As the public debate swirls over the risks that hedge funds pose to capital markets and the global economy, banks and brokers are far from disinterested bystanders.
In any logical scenario of systemic collapse triggered by hedge funds, they would be the next dominoes to fall.
Large brokerage houses like Goldman Sachs Group Inc., Morgan Stanley, and Bear Stearns Cos. still dominate the prime brokerage market, but banking companies - including Bank of America Corp. and Citigroup Inc. - are elbowing their way into the field.
Hedge funds demand trading and custodial services, securities lending, cash management, advisory services, credit intermediation, and risk management, among other things. Though the bank typically makes its money on the lending relationship, hedge funds are, in short, a cross-selling bonanza.
The complicated relationships make it difficult to assess bank and broker exposure to hedge funds, though experts generally conclude that the risks are manageable, and that fears of a systemic crisis are overblown.
"Everybody is expecting something to happen, and I think something will. I just don't foresee a disaster scenario - at least not at this point," said James Moss, the managing director for U.S. banks at Fitch Inc.
But that general consensus has not ended speculation that hedge funds will cause a market disaster. Banks and brokers do not disclose enough data about their relationships with hedge funds to disprove the gloom-and-doom postulations. Banking regulators' reluctance to discuss the topic is a pretty good indication that they have not come to any conclusions about the risks - or have come to conclusions they would rather not discuss publicly.
Complicating the task of calculating exposure are the messy relationships between banks and hedge funds. The credit exposure is primarily through securities lending and counterparty risk, but banks also stand to lose substantial revenue if trading activity slows down. The risk is in interest income and fee income, on the income statement and on the balance sheet.
Picking apart these strands is difficult, but it's not just the slew of services that banks provide hedge funds that complicate the risk picture; it's that as hedge funds have become larger and more sophisticated, they have bumped up against banks in several areas.
A hedge fund may use bank financing to extend a corporate loan that the bank might prefer to make itself, or assume an investment-banking advisory role that competes with the bank. And a bank's proprietary trading desk can resemble a hedge fund in its use of complicated, model-driven strategies. In addition to representing risks of their own, the competitive concerns stifle the free flow of information that would shed some light on who's on the hook to whom.
While experts debate the risks, the money continues to pour into the sector. According to the International Monetary Fund, hedge funds grew 20% last year alone and now hold about $1 trillion of assets. Most hedge funds employ substantial leverage, so their market muscle is easily two or three times that total.
They exert that muscle in every corner of the capital markets. There is no tidy description, no handy distillation, of hedge funds' strategies and methods. It's hard to generalize about an investor class that would just as soon invest in mezzanine tranches of collateralized debt obligations as it would in the common stock of General Electric Co.
But the funds have attained a collective reference because of the way they are managed: as quietly as possible, and without regulation. While hedge fund investors value that discretion, it makes a counterparty's job more difficult.
Citigroup Inc., which pulled back from prime brokerage after the 1998 collapse of Long-Term Capital Management, has recommitted to the business.
Jessica Palmer, the head of risk management at Citi's corporate and investment banking unit, said at the unit's May 26 investor day that hedge funds are an "increasingly important client set for us and the market in general" but that their "very opaque" management style presents unique risk-management challenges.
"We have found that the smaller hedge funds that want to do more business with us are more open and transparent, but they happen to be a bit riskier hedge funds," she said. "The very large hedge funds - who in some ways are competitors of ours, as well - don't want us to know what their trading strategies are, so they are only going to show us a small piece of the information."
Disclosing financial positions has its limitations, because hedge funds tend to be short-term investors, and portfolio turnover is substantial enough that a given list of investments at any point in time may not be illustrative of its risks.
Traditional credit activities like corporate lending also are not static, so the discipline of assessing hedge fund risk is not entirely different from that of sizing up a bank's credit exposure.
"You have to rely on what process has been put in place to manage things," Mr. Moss said. "You come back period after period and see whether they are running the process the same way and delivering relatively consistent results."
He said he is generally comfortable with the way bankers are managing the risks posed by hedge funds.
"Even though the business is keenly competitive and is getting more competitive … we have not seen the competitive environment at this point in time get to the extreme where it is an imprudent business activity," he said.
Citi stresses its rigorous due diligence in limiting exposure, as well as its willingness to walk away from hedge funds that do not meet minimum standards - which include nonquantitative factors like judgment, intuition, and even the personal relationships between a fund's portfolio managers and risk managers.
Securities lending is also collateralized, and banks generally are exercising appropriate limits.
"It's not as easy as one thinks to put a bank at extreme risk by exposing it to a hedge fund's credit risk," said J. Darrell Duffie, a finance professor at Stanford University's Graduate School of Business. "In this day and age, there is significant amount of attention paid to the amount of leverage granted to any particular hedge fund by a bank."
As careful as experts say the bankers have been in managing risks, the specter of Long-Term Capital Management's collapse just will not go away. But in fact the growth of hedge funds - there are now over 8,000 - has minimized systemic risk.
"None of them are big enough to do what Long-Term Capital Management did … [and] none of them have the ability to corner meaningful markets," said Richard Bove, a bank analyst with Punk, Ziegel & Co. "The net effect is that I don't believe there is any systemic risk whatsoever."
But hedge funds have a little problem. They came into existence as investment pools using innovative techniques to beat standard performance indexes, and they are now struggling to do so.
While there are still plenty of hedge funds that make normative investment decisions about the prospects of a particular stock, bond, commodity, or other financial product, most fund managers make buy and sell decisions based on complex, proprietary financial models designed to capture pricing inefficiencies.
That strategy has given rise to a Catch-22 as vexing as Alan Greenspan's interest-rate conundrum: Money is flowing into the funds, and that liquidity by definition reduces volatility - thereby decreasing the inefficiencies that hedge funds exploit to make money.
The real risk for hedge funds is that they "don't take enough risk," said Stan Jonas, the managing director of derivative products at Societe Generale SA's Fimat USA Inc. "Hedge funds are such wimps that they actually stabilize the system - that's why things are so boring and volatility is dead. There is no action, and that's the real risk to the hedge funds: They can't make their money, because nothing is moving."
It's a virtual lock that some hedge funds will collapse, but most analysts say it's unlikely that calamity will follow. If the experts are right, what goes wrong will merely be characterized as credit events, not systemic events, and the result will be marks against bank earnings, rather than drastic reductions of capital.
"There will be fallout. There are all the classic symptoms of too many companies, too many dollars, and a lot of them have the same strategy," Mr. Moss said.
