Data in new UBS report supports Bernanke’s view that HF leverage not a top concern

Hedge Fund Regulation 26 Feb 2009

Was it just us, or earlier this week during Ben Bernanke’s testimony in front of the US Senate, did Senator Chuck Schumer have a real bee in his bonnet about hedge fund leverage?…

Schumer: It’s clear that one of the key problems over the past few years has been excessive risk taken by financial institutions.  Some of that was by big depository institutions – some was by smaller hedge funds and private equity funds.  Do you agree with me that we need to more greater supervise smaller players such as hedge funds and private equity funds…And do you agree more broadly we need to put in place stronger curbs on risk taking – in particular on the amount of leverage that financial institutions – whether large or small – use in their investing strategies?

Bernanke: Senator, I think we need a more macro-prudential oversight…yada yada yada…

Schumer: But…Isn’t it true that smaller institutions can cause systemic risk…?

Bernanke: Well they can.  But that’s more likely if either there is large number of them in the same boat…or (where) a larger more complex institution is more likely to (inaudible).

Schumer: But you don’t rule out some kind of regulation for the smaller (institutions).

Bernanke: Well we already have regulation…yada yada yada…

Schumer: But that doesn’t answer my question.  I asked you about the small ones and you gave me an answer about the big ones.

Bernanke: I think that if you’re going to prioritize resources, you gotta look where the biggest risks are.  The big risks are in the big firms…

Schumer: Yes….but you do have to look at the smaller firms – for instance registration

Would you address the leverage question I asked?…There were a lot of institutions with no capital standards…who used huge leverage – 30 to 1, 40 to 1 50 to 1…

Bernanke (clearly confused): Are you referring to…who’s leverage are you referring to?

Schumer (exasperated): I am saying there are institutions that use this leverage who didn’t have any capital standards.  How do we deal with the leverage issue for non-depository institutions?  That’s what I’m asking.

So what of the “50 to 1” leverage used by hedge funds?  Well, by happy coincidence, a report released recently by UBS sheds some timely light on this topic.  It was penned by one of favorite hedge fund authors, Alexander Ineichen (now responsible for Industry Research at Alternative and Quantitative Investments (A&Q) which is the hedge fund platform of UBS Global Asset Management.).  The report was written for clients, but has been made available here at with permission from Ineichen.

True to form, Ineichen draws extensively on history, philosophy, literature and comedy to illustrate how hedge funds will be affected by major secular shifts occurring right now.

But he also makes some interesting points about hedge fund leverage that might interest Senator Schumer.  As the chart below illustrates, the typical amount of leverage used by hedge funds in 2007 (arguably the peak for hedge fund leverage) was only around 2.5x equity.  It varied significantly by strategy.

This meant that by January 2008, the $2 trillion hedge fund industry actually controlled about $5 trillion (as the table below shows):

However, losses, redemption and deleveraging changed this picture dramatically by early 2009:

Aggregate leverage now stands at around 2x equity and gross exposure is around $2.6 trillion.  But note that net exposure is likely to be much less that this due to the short positions in many strategies (particularly, of course, market neutral and long/short equity).

While particular hedge funds may have indeed been buyers of CDOs, CDSs and other derivatives that embedded a lot of leverage, we don’t think it’s accurate to describe hedge funds themselves as being “…leveraged 30 to 1, 40 to 1 or 50 to 1.”

By the way, if anyone is looking for a good chart placing recent hedge fund drawdowns and redemptions in a historical context, check this one out from Ineichen’s report:

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