FOR PROFESSIONAL INVESTORS ONLY

Are Hedge Funds Shadow Banks?

Douglas Shaw

COO Fundamental Equity, BlackRock

April 2011

What is a Shadow Bank?

Poorly defined:

• SIVs

• GSEs

• Finance companies

• Credit hedge funds

• Securities lenders

• Levered loan funds

• Money market mutual funds…

Maturity and credit transformation

Yesterday’s risk dispersion is today’s shadow banking

Hedge Fund Industry 1990 – 2010

-$500,000

-$250,000

$0

$250,000

$500,000

$750,000

$1,000,000

$1,250,000

$1,500,000

$1,750,000

$2,000,000

$2,250,000

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

Ass

ets

($M

M)

Net Asset Flow Estimated Assets

Source: HFR 2010 Report

Recent flows have favoured the larger funds

$1,006

$459

$969

-$785

$4,716

$6,787

-2000

-1000

0

1000

2000

3000

4000

5000

6000

7000

8000

< $100 Million $100 to $250Million

$250 to $500Million

$500M to $1Billion

$1 to $5 Billion > $5 Billion

Net

Ass

et F

low

s ($

MM

)

Source: HFR 2010 Report

Banks might be, but hedge funds are not too big to “fail”

-2000

-1500

-1000

-500

0

500

1000

1500

2000

2500

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

Q1

2010

Q2

2010

Q3

2010

Nu

mb

er o

f F

un

ds

Launches LiquidationsSource: HFR 2010 Report

Hedge funds frequently “failed” – few people noticed!

No burden on taxpayers

Source of Hedge Fund Borrowings – September 2010

Unsecured Borrowing

PB Borrowing

Repo Borrowing

Synthetic Borrowing

Source: FSA HFS

Source of funding means counterparties have much protection against hedge fund failure

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

10

15

20

25

30

35

40

45

Q2

20

00

Q4

20

00

Q2

20

01

Q4

20

01

Q2

20

02

Q4

20

02

Q2

20

03

Q4

20

03

Q2

20

04

Q4

20

04

Q2

20

05

Q4

20

05

Q2

20

06

Q4

20

06

Q2

20

07

Q4

20

07

Q2

20

08

Q4

20

08

Q2

20

09

Q4

20

09

Q2

20

10

BoA Citi JPM GS ML MS

Huge expansion of banks’ balance sheets heralded the financial crisis

Source: Bloomberg

9

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

Hedge funds’ balance sheets are not on the same scale

Qualified Fund Footprint as a Percent of NAV

Source: FSA HFS

0

200

400

600

800

1000

1200

1400

1600

Equity LongShort

Credit LongShort

FI Arbitrage EmergingMarkets

GlobalMacro

ManagedFutures

Multi-Strategy

Other Total

%

Oct 09 Survey Apr 10 Survey Sep 10 Survey

Hedge funds’ leverage not even on the same scale as banks’

Capital invested by hedge funds & prop. trading desks

1 Jan 2008

1 Jan 2009

1 Jan 2010

1 Jan 2011

Total Amount of Securities Owned by Hedge Funds

$5.7 trillion

$2.8 trillion

$3.2 trillion

$4.8 trillion

Total Amount of Securities Owned by Proprietary Capital*

$4.0tr $0.4tr $0.5tr $0.5tr

Total in Position

$9.7tr $3.2tr $3.7tr $5.3tr

Source: Hedge Fund Research, Inc., Credit Suisse, BlackRock

* Proprietary Trading Desk Capital Base and Leverage, BlackRock Alternative Advisors estimates.

0

1

2

3

4

5

6

7

8

9

$ T

rillio

ns (

US

D)

Capital Base Leverage

Jan2008

Jan2009

Jan2010

Jan2011

3x

8x

2x

4x

2x

4x 5x

2.5x

Total $9.7 trillion Total $3.2 trillion Total $3.7 trillion Total $5.3 trillion

Hedge Funds

Hedge Funds

Hedge Funds

Hedge Funds

Proprietary Trading

Proprietary Trading

Proprietary Trading

Proprietary Trading

Maturity Transformation

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

Borrow short term – Lend long term

Maturity Transformation – Hedge Fund Style

0

10

20

30

40

50

60

70

80

90

100

<5 Days 6 Days - 15Days

16 Days - 30days

31 Days - 90Days

91 Days - 180Days

181 Days - 1Year

1 Year +

%

Portfolio Liquidity (as %) Financing Term (as %) Investor Liquidity (as %)Source: FSA HFS

Borrow (raise funds) longer term – but invest shorter term!

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)

Credit Arbitrage Strategies

-$1,000

$0

$1,000

$2,000

$3,000

$4,000

$5,000

2002

2003

2004

2005

2006

2007

2008

2009

Q1

2010

Q2

2010

Q3

2010

Q4

2010

Ass

ets

($M

M)

Net Asset Flow Estimated AssetsSource: HFR 2010 Report

Fixed Income & Asset Backed Strategies

-$10,000

-$5,000

$0

$5,000

$10,000

$15,000

$20,000

$25,000

$30,000

$35,000

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

Q1

2010

Q2

2010

Q3

2010

Q4

2010

Ass

ets

($M

M)

Net Asset Flow Estimated AssetsSource: HFR 2010 Report

Tiny flows back to Credit and FI strategies, into the larger ones, already much more heavily scrutinised

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

19

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