Introduction
The Hedge fund industry is surrounded by many debate and controversy. Lack of excessive returns, unclear impact, oversight on the market are all subjects of concerns for the public and market participants. The hedge fund industry worries small investors and financial professional who do not know how to accurately assess the risks associated with hedge funds. Hedge funds are mainly operating like mutual funds but not the managers. Oversight and low regulation allow them to not make public information on their profits and losses or investment strategies. Hedge funds rely a lot on volumes to achieve profits. Systemic risk became a major part of the debate since LTCM in 1998.
Story of LTCM
Background
Long Term Capital Management - LTCM - was a hedge fund that was established in 1994 by John Meriwether who was a successful bond trader at Salomon Brothers. Meriwether was one of the first on Wall Street who hired professors and academics who applied models based on financial theories to trading. This team demonstrated an ability to precisely calculate risk and generated amazing returns (Goldberg, M., 2012).
The partners of LTCM included a professor from Harvard University, Nobel Price-winning economists, a former vice president of the Board of Governors of the Federal Reserve, and other successful bond traders. This group of traders and academics attracted about $1.3 billion from different institutional clients (Goldberg, M., 2012).
Investors were not allowed to take any money out for three years and paid $10 million to get into the fund. Annual return in 1995 was 42.8% after management took 27% off the top in fees. In 1997 LTCM successfully hedged most of the risk from the Asian currency crisis by ...
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...ge (Goldberg, 2012).
Should the Fed have intervened?
In order to save the U.S. banking system, the President of the Federal Reserve Bank of New York William McDonough convinced 15 banks to bail out LTCM with $3.5 billion, in return for a 90% ownership of the fund. Also, the Fed started lowering the Fed funds rate as a assurance to investors that the Fed would do whatever it took to support the U.S. economy. Without that direct interference, the entire financial system was threatened with a collapse (Amadeo, 2012).
However, the Fed brokered and intervened a better deal for the LTCM managers and shareholders. This was the precedent for the Federal Reserve's bailout role with AIG, Bear Stearns, Fannie Mae and Freddie Mac during the financial crisis. Once financial companies realized that the Fed would bail them out, they were more willing to take risks (Amadeo, 2012).
A resolution passed by Congress was the Financing Corp. (FICO), created in 1987 to provide funding to the FSLIC. FICO contributed $8.2 billion in financing. Then came the enactment of FIRREA, The Financial Institutions Reform, Recovery and Enforcement Act by Congress in 1989, which began the taxpayer’s involvement. The large number of failures overwhelmed the resources of the FSLIC, so US taxpayers were required to back up the commitment extended to insured depositors of the failed institutions. As of Dec. 31, 1999, the thrift crisis had cost taxpayers approximately $124 billion. ( Curry et al. 2000)
The company was taking the big risks of financial. Due to the firm was started winding down after collapse of the Bear Stearns hedge fund. The firm also had accumulated a very large commercial real estate portfolio. The CEO of the firm believed that it had sufficient funds to tackle the problems after borrow money from the federal reserved investment.
Money Market Mutual Funds (MMMF) were first established in 1971, and they are a type of mutual fund that is required to invest in low risk securities. These securities include highly liquid assets that have short-term debt such as: Commercial Paper, Certificates of Deposit, US Treasuries, and Repurchase agreements. MMMF’s hold a net asset value (NAV) of $1 per share, while the change in interest rates reflect the yield earned for investors. MMMF’s are an attractive place for investors to keep money because they can be tax-free or tax deductible, also there are usually fees to enter or wi...
The years 2008 shined a light on a group of people who were considered high society. When the stock market crashed in September 2008, the world shines a spotlight on the financial corporation. Words such as hedge fund manager and financial instrument such as credit default swaps are not words not known to everyday citizens. The economic downturn forced society to ask question not normally asked.
These crises brought the global financial system to the point of collapse. The U.S. Federal Reserve took steps to expand money supplies. The U.S. gave nearly 1 trillion dollars worth of two stimulus packages in 2008/2009. The reaction of the Federal Reserve was immediate. In the last quarter of 2008, the central banks purchased 2.5 trillion US dollars of debt and private assets from banks. This was the largest liquidity insertion into the credit market, and in the history of this world it was the largest monetary policy action. The U.S. and European governments raised the capital of their national banking systems by $1.5 trillion, by purchasing newly issued preferred stock in their major banks. Governments also bailed out lots of firms by taking over their large financial obligations.
Major banks are cutting back on some of their legally permitted operations, such as- market making, and that has led to liquidity issues in the bond markets. Proprietary trading could become unregulated if more banking activities continue moving towards the shadow banking system. This would essentially defeat one of the main purposes of Volcker Rule. [d] The third major unintended consequence has been the degree by which the Federal Reserve has become the main regulator of the finance industry. In order to discourage future bailouts similar to the ones during the financial crisis, the Dodd-Frank Act limited the Fed’s emergency powers. However the liquidity and capital standards now imposed by Fed has purportedly become one of the most important regulatory developments of the Dodd-Frank Act.
Until recently, managed futures strategies offered high probabilities to deliver positive returns, with very low correlation to equity and fixed income markets, and the ability to perform best during any financial crisis. When the dust settled on 2008, managed futures industry outperformed all other markets. Post-financial crisis, only two markets produced positive returns: managed future funds and fixed-income. The average manage future fund rose 18 percent, while many individual managed future funds were up 40 percent.1 Conversely, all other markets on average took a significant drawdown, US stocks declined 37 percent, REITs declined 37.34 percent, Int’l stocks declined 43.39 percent, and commodities declined 48.49 percent.2 Managed future funds positive performance in such a negative environment opened the eyes of many investors, and infused a rapid demand for managed future funds. Assets in managed futures strategies grew 120 percent from 2007 to 2011, totaling to 188 billion...
Flawed financial innovations: the implementation of innovations in investment instruments such as derivatives, securitization and auction-rate securities before markets. The indispensable fault in them is that it was difficult to determine their prices. “Originate to distribute securities” was substituted by securitization which facilitated the increase in ...
Among the big skeptics in The Big Short are two thirty-year-old men who founded a small money management firm and named it Cornwall Capital Management. Charlie Ledley and Jamie Mai, later joined by Ben Hockett, ventured into running a money making business out of a house garage in Berkeley, California, with just a little over a hundred thousand dollars in their bank account and absolutely no experience in investments. Rather than knowledge and expertise, the young financiers were equipped with the conviction that “the best way to m...
William Sharpe, Gordon J. Alexander, Jeffrey W Bailey. Investments. Prentice Hall; 6 edition, October 20, 1998
Finally, the third phase is where we profited from our investments. Having performed poorly in the equity market, we developed a new strategy of investing. This strategy focused more on the commodity sector rather then the equity sector. Therefore, at the beginning of March we bought contracts in gold, corn, platinum, lumber, and the United States currency. As equities dropped, the prices of commodities increased allowing our lumber, corn, and platinum to make huge gains.
The Dow went around 11,000 until September 29, when the Senate voted against the bailout bill. The Dow then suddenly fell 777.68 points, the most in any single day in history. Global markets also panicked such as, The MSCI World Index dropped 6 percent in one day, the most since its creation in 1970. Brazil's Ibovespa was halted after dropping 10 percent. The London FTSE dropped 15 percent. Gold soared to over $900 an ounce. Oil dropped to $95 a barrel.Congress finally passed the bailout bill in early October, but the damage had already been done. The Labor Department reported that the economy had lost a crazy amount of 159,000 jobs in the previous month. On Monday, October 6, the Dow dropped 800 points, closing below 10,000 for the first time since 2004. The Fed tried to prop up banks by lending $540 billion to money market funds. The funds needed the cash to meet a continuing barrage of redemptions. Since August, more than $500 billion had been withdrawn from money markets. On September 21, 2008 Goldman Sachs and Morgan Stanley, the last two of the major investment banks still standing, convert from investment banks to bank holding companies to gain more flexibility for obtaining bailout funding. On September 25, 2008 After a 10-day bank run, the Federal Deposit Insurance Corporation (FDIC) seizes Washington Mutual, then the nation's largest savings
Fourthly, that there was intense pressure by the New York Federal Reserve President Timothy Geithner and U.S. Treasury
Wall Street has a long and varied 200-plus years of history, full of colorful vignettes and wheeling-dealing. Almost from the moment that the market was organized out-of-doors in the 18th century, it has been a symbol of the best and worst finance has had to offer. It has been known for its scandals, avarice, and greed on the one hand and ingenuity and even patriotism on the other. At times, it is impossible to live with, while at others, impossible to live without. And lurking just below the surface, are events and personalities that have shaped American history.
Morgenson, G. (2005, September 17). Clues to a Hedge Fund's Collapse. In The New York Times. Retrieved November 1, 2013