Local economists say that hedge funds, generally seen as investment vehicles used by the wealthy, are in large part responsible for recent losses on Wall Street.
For most investors, who do not own securities backed by subprime mortgages, recent market volatility probably had little impact.
For hedge funds managers, attracted to the returns promised by subprime-backed instruments, the damage has been severe. Many made speculative bets without adequately hedging against potential downturns. Now, with the collapse of the market, some funds are recording double-digit losses. A number of funds are unable to determine the value of their portfolio, because the value of securities backed by hedge funds is unknown.
The subprime crash has also tightened lending standards, making it more difficult to purchase homes and for large companies to make big acquisitions. Uncertainty surrounding hedge-fund losses and the lack of liquidity in the market has led to sharp drops in the Dow Jones industrial average in recent weeks. Tuesday the Dow lost more than 200 points.
Many analysts have painted hedge funds as a victim of the subprime crash. However, Peter Morici, professor at the University of Maryland School of Business and the former chief economist at the U.S. International Trade Commission, said careless investing by hedge fund managers into subprime instruments — not the subprime instruments themselves — have caused Wall Street’s recent problems.
“We haven’t had good due diligence in assessing the borrower’s ability to pay,” he told The Examiner. “The investments they were making were not always as safe as they were presented … to people who invested in their funds. The risk was underrated.”
Hedge funds are likely to continue to take losses, Morici said. Though the Federal Reserve’s cash infusion last week helped stabilize the market, it did not solve the
larger problem.
“At the end of the day, if they sold instruments that are not solvent, people are going to take losses,” Morici said.
Joseph Cater, chief economist at Annapolis-based Market-Economics, said it would be difficult to value these instruments, as adjustments on the loans, which triggered the fallout, will continue over the course of the next few years.
“Any security backed by a subprime mortgage has uncertain value,” he said. “Can we model foreclosure rates? Can we understandthe characteristics of the borrower? Everyone is scrambling to analyze these loans and forecast how many are going into foreclosure.”
Morici said that large losses should be limited to the hedge fund market if credit doesn’t dry up.
“Even though it’s a big problem, it’s not one that has to be terribly menacing to the economy,” he said. “As long as the bond market continues to function so that people can get loans for good projects, the economy will go forward.”
