Truth about Hedge Funds

PENANG: After the bailout of Long-Term Capital Management (LTCM), there are news and rumours that several other hedge funds could now be in trouble and that this may pose a risk to global financial stability.
More than a year ago, Malaysia had raised the alarm and requested the IMF to review the role of hedge funds in the Asian crisis.
Due to the agency’s bias for a financial free market, however, the IMF chief defended speculation last December and the IMF secretariat in April 1998 produced a weak report largely exonerating hedge funds.
It was a wasted opportunity to limit the funds’ powers. As a result of non-action, the hedge funds have been able to continue their operations without any tighter regulations, and they are now implicated not only in the original Asian crisis but also in speculation in Hong Kong, Russia and now in the recent volatile turnaround in dollar-yen rates.
Central realities
The LTCM debacle brought to light many central realities at the heart of the global financial crisis.
One of these realities is that some hedge funds are very influential in swaying financial markets, as they specialize in intense speculation in various markets (in equity, bonds, currencies).
Their awesome power is derived from their ability to command very high leverage by borrowing up to twenty or forty times more than the value of their equity. For example, with capital of less than US$5 billion, LTCM was able to borrow up to US$200 billion.
Their command over huge financial resources enables hedge funds to have a tremendous advantage and sway over the markets. For example, they can attack currencies and stocks and cause them to depreciate sharply, more sharply than can be justified by economic fundamentals.
Indeed, hedge funds have the power to trigger financial crises that cause recession and depression of whole economies in the developing world.
Another reality is that the crash of even one highly- leveraged hedge fund has the potential to cause a meltdown of a financial system as large as that of the United States.
Finally, since hedge funds are owned by very rich and powerful individuals and institutions, their activities are guarded and defended by governments in their home countries. After all, the profits of the hedge funds’ adventures in emerging markets have benefitted the rich countries (or at least the top crust of their elites).
And when these funds themselves suffer huge losses, these governments will rush to the rescue by organizing massive bailouts. Even though the same governments preach to others that bailouts of a collapsed company must be avoided at all costs, as a cardinal market principle.
For some time already, attempts to highlight the damaging role of hedge funds had been made by a few developing countries that became victims of hedge funds and other speculative institutions.
Malaysia was first off the mark as early as August 1997, when its premier Dr Mahathir Mohamad bluntly attacked hedge funds (in particular those related to George Soros) for triggering the currency collapses in Asia.
A few months ago, the Hong Kong authorities joined in, blaming hedge funds for manipulating the local currency and stock markets, and intervened massively to beat the speculators off. Hong Kong has now joined Malaysia in campaigning to rein in and regulate the hedge funds.
But the shouts of the victim Asian countries had been ignored, even ridiculed and dismissed as figments of the imagination of leaders seeking to blame foreigners for their countries’ plight and thus deflect blame from themselves.
Today, in the wake of the LTCM debacle and mounting losses in other funds, the laughter and derision have come back full circle to haunt the hedge funds, their investors and creditors, and most of all the financial authorities of the US and other rich nations.
"Shorting" currencies
Hedge funds are a leading component of financial institutions that have speculated on the currencies of many countries. One of their main methods is to "short" a currency. Using its high leverage, the fund borrows many billions of dollars’ worth of a local currency and then sells this local currency continuously in a bid to get the currency to fall drastically.
The central bank concerned, trying desperately to maintain its currency’s level, usually has far fewer resources than a single well-leveraged hedge fund. It buys up its own currency that is being flooded in the market by the speculators and sells off its limited supply of US dollars and other foreign currencies.
Soon enough, its foreign reserves dwindle to danger levels. When the central bank is no longer able to support the local currency, it devalues sharply. The hedge fund now needs far less US dollars to repay the local currency it had borrowed, and thus it pockets a large amount in profit.Taken from : http://www.twnside.org.sg/title/rein-cn.htm