Hedge Funds

Chapter 6 Memorandum

Re: Hedge Funds

Date: September 29, 2010

Hedge funds are a large contributor in the shadow banking system as these funds have the ability to sell assets, in which they may utilize leverage. They are important to the financial system because they can provide liquidity to the market, may correct mispricing in the market, add value by trading and increasing price discovery, and by providing investors access to leverage and to investment strategies that yields great results. Hedge funds began their rapid growth around 1992 having great success in the market until 2007 when the crisis hit. Just to show how poorly they have been doing since the crisis, in 2008 the average return on a hedge fund was -10.11 percent with the equity hedge funds bringing in a return of -15.45 percent.

The initial collapse of the subprime-backed collateralized debt obligations occurred mostly due to the failure of two highly levered Bear Sterns hedge funds. These hedge funds however, did not cause the growth in the subprime mortgage market nor did they drive the housing prices down so the subprime loans would default. Hedge funds, in general, are not really regulated so a number of policies have been proposed:

• Hedge funds should be required to provide regulators with sufficient information about their leverage level and asset position. Because hedge funds are not very transparent, this regulation will help regulators measure and manage possible systemic risk.

• Hedge funds need to be treated as a systemic institution to be regulated as one, if and only if the hedge fund falls into the class of large complex financial institutions (LCFI). This exception is allowed when hedge funds impose externalities on the financial system.

• In a systemic-risk subset hedge funds may need regulation that discourages investors from withdrawing funds after a poor performance. Bad performance by a fund may lead to a run on the fund’s assets under management,...