Are hedge funds leveraging our future?

Let the good times roll. It's a great time to be in finance. Global equity markets are on the rise, massive M&A's are proliferating, and buyout firms are flush with cash. Yet the recent troubles at two Bear Stearns hedge funds are of concern to us all. Is this the precipice? Is there a price we all must bear? When times are good there always seems to be a doomsayer around. (Curiously, they are also abound in the bad times).

It is prudent to examine potential problems early on rather than after the collapse, and the problems in the global debt market might be in serious trouble. The current situation has been brewing for years. During the US real estate boom, competition drove lenders to issue billion of dollars in subprime mortgages - housing loans to risky debtors. Lenders used to carry the burden of defaults, but through advances in financial engineering, such assets are rarely held for long. The mortgages are spliced into securities with different risk profiles, and are then bought up by hedge funds and other investors.

The Bear Stearns hedge funds were heavily invested, with leverage, in subprime mortgage securities and required a bailout of US$1.6bn. The total losses, however, have not yet been calculated.

Over the past 10 years, hedge fund managers and private equity players have become the kings of the financial world. Hedge funds are private partnerships that use leverage in exotic trades to ‘hedge' risk away in order to maximise returns; private equity firms acquire companies with a smidgeon of cash and a swash of debt. Both have created great fortunes, therefore increasing the appetite for larger and more frequent deals.

It is definitely passé to hype up the threat of alternative investments, and I don't believe these businesses are ominous, but the leverage that is used for their operations is troubling. To loosely paraphrase Warren Buffett, many great fortunes were squandered due to leverage - leverage being borrowed money.

Long ago, fractures would appear in certain sectors of the economy that did not spread, but the global debt market is material to us all. One immediate effect is the weakness of the US dollar, which is partially depressed due to the uncertainty of the scope of the subprime loan crisis. A weak dollar is something we all feel in the GCC.

A weak bond market also makes buyout deals more difficult to complete, and for companies to raise capital. Two recent bond offerings show that the market is softening: Kia Motors canceled a US$500m bond sale, and a Dutch company has postponed the sale of US$650m in notes. This affects stock markets which have received a lift from companies that go private.

While most of us probably ignore bond benchmarks (yield spreads, LIBOR), these realities care about us. Increased interest rates, reevaluated currencies, and fledgling equity markets affect us all, and these are all interlinked with the actions of highly leveraged investment companies and unintended failures of financial innovations.

There are historical precedents. The 80s were dominated by leverage and junk bonds, and resulted in the collapse of savings and loans institutions which were heavily invested in risky securities. The bailout cost US taxpayers US$140bn.

Of course that was more than just leverage, there was malfeasance. Yet the cause and effects of such downturns are eerily similar. Very smart men shun the traditional norms of investment, overextend themselves, and fall. Investors examine the remains and realise the limits of their sophistication. Somehow, the losses are exacerbated and institutions (and governments) need to step in to deter an all out collapse. Just as risk is spread through financial engineering, bailout costs are spread to the population at large. There is a cost to unchecked leverage. Sooner or later, we all might have to foot the bill.

READERS' COMMENTS

MORE FROM ARABIANBUSINESS.COM