Banks Dancing with Hedge Funds

On August 9 and 10, 2007, the last two business days of the previous week, European and U.S. bank regulators injected billions of dollars worth of liquidity into the financial system because of fallout from the subprime mortgage mess. They also expressed sympathy for those that have money invested in the financial markets. But they didn't lower interest rates, and some European regulators even made some noise about raising interest rates. What's with the good cop, bad cop routine?

The regulators are struggling with the dual nature of the world financial system. Part of the system is heavily regulated. These would be the commercial and investment banks. The other part of the system is essentially unregulated. These would be the hedge funds. Both parts of the system operate side by side, doing business with each other in ways that have made them become financially intertwined.

Banks, being heavily regulated, are usually pretty transparent. They have to report their financial condition, and reveal their activities. Examination staff from the federal bank regulators, and inspection staff from the SEC, from time to time visit the banks within their respective jurisdictions to sniff them over. Indeed, federal examiners are continuously on site at the largest commercial banks.

Hedge funds, on the other hand, are virtually unregulated. An attempt to require them to register with the SEC and provide some information about what they were up to was given the thumbs down by the U.S. court of appeals in Washington, D.C. The SEC has been trying to figure out where to go next. But the reality for now is that no one knows what the hedge funds have been doing, where their financial exposures and liabilities are, and how much of a threat to the world financial system they present.

Banks and hedge funds interact in a number of ways. Banks loan money to hedge funds. They sell investments to hedge funds, making commissions and perhaps trading profits, and buy investments from hedge funds, making more commissions and perhaps more trading profits. Banks and hedge funds enter into derivatives contracts, which adds to their liabilities to each other. Some banks may sponsor hedge funds, so they can earn even more money from asset management contracts (that 2% and 20% formula would not have escaped the bankers' attention), and their own proprietary investments in the hedge funds.

All this is hunky dory in a rising market. After all, there is hardly any risk that isn't worth taking in a rising market. Hedge funds proved to be extremely successful. (Then again, who isn't successful in a rising market?) So they grew--and grew and grew. As they grew, so did the amount of intertwined liabilities they had with the regulated part of the financial system, the banks.

However--and in the financial markets, there will always be a however--the market stopped rising. In this case, it was the real estate market. And when the real estate party ran out of booze, mouths dried out and heads started to pound.

At this point, the intertwined liabilities of the banks and hedge funds became, well, liabilities. There wasn't a rising market to smooth them over. Some of them--like margin loans--actually became due and payable. Others, like derivatives contracts, may be partially or entirely uncollectible from hedge funds that have collapsed or shut down. The fee income from ailing hedges is likely to be much lower than it is from the healthy ones. (The ailing ones don't buy as many investments, and the 2%/20% formula is a lot less rewarding when the fund's assets are shrinking like a falling souffle.)

Banks live on a cushion of credit. That may sound strange for institutions that hold so much money. But both investment and commercial banks avidly borrow money every business day for a number of different purposes, and couldn't survive without credit. Ordinarily, banks have an easy time borrowing, since much is known about their activities and financial condition, and because they are heavily regulated (which fosters confidence among customers and creditors).

But with the subprime mess, things have changed. The banks' exposures to hedge funds are largely indeterminate right now. And creditors hate uncertainty. Word on the Street has it that a shipload of losses (well, you know what we mean) from the subprime mess lurks somewhere in the financial system. But there ain't too many folks owning up to those losses.

In such a shadowy environment, lenders pull back. Banks that may or are rumored to have subprime exposure suddenly find it hard to borrow. Without credit, they cannot operate, and are at risk of collapse. Credit for banks is like air for humans--without air, humans expire quickly. Without credit, banks go under and very quickly.

That's why the bank regulators infused liquidity into the financial system last week. Banks that couldn't otherwise breath needed emergency oxygen. However, this is just treating the symptoms. The patient is still breathing, but we can't tell if his condition is stabilized. The root causes of the problem--outsized and reckless risk taking by hedge funds and their bank lenders--remain to rear their ugly heads another day.

One could argue that surely the financial services industry will learn from this experience and be more prudent in the future. After all, a co-president of Bear Stearns and senior executives at a German bank lost their jobs because of subprime stumbles. Hedge funds have collapsed and tastelessly opulent apartments on Fifth Avenue remain unbought.

Let's remember, though, that we've been here before. In 1998, Long Term Capital Management did the love-that-leverage dance, only to end up with a beyond-the-stress-testing-of-our-computer-model mess. The Federal Reserve had to deputize a posse of large banks to ride to the rescue. Perhaps we smell a faint whiff of moral hazard here. The financial services industry's learning curve was apparently warped by the 1998 bailout. Instead of focusing on finding effective ways to identify and manage risk, the industry leaped into the next rising market (this time, real estate) and exuberantly took up where it had left off.

The regulated bank-unregulated hedge fund relationship is like a couple on the dance floor, where one person is doing the tango and the other the waltz. Sooner or later, they will trip over each other. But even with the couple now sprawled on the floor, regulation of hedge funds remains political anathema. Leading politicians can hardly bring themselves to speak of it. So, instead of discussing that whose name shall not be spoken, let's call it broccoli.

Broccoli is quite common. The banking industry has been eating broccoli since 1913, with the creation of the Federal Reserve System. It ate more broccoli in 1933, with the creation of the Federal Deposit Insurance Corporation. Today, both the Fed and FDIC are part of the bedrock of the financial system. The securities industry has been eating broccoli since 1934, and the SEC, too, has become part of the bedrock of the financial system.

Broccoli proved to be very good for banking. It restored depositor confidence, and has prevented the widespread bank failures that plagued the United States before 1933. Broccoli also did much to restore investor confidence in the stock markets. The mutual fund industry, which eats a lot of broccoli, has been one of the fastest growing segments of the securities industry in the last 30 years.

Hedge funds may account for 20% or more of the trading in the stock markets. They engage in untold amounts of derivatives trading and other investment activities. Intertwined as they are with the regulated part of the financial system, their losses create systemic financial risk, and ultimately become our losses. Yet, without any broccoli, there is no way to ascertain the scope or extent of the dangers they pose. When hedge funds first emerged 50 to 60 years ago, they were small and posed no danger to the general public or the taxpayer. Today, neither is true.

Many hedge fund managers have recently been having a new and unpleasant experience. They've received withdrawal requests. 2% and 20% of zero is zero. In the past, they knew what it was like to have investor confidence. Now, they are finding out what it's like to lose investor confidence. Investors are only doing what's rational. They don't know squat about what's going on, and pulling out their money is the one thing they understand.

With hedge funds being such a large part of the financial system, they can now subject the U.S.--and the world--to the types of financial panics that plagued the 19th and early 20th centuries. A historical footnote: some of the men who couldn't find jobs as a result of the financial panic of 1873 joined the Army and rode under George Custer's command into the Little Bighorn valley in 1876. There, they learned that financial panics have all sorts of undesirable consequences.

The current financial panic is driven by fear. Remember that when FDR said that we have nothing to fear except fear itself, he didn't merely offer words. He also offered a serving of broccoli. It proved to be good. The issue of whether hedge funds should eat some broccoli deserves reconsideration. It need not be an enormous serving. Probably moderate amounts would have significant health benefits. The patient is ailing today. And if broccoli helps, the hedge funds may find they like the stuff.

Crime news: some people aren't cut out to be bank robbers. http://www.wtop.com/?nid=456&sid=1211698