The Role of Hedge Funds in a Crisis

In a study published in the Federal Reserve, “How Important are Hedge Funds in a Crisis,” the author, Reint Gropp, argues that hedge funds were the most important group in the transmission of “spillover effects,” or shocks that caused the losses suffered by commercial and investment banks during the 2007-09 credit crisis.

This conclusion is based on a statistical analysis. However, his attempts to explain the economic and financial forces that underlay this transmission are, to put it mildly, simplistic. Dr. Gropp states: “If highly leveraged hedge funds are forced to liquidate assets at fire-sale prices, these asset classes may sustain heavy losses. This can lead to further defaults or threaten systematically important institutions not only directly as counterparties or creditors, but also indirectly through asset price adjustments. One channel for this risk is the so-called loss and margin spiral. In this scenario, a hedge fund is forced to liquidate assets to raise cash to meet margin calls. The sale of those assets increases the supply on the market, which drives prices lower, especially when market liquidity is low. This in turn leads to more margin calls on other financial institutions, creating a downward spiral.” In reaching his conclusion, Dr. Gropp examines the interaction between investment banks, commercial banks, hedge funds and insurance companies, and concludes that the transmission between the groups is only significant in the case of hedge funds. However, Dr. Gropp does not, at least in this article, examine the interaction between investment banks with each other. If one admits that the failure of Lehman Brothers is one of the major reasons the fiscal crisis was as long and severe as it was, an examination of that even is important for his argument. However, the major cause for Lehman Brothers’ ultimate collapse was the demand for collateral and fire-sale disposition of assets by banks and investment banks, not hedge funds. Indeed, the margin loans and credit lines extended by banks to each other dwarfed those extended to hedge funds.