Someone else notices that the silver market is manipulated


Could a Few Hedge Funds Spoil the Party?

By Anna Bernasek
The New York Times
Sunday, July 3, 2005

When the Long Term Capital Management hedge fund was sinking in
1998, leaders of the Federal Reserve were worried. They feared that
if the fund failed, a major disruption could be set off in financial
markets, with dire consequences for the global economy. Indeed, that
worry was the impetus for the hastily arranged bailout of the fund.
Since then, the financial system hasn't faced a similar test. At
least not so far.

Lately, though, there have been signs that hedge funds are again
taking on big risks. That's not to suggest that a crisis is
imminent, but the situation does raise important questions: While
the rewards of hedge fund investing are well known, what about the
downside? Could the actions of hedge funds again threaten the

The numbers involved are enormous. At its near-collapse in 1998,
Long Term Capital Management held $5 billion of its investors'
money. In the seven years since then, the hedge fund industry as a
whole has nearly tripled in size, now wielding more than $1 trillion
in invested funds. With so many more funds and so much more money,
it is becoming a lot harder to be confident that the industry is
being responsible.

And the incentive to take risks with all that money is huge. A
typical fee structure, called "2 and 20," gives managers 2 percent
of the assets under management and 20 percent of gains realized by
the fund. At large funds, this means that a single year's winnings
can set up the managers for life. But as more funds pile into the
winning strategies of the past, competition inevitably shrinks
profit margins. And that has tempted managers to find new, sometimes
riskier ways to maintain their spectacular returns.

The crowding effect is visible in some markets, particularly fixed
income and convertible arbitrage, which hedge funds have come to
dominate. In May, in its latest report on global financial security,
the International Monetary Fund found that hedge funds might account
for 80 to 90 percent of all participants in those markets. Because
of that high concentration of hedge funds, the IMF warns of trouble.
It found that those funds, if stressed, might find themselves all
selling at once, putting a strain on the entire financial system.

How can outsiders judge the risks of hedge funds? Ever since the
Long Term Capital bailout, hedge fund leverage has been a concern
for regulators and parties dealing with the funds. Leverage is
attractive to hedge funds because it lets them make much bigger bets
than they could otherwise. By taking large leveraged positions,
hedge funds benefit handsomely when things go right. But when things
go wrong, losses are similarly multiplied.

Return to Long Term Capital for a moment. Starting with just $5
billion in capital, the fund was able to get $125 billion in
additional funds. Using that leverage, it took on trading positions
with an estimated potential value of $1.25 trillion. Despite the
fund's seemingly brilliant strategy, the high leverage meant that it
didn't take much of a setback to wipe out the fund's underlying
capital. And the potential freezing of $1 trillion worth of
positions, even temporarily, was seen as a major risk to the system.

What is happening to leverage today? Timothy F. Geithner, president
of the Federal Reserve Bank of New York, discussed the issue in a
recent speech. In his view, leverage in the industry has decreased,
on average, since the 1998 bailout. Over the last year, though, the
Federal Reserve and the IMF have noticed that leverage is creeping
back in some areas, probably because of heightened competitive

The trouble is that average leverage isn't really a good indication
of the risks involved. Even if the industry is generally healthy, a
couple of very bad apples could spoil everything. After all, the
Long Term Capital Management crisis started with just one fund, not
the whole industry.

On that score, there has been talk on Wall Street about risky hedge
funds. In particular, some traders who deal with hedge funds suspect
that leverage in some cases today exceeds that of Long Term Capital
Management. And borrowed money isn't the only reason. Traders
concern themselves with a broader measure called economic leverage,
which takes borrowing into account but also includes risks like
those arising from derivatives and other complex financial
arrangements. Economic leverage can be high even when borrowing, or
balance-sheet leverage, is moderate.

Another concern involves hedge funds that invest not in the markets,
but in other hedge funds. These "funds of funds" sometimes employ
leverage as well, creating a layering effect. The financial partners
who lend to or trade with funds of funds take on some of the extra
risk, increasing overall risk to the financial system. Similarly,
leverage is created by offering specially constructed products to
hedge fund investors.

FOR regulators and the public, the available information on leverage
is not terribly comforting. Hedge fund research groups rely on
voluntary reporting from the funds. This means that the data they
collect reflects only a self-selected slice of the industry putting
its best foot forward. A 2003 study by the Center for International
Securities and Derivatives Markets found balance-sheet leverage at
hedge funds ranging from less than one times capital to 25 times
capital. But because hedge funds can shift positions or increase
leverage almost instantly, it's not clear that a static snapshot
conveys the information needed.

True economic leverage is nearly impossible to understand without
full disclosure of all of a hedge fund's commitments. This means
that many decision makers -- at banks, in government and on Wall
Street -- are merely guessing at the risk components they can't see.
Individual funds have all the relevant facts pertaining to
themselves, but nobody has the complete picture. And that may be the
biggest risk of all.


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