Financial storm gathering?

Andrew Lo of MIT apparently thinks so.  His work provided the basis for this New York Times article by Mark Giben, an article that probably will attract less attention today than it would in more tranquil times.

Lo worries that hedge funds are investing less liquid instruments, complex derivatives as well as physical assets that are hard to sell for cash in a pinch.  Ironically, stable investment returns - in his view - are a sign of risk, since they suggest investment in less liquid instruments.

Traditionally, economists have thought that big up-and-down fluctuations in returns indicated risky investments, so many hedge fund investors have hoped to see a pattern of smooth and even returns. But Mr. Lo quickly saw that lots of hedge funds were posting returns that were just too smooth to be realistic. Digging deeper, he found that funds with hard-to-appraise, illiquid investments - like real estate or esoteric interest rate swaps - showed returns that were particularly even. In those cases, he concluded, managers had no way to measure their fluctuations, and simply assumed that their value was going up steadily. The problem, unfortunately, is that those are exactly the kinds of investments that can be subject to big losses in a crisis. In 1998, investors retreated en masse from such investments.

Now, in a paper to be published by the University of Chicago, Mr. Lo, working with his graduate students, has come to a disturbing conclusion: that smooth returns, far from proving that hedge funds are safe, may be a warning sign for the industry.

That doesn't necessarily hold true for every individual fund, but as Mr. Lo shows in his paper, measuring the smoothness of returns gives economists a good way to estimate the level of relatively illiquid investments in the hedge fund world. The approach lets economists measure industry wide liquidity risks without knowing the details of the investments - information that hedge funds just don't give out.

By Mr. Lo's measures, hedge fund investments are less liquid now than they have been in 20 years. His work shows that the same pattern of investing preceded the 1998 global hedge fund meltdown and the 1987 stock market crash.

Emphasis added. 

Lo also worries that current low hedge fund returns create an incentive to borrow more to make bigger bets.  

Mr. Lo argues that while a hedge fund crisis appears to be sudden and to be caused by unforeseen events, the breakdown is only the late stage of the problem. As more hedge funds compete for the same slice of the pie, he says, their managers feel that they have no choice but to "leverage up," juicing their returns by borrowing more money to make bigger investments.

That, in turn, makes the investments more prone to a sudden credit crisis. Hedge funds that are highly leveraged are vulnerable to having their lenders - banks and big brokerage firms - cut off credit when they think that their money may be at risk. And Mr. Lo thinks that lenders would do exactly that in an industry wide downturn. That would force hedge funds to close out their positions at the worst possible time - the kind of cycle that brought down Long Term Capital Management.

Here again, his data suggests that the current situation is serious. His research indicates that the industry may have already entered a period of lower returns that signal a prelude to crisis.

Lo's conclusion:

"The concern that I and others have is that we're approaching the perfect financial storm where all the arrows line up in one direction," Mr. Lo said. The more money that is invested in hedge funds, he said, "the bigger the storm will be."

I would add another risk.   As the yield curve flattens, bank profitability gets squeezed a bit.   Some big "universal" banks are also in the business of providing credit to hedge funds, in part because they also profit from all the trades that hedge funds make.    As the banks profits elsewhere get squeezed, they may be tempted to help their best clients take on more risk - particularly in an environment where more and more banks are trying to get their share of the hedge fund business.

I don't get the sense that the financial system that has emerged in the past few years, one marked by the absolutely explosive growth of credit derivatives and a huge expansion in the number of hedge funds and the assets managed by hedge funds (though not necessarily in hedge fund leverage - no one, I hope, is as geared up as LTCM) has truly been tested by a the financial equivalent of a category four or category five storm. The auto company downgrades this spring strike me as more like a category one storm. 

Hence, the various statements of concern from FRBNY President Geithner, and more recently, even from Chairman Greenspan.

Lo's paper can be found here.