More Harm From Hedge Funds?

Secretive, run by and often for the super rich, hedge funds control a gigantic pool of money. Often they make huge profits, but not now. Two shut down this week. What happens to the markets if more fail?

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These, of course, are hard times for hedge funds in the United States, those secretive investment funds run by, and sometimes for, the very rich. So what happens to the rest of the market if these giants fail? We asked NPR's David Kestenbaum.

DAVID KESTENBAUM: Hedge funds collectively manage a large pool of money. Some estimates put it at over $2 trillion. That worries James Kaufman(ph) who worked for almost three decades at the Securities and Exchange Commission.

Mr. JAMES KAUFMAN (Former Executive, Securities and Exchange Commission): I worry because I don't know what I don't know. You don't know what's in them. You don't know who runs them. I don't know who they owe money to.

KESTENBAUM: So there are a lot of questions. Here's what we do know. Hedge funds have reputations for hiring some unusual employees, like physicists and mathematicians. Joel Schwab says there's some truth to that. He's managing director of Channel Capital Group which provides information for investors on hedge funds.

Mr. JOEL SCHWAB (Managing Director, Channel Capital Group): Basically, they've programmed computers to look for various patterns and mispricings that might even only last a second. And those computers are then able to implement trades. Sometimes there's a human overlay over those, and other times the humans build a model and then they let the computer run with it.

KESTENBAUM: But not all their investments are that complicated. Hedge funds have generally done quite well. Until recently, they've earned pretty steady 10 or 20 percent returns. Steady is the key. They generally try to place bets so they win whether the market goes up or down. But the market is so out of joint that's not working right now. Schwab says hedge funds are losing money, on average something like eight percent this year.

Mr. SCHWAB: The hedge funds are having a very poor year. It's possibly their worst year since the early 1990s. It may go down as their worst year ever.

KESTENBAUM: As a result, a few have closed. And some investors are asking for their money back. Oliver Schupp is president of the Credit Suisse/Tremont Hedge Fund Index.

Mr. OLIVER SCHUPP (President, Credit Suisse/Tremont Hedge Fund Index): Our estimate is that by, let's say, the first quarter in 2009, the industry may correct by about 20 percent. So that would be, call it 400 billion-ish.

KESTENBAUM: One concern is that if people yank their money out, the hedge funds might collapse in an ugly way. Hedge funds borrow money so they can place bigger bets and make bigger profits. But if they can't repay those banks, that could be really bad. The banks are already in trouble. Joel Schwab says that shouldn't be a problem if the banks were careful when they lent that money.

Mr. SCHWAB: Provided everyone's kind of doing their job, if the prominent investors have done the right due diligence...

KESTENBAUM: But this whole crisis is about people not getting that very thing right.

Mr. SCHWAB: Yeah. Time will tell. I do not think, though, there is a hedge fund that poses a systemic risk to the financial markets.

KESTENBAUM: Oliver Schupp with Credit Suisse says on average hedge funds may borrow twice what they have from investors, what's called two-to-one leverage. But Lehman Brothers, before it fell, had a leverage ratio of 30 to 1. Some observers blamed stock market plunges this week on hedge funds being forced to liquidate part of their holdings. Greg Newton was not convinced, though. He's followed hedge funds for 18 years and writes a blog called NakedShorts.

Mr. GREG NEWTON (Blogger, NakedShorts): The attempt to pin market chaos on hedge funds is in my view, you know, giving them rather more credit than they deserve. There are a lot of moving parts, and hedge funds are just one of the moving parts in what's going on in the market at the moment.

KESTENBAUM: Hedge funds may seem mysterious from the outside, he says, but they're not all powerful. David Kestenbaum, NPR News.

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