Wille Faler’s Buzzword Bingo

The traditional definition of Hedge Funds are that they are striving for absolute returns: they should make money in both good markets and bad. Furthermore, the word “hedge” probably comes from the fact that they supposedly hedge their risks, for instance by selling some stock short to cover the risk of their long bets. However, hedge funds apply a variety of strategies, investing in a variety of types of markets (not only stock markets).

Given hedge funds supposed “hedging” of risk, it is ironic to note that the drop in the markets over recent weeks have been in large degree due to hedge funds with big exposures towards subprime mortgages. The reality is that a lot of hedge funds simply do not hedge risks, at least not sufficiently, the proper current definition of a hedge fund should really be “any fund that is not regulated in the same way as a mutual fund retail investors can invest in”.

Investing in areas such as subprime mortgages, private equity, real estate and venture capital is by it’s nature investing in illiquid markets: a major stock bought and sold on a major stock exchange can most often be sold within moments even in a market enduring a big down movement. The case is very different however when it comes to illiquid investments such as the buying and selling of subprime mortgages: since the potential number of buyers and sellers are very limited, bad news can mean that it may become hard to sell the investment at any price, in fact, it could even become hard to give it away!
Add to this the fact that hedge funds often leverage their investments by borrowing money, while hedge funds investors can withdraw their investment at given points in time, and you can easily see how both panic and losses compound into a death spiral:
Investors withdrawing money means hedge funds having to sell of whatever assets they can (such as stocks) to pay out that money. The massive selling starts a down movement, where losses are compounded by the fact that the funds are using borrowed money. Voila! A meltdown is a fact.

This is pretty much what has happened in recent weeks: the subprime woes have meant that funds can expect to write large parts of their investments off completely, that news in turn triggers fund investors to cut their losses and withdraw money, resulting in funds having to sell of their assets en masse, starting a large down movement.
This means that the fundamentals of the economy outside of the subprime mortgage sector might not have changed too much to the negative, but that the subprime woes necessitated a massive global sell off from hedge funds needing to cover their liabilities such as loans and investors withdrawing their investments.

Personally, I’m not too worried about the economy, because I don’t see how the fundamentals have changed in any considerable way outside of the hick-up in subprime (point of note: cheap money is rarely cheap in the end). There will probably be some tightening of credit criteria as a result, but as long as the tightening is reasonable and not draconian, it will only make the economy healthier in the long-term. My only worry is that the recent woes will result in draconian tightening of credit, and lower availability of capital in the markets due to investors running scared.
In other words, in my mind the biggest threats to the economy are not fundamental, but psychological.
However, the consequences of the psychological factors can quickly start affecting the fundamentals, so it will be interesting to see how this unravels, and whether reason or hysteria will come out on top…

(As always to all my posts, my disclaimer applies to the contents of this post..)