[Marxism] Greenspan warns about hedge funds and derivatives

Marvin Gandall marvgandall at rogers.com
Sat May 7 06:36:02 MDT 2005

(Worry continues to mount within ruling circles about the shaky new
financial system built on derivatives and hedge funds, which Allan Greenspan
told a regional meeting of the Federal Reserve on Thursday, hasn't
"adequately been tested by market stress". Since the collapse of then
relatively obscure Long Term Capital Management (LTCM) almost brought the
system down in 1998, similar hedge funds employing derivatives like
collateralized debt obligations and other intricately-structured and highly
leveraged instruments have become as ubiquitious as stock and bond mutual
funds. They're largely unregulated and, as Greenspan noted, their risk is
understated and most institutional investors - employee pension fund and
public officials included - don't understand how they work. The major banks
trade large volumes of derivatives on their own account and are heavily
exposed to the hedge funds. The funds could, in Greenspan's practiced
delicate phrasing, become subject to "funding pressures", ie. go bust
overnight on a wrong market call, with the potential to trigger the biggest
global financial crisis since the 30s.)
Greenspan warns on credit derivatives
By Richard Beales and Gillian Tett
Financial Times
May 5 2005

Rapid growth in the credit derivatives markets has created considerable
uncertainty about how the global financial system might react to any new
economic shocks, Alan Greenspan, chairman of the US Federal Reserve, warned
on Thursday.

The sheer complexity of derivatives instruments, in particular, coupled with
the consolidation in the financial industry, made it increasingly hard for
regulators and bankers to assess levels of risk, he said.

"The rapid proliferation of derivatives products inevitably means that some
will not have been adequately tested by market stress," Mr Greenspan told a
Federal Reserve Bank of Chicago conference.

Mr Greenspan stressed that derivatives had also brought considerable
benefits, by spreading risks between multiple investors, which appears to
have made the banking system more resilient to recent shocks.

He also indicated that market forces were the best way to ensure investor
prudence, indicating that he opposes excessive regulatory interference - or
any clampdown on hedge funds.

However, his comments come at a time of growing unease among international
regulators about the potential challenges created by the fast-growing
derivatives world.

And, as Mr Greenspan acknowledged, regulators' problems are being
exacerbated by poor information about the size of the market, the degree of
leverage, and the balance of risk-sharing between investors.

These issues are particularly acute in the collateralised debt obligation
(CDO) market, since when pieces of a CDO instrument are sold to investors,
they carry widely differing levels of risk.

A recent study by Morgan Stanley, for example, showed that while the face
value of all CDOs sold in the past 16 months was $131bn, but when adjusted
for risks, its fair value was nearer $350bn.

However, as Mr Greenspan pointed out, current regulatory regimes tend to
measure CDOs according to their book value, not their risks. Moreover,
investors may not always fully understand the instruments they are

"Understanding the credit risk profile of CDO tranches poses challenges to
even the most sophisticated market participants," Mr Greenspan said.

The issue is further complicated by the growing role of hedge funds, since
these are opaque, highly leveraged - but also could potentially rush out of
the market in a crisis.

"Hedge funds could become subject to funding pressures that would impair
their ability to supply liquidity to markets," Mr Greenspan warned.

Separarately, he also repeated his earlier warnings abut the concentration
risks created by the dominant role played by Fannie Mae and Freddie Mac, the
two government-sponsored mortgage institutions, in the dollar interest rate
derivatives market.

"Concerns about potential disruptions to swaps market liquidity will remain
valid until the vast leveraged portfolios of mortgage assets held by Fannie
and Freddie are reduced," he said.

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