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Opportunities and Challenges for Hedge Funds in the Coming Era of Optimization
Several reinvestment pools had exposure to real
estate markets through residential mortgage backed
securities (RMBS) and through structured investment
vehicles (SIVs) with exposure to sub-prime mortgages.
Spreads widened out substantially on these funds and
pre-payment speeds slowed significantly as investors
sought to exit and the result was deterioration in
the net asset value of these funds below the $1.00
threshold. As $1.00 invested in these pools became
worth less than$1.00, this set off a panic in the industry
and some lending agents sought to stem declines by
imposing gates on their collateral reinvestment pools.
Though these were temporary measures and most
clients were able to eventually withdraw from these
pools, many had to wait for an extended period to
retrieve their capital. The unexpected risks and
losses that emerged during the crisis elicited a strong
backlash in the industry.
Increased Scrutiny Impacts Appetite
for Lending
Losses incurred during the GFC forced many asset
owners to defend their lending programs to their
senior management and board of directors. Concerns
about the amount of risk taken in a program that
many viewed as “safe” mixed with mounting public
concern about short-selling and the role that lenders
had in facilitating these trades. Reputational risks
caused many asset owners, particularly institutions
such as pension funds, to step back and assess their
participation in lending programs.
Actual withdrawals from lending programs were
limited, however. Leading data provider Markit
notes that the total value of global lendable assets
at the end of August 2008 was $8.2 trillion and that
by February 2009, that figure had reached a low of
$5.0 trillion. Much of this was based on declining
equity values. By the end of 2009, more than half
the decrease in lendable supplies had been recovered
with assets reaching $6.6 trillion.
Some institutions were unable to withdraw from their
programs in the immediate aftermath of the Lehman
Brothers bankruptcy because their liquidity was
locked up due to the gates that were imposed on their
collateral reinvestment funds. In the months following
the crisis, many of the agent lenders running these
funds were either able to lift their gates after capital
injections from their parent company to help balance
out realized and unrealized losses or they were able
to resume selling stressed assets in a somewhat
more stable trading environment to improve the
valuations of the fund. As asset owners began to see
their liquidity improve, they became more willing to
work with their lenders and extend their programs
to give them time to work through issues that were
uncovered during the GFC.
Nonetheless, therewas an increasedsensitivity to risks
around lending in this period and many organizations
began to impose more limits on their programs. This
coincided with a slowdown in demand as AUM in the
hedge fund industry was down sharply to only $1.4
trillion in December 2008 from a June 2008 peak of
$1.9 trillion. Beyond the asset drop, there was also
a sharp contraction in the amount of leverage being
used to run hedge fund portfolios, in part a response
to the limitations being placed on borrower balance
sheets in the aftermath of the crisis. These factors
translated to smaller position holdings.
Chart 7 shows a fairly significant drop in the value of
assets on loan from $3.5 trillion at the end of 2007
to only $1.76 trillion at the end of 2008—a decline of
50%. The value of securities out on loan stabilized,
however, after 2008 and has remained steady all the
way through the present time.
While few asset owners withdrew from lending
programs, the characteristics of those programs did
change dramatically in the years following the GFC.
“ We saw lots of funds chasing returns by giving up liquidity, which
is fine when all is well but a real problem when there is a crisis,”
—Asset Owner
“ The big issue was with cash collateral re-investment. Agent Lenders
on behalf of clients bought risky assets that suffered losses. The
risky assets that were purchased were approved by clients and
many managing their own cash collateral also suffered losses,”
— Securities Lending Consultant
“ Agent lenders had been investing in more aggressive collateral such
as sub-prime mortgages. They were doing so with the approval of
their clients who wanted the high basis point returns. Beneficial
owners managing their own cash collateral were doing it, too. We
ended up seeing some losses in the sub-prime market, but real
losses in SIVs and Lehman bonds,” — Securities Lending Consultant