Wednesday, October 01, 2008

Whither Hedge Funds? 
Someone on Megan McArdle's blog asked for a primer on hedge funds. (Why anyone asks for primers on noncontroversial topics in the age of Wikipedia is beyond me) but here is my response to the request for a primer on hedge funds, and why they might be the next shoe to drop:

A hedge fund is basically a counterparty to transactions. Sometimes they become great big hairy stinking counterparties to transactions. They get so huge largely because they employ so much leverage.

The reason they employ so much leverage is because they think they are magnifying returns on a sure thing. I.e., arbitrage.

They blow up once in a while because even arbitrage transactions aren't sure things. And even if they are, the timing on their payoff isn't, and sometimes the payoff comes AFTER the fund goes insolvent. C.f. Long Term Capital Management.

Hedge funds imploding every once in a while is not a terrible thing -- UNLESS you are a lender to them (enabling them to get highly leveraged, or unless they are a counterparty to your much-needed transaction.)

Hedge funds tend to be fairly nimble, though, which enables them to dodge the occasional bullet.

Problem is, there are a number of different bullets headed their way right now, including a sudden and sharp rollback in available credit. And some of these hedge funds rely on continued high levels of credit in order to maintain their highly leveraged positions. If they get a lot of loans called at the same time, they may be forced to sell assets...or even non-asset assets like positions in derivatives at fire sale prices in order to raise cash...all to a market that no longer exists because no one else can leverage up to buy so many positions at the same time either.

The markets are discovering the meaning of counterparty risk.

Pass the popcorn.

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