Question

5. Along with investment banks, hedge funds have figured prominently in the commentary that has been written on the GFC. With reference to the types of strategies that hedge funds may use, outline some of the reasons why hedge funds may have attracted criticism during and after the crisis. (LO 3.7)

Answer 1

Investment Banking firms play a vital role in the development of an economy, The story of the GFC started with the mortgage lenders, the unfair practice of moving the mortgages off the books and while the trading firms are making profits from the mortgage-backed assets which sought the lenders to create more riskier mortgage loans due to the increase in demand. The credit ratings of the lenders took a nosedive as a result of these funds which led to more complex financial products in the markets. People who could not pay their loans opted for refinancing or selling their properties and these financial products were blooming until the people stopped buying new homes. The rating agencies have started downrating hundreds of mortgage, Hedge and Mutual Funds.

On the other hand, Hedge funds which work on several strategies, they rely heavily on short term funding through money market funds. Generally, these funds are safe hedge funds buy and resell these funds to investors to generate capital for margin accounts to be alive. These are asset-backed derivatives but at the time of crisis, investors were panic and sold even those 100% safe instruments which led the Hedge funds to sell their positions which created even more volatility in the markets.

In the first half of 2007 many Hedge funds have started flat and to invest in Mortgage-backed securities which did not perform well and to maintain margins they had to sell and to reduce the risk which created the volatility. Thus, Hedge funds have sent the signal to the market that it can destroy any reputed banks even led reputed firms like JP morgan to claim bankrupt.