Why Are Hedge Funds Not Blowing Up All Over the Place?

There are many things I do not understand about the financial crisis, but the one thing that currently puzzles me the most is how there have not been dozens of huge hedge-fund failures over the last few months.

I am sure there are plenty of hedge funds that are long mortgage-backed securities. Moreover, hedge funds are often highly leveraged.

Even if a hedge fund was just fully invested in equities — not mortgage-backed securities, but leveraged five times — it might have lost everything.

On top of this, the money in many hedge funds is “hot money.” In other words, if things start to go south at a particular hedge fund, many investors pull their money out as quickly as they can. This compounds the hedge fund’s problems, because it means it needs to liquidate positions to pay out the investors who withdraw their money.

I suspect there are two reasons why we have not yet seen massive hedge-fund failures. The first is that most hedge funds have “lock up” periods, so that investors can only get their money out with a lag of a few months or maybe up to a year.

My guess is that many hedge funds are facing huge redemptions; they just haven’t reached the end of lock-up periods yet so they haven’t had to pay out. A lot of lock-ups are probably timed quarterly, which means the next chance out is at the end of the calendar year.

The second reason that hedge funds might not yet be blowing up is that they are nearly unregulated, so they don’t face “mark to market” rules or required capital ratios. So these hedge funds could be in terrible shape, but might be able to hide that fact — at least until the redemptions hit.

My prediction: the next few months will see a string of huge hedge-fund failures, which will lead hedge-fund investors to pull their cash out of hedge funds en masse, triggering further hedge-fund blow ups.

I would not want to be holding the same assets that these hedge funds are holding, because they may have to liquidate at fire-sale prices.

[Addendum from Dubner: Levitt is such a smart guy that he doesn’t even have to read the newspaper. If he did, he’d have seen today’s front-page article in The Times about how hedge funds are blowing up all over the place, or at least will be soon.]