Are Hedge Funds Shadow Banks?

1. Are Hedge Funds Shadow Banks? Douglas Shaw COO Fundamental Equity, BlackRock April 2011

2. What is a Shadow Bank? Yesterday’s risk dispersion is today’s shadow banking • Poorly defined: • SIVs • GSEs • Finance companies • Credit hedge funds • Securities lenders • Levered loan funds • Money market mutual funds… • Maturity and credit transformation

3. Hedge Fund Industry 1990 – 2010 Source: HFR 2010 Report

4. Recent flows have favoured the larger funds Source: HFR 2010 Report

5. Banks might be, but hedge funds are not too big to “fail” Hedge funds frequently “failed” – few people noticed! No burden on taxpayers Source: HFR 2010 Report

6. Source of Hedge Fund Borrowings – September 2010 Source of funding means counterparties have much protection against hedge fund failure Source: FSA HFS

7. Credit Transformation • Banks bundling mortgages, tranching & selling them • Especially the risky mortgages • Complex & Befuddling • investors • regulators • rating agencies • insurers • even banks themselves • Hedge funds were the early warning system • shorted into the bubble • presented to G7 Philadelphia 2007 • http://www.bbc.co.uk/programmes/b00m67vv • “The Big Shorts”

8. Banks’ balance sheets 45 40 35 30 25 20 15 10 Q4 2000 Q4 2001 Q4 2004 Q2 2005 Q4 2005 Q2 2007 Q4 2007 Q2 2008 Q4 2009 Q2 2000 Q2 2001 Q2 2002 Q4 2002 Q2 2003 Q4 2003 Q2 2004 Q2 2006 Q4 2006 Q4 2008 Q2 2009 Q2 2010 BoA Citi JPM GS ML MS Huge expansion of banks’ balance sheets heralded the financial crisis Source: Bloomberg

9. Hedge funds’ balance sheets are not on the same scale The leverage indicator is estimated using a rolling (24-month window fixed effects) regression of hedge fund returns on a variety of market-based risk factors. It is the sum of the coefficients on these risk factors and is thus a measure of the aggregate sensitivity of hedge fund returns to movements in underlying prices. ‘All hedge funds’ includes market neutral (excluding equity hedged), directional, equity (including equity hedged), fixed income and fund-of-funds style families of active funds reporting to HFR database; weighted by assets under management in each style family. Source: HFR, BIS calculations

10. Qualified Fund Footprint as a Percent of NAV Hedge funds’ leverage not even on the same scale as banks’ Source: FSA HFS

11. Capital invested by hedge funds & prop. trading desks Hedge Funds Hedge Funds Proprietary Trading Hedge Funds Hedge Funds Proprietary Trading Proprietary Trading Proprietary Trading Source: Hedge Fund Research, Inc., Credit Suisse, BlackRock * Proprietary Trading Desk Capital Base and Leverage, BlackRock Alternative Advisors estimates.

12. Maturity Transformation Borrow short term – Lend long term • Reliance on short duration repo markets converted risky long term assets to near cash • Money Market Funds drifted into longer maturity asset backed paper (and some were befuddled in so doing) • Valuation problems in BNP money funds heralded the financial crisis • Banks became highly levered and ran mismatches between • long dated assets that became illiquid & • short term funding that was withdrawn as confidence in ability to value assets evaporated causing further asset sales at depressed prices

13. Maturity Transformation – Hedge Fund Style Borrow (raise funds) longer term – but invest shorter term! Source: FSA HFS

14. Hedge funds didn’t always get asset maturity right • When withdrawals were at the peak in winter 08/09 • Some hedge funds could not close asset positions quicker than the investor redemptions to which they were responding • So some hedge funds restricted redemptions through • Gates • Sidepockets • Suspensions • As allowed by their prospectuses • Some clients were surprised and disappointed • But hedge funds did not exceed their powers (generally)

15. Credit Arbitrage Strategies Source: HFR 2010 Report

16. Fixed Income & Asset Backed Strategies Tiny flows back to Credit and FI strategies, into the larger ones, already much more heavily scrutinised Source: HFR 2010 Report

17. To Conclude: • Hedge Funds are not shadow banks • Significantly less levered • No credit transformation • though sought to profit from those who did • Some maturity transformation • not in the expected direction! • generally asset / shareholder mismatches well managed • No claim on the tax payers • Responding well to increased scrutiny • Regulators’ surveys • AIFMD

18. What’s next? • Clamp down on “speculators” • “It was obvious that one day Greece would have to face this kind of problems, and I knew that problems would arise because we - the French, the Germans, ECB President Trichet, the Commission and myself - had been discussing the perspectives of what was not at that time known as so-called Greek crisis…… • …..The Greek crisis could have been avoided, but not starting last year, starting two or three decades ago”* Jean Claude Juncker, twice President of the Council of Europe, Luxembourg Prime Minister • Financial Transaction Taxes • Who’s the target? • Who gets the proceeds? *Source: http://openeuropeblog.blogspot.com/2010/10/europes-worst-kep-secret.html , quoting Le Monde

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