UK Watchdog Says Hedge Fund Defaults Pose Minimal Systemic Risk

With hedge funds' “footprint” within markets being “generally small," the UK Financial Services Authority says defaults in the asset class pose little threat to the country’s financial system.

(July 28, 2011) — Britain’s Financial Services Authority (FSA) has said that while hedge funds are not systemically risky, the industry is gaining in influence in certain areas, suggesting a growing presence in the global convertible bond market and in the “much larger and more systemically important” interest rate and commodity derivative markets.

According to the FSA’s report published yesterday, the average fund returned 7% over six months to March 31, well above the 2% during the corresponding period before its September 2010 survey.

The watchdog’s findings are based on its most recent Hedge Fund Survey, which polled 50 investment managers with a total of $390 billion in assets under management. The watchdog estimated that the survey represented about 20% of global hedge fund industry assets under management.

“Funds’ footprint remains modest within most markets, so that current risks to financial stability through the market channel seem limited at the time of the latest surveys,” the FSA said in its report. Assets below their highwater mark have declined considerably and remain low, the report stated. According to funds surveyed in the HFS they have declined from 43% of aggregate net assets under management (NAV) in the October 2009 survey and are now less than 5%.

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Furthermore, the FSA found that roughly 60% of hedge fund portfolios could now be liquidated in less than five days. The group noted: “Some potential risks to hedge funds remain, particularly if they are unable to manage a sudden withdrawal of liabilities during a stressed market environment, potentially resulting in forced asset sales. If this occurs across a number of funds or in one large highly leveraged fund, it may exacerbate pressure on market liquidity and efficient pricing…In a stressed market environment, market liquidity may deteriorate significantly and rapidly relative to the current portfolio liquidity.”

As investorscontinue to allocate new capital to hedge funds despite volatile markets, separate data from Hedge Fund Research — which tracks asset flows and performance figures — has shown that global hedge-fund assets rose to a record $2.04 trillion by the end of the second quarter.

Meanwhile, the firm found that investors put $30 billion of new money into hedge funds during the second quarter, down slightly from the $32 billion they added in the first quarter. The firm also noted that inflows in the first half of 2011 were in excess of $62 billion.

“Strong second-quarter inflows offset a modest performance-based asset decline,” according to a news release accompanying HFR’s second-quarter performance and flows report. “Financial markets continue to be dominated by uncertainty and volatility and investors are allocating to hedge funds, expecting…this uncertain environment to persist,” Kenneth J. Heinz, president of HFR, said in the news release.

To contact the <em>aiCIO</em> editor of this story: Paula Vasan at <a href='mailto:pvasan@assetinternational.com'>pvasan@assetinternational.com</a>; 646-308-2742

(July 28, 2011) — A new paper by Credit Suisse predicts that in the unlikely event that the United States defaults on its debt obligations, stocks would drop 30% and gross domestic product would fall 5%.

Furthermore, the report asserts that worries about public finances in the United States will likely bring investors to focus increasingly on ultra-safe equities.

The chance of a rating downgrade on US sovereign debt could happen even if the debt ceiling is raised, the report said. Yet, expressing confidence that a ratings downgrade would not lead to disaster, the firm wrote in its paper: “We think there is a 50% chance of a ratings downgrade on US sovereign debt. This could happen even if the debt ceiling is raised. We doubt it will have much effect.”

Additionally, the report predicted that if no budget deal is struck, but the US fails to default, stocks and the economy will experience difficulties. “It is almost unthinkable to believe that the US would miss a coupon payment ($29 billion is due on August 15th),” the report stated. “If the US does default, there are massive ramifications. According to Credit Suisse chief economist Neal Soss, the repo market would probably cease to work. It is hard to imagine money market funds operating under this scenario. The inter-bank market would freeze up. The fallout would be far worse than after the Lehman’s default. Back then, the US government could at least spend and do the ‘right thing’, while now the only back-stop would be the Fed.”

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Rating agency Moody’s recently suggested complete elimination of the debt ceiling. “We would reduce our assessment of event risk if the government changed its framework for managing government debt to lessen or eliminate that uncertainty,” Moody’s analyst Steven Hess wrote in a report.

Last week, the rating agency cautioned that it would slash the US’ AAA credit rating if the government misses debt payments. It noted that because lawmakers have acted to increase the debt ceiling, it had not previously considered the situation high-risk.

To contact the <em>aiCIO</em> editor of this story: Paula Vasan at <a href='mailto:pvasan@assetinternational.com'>pvasan@assetinternational.com</a>; 646-308-2742