When leverage becomes systemic
The evolution of hedge fund financing since the global financial crisis has shifted risk away from banks' balance sheets but concentrated it within highly leveraged investment vehicles.
Since the global financial crisis, hedge fund financing has evolved, shifting risk from banks to highly leveraged investment vehicles. Situational Awareness, a hedge fund managed by Leopold Aschenbrenner, gained over 1,000% since its inception due to high levels of brokerage lending, reaching close to 400% leverage. As leverage acts like a pendulum, swinging both ways, Aschenbrenner's fund experienced a seismic blowup, prompting other funds to scale back exposure.
Despite this, borrowing among funds remains near its recent average. High leverage has become standard practice in the industry, with broker loans to hedge funds now worth nearly 10% of US GDP. Wall Street banks' Q2 earnings showed a 72% increase in equity financing revenue, driven by higher revenues in equity financing, attributed to increased leverage.
Industry-wide gross leverage climbed eight times NAV, with funds attempting to control exposure through various strategies. However, leverage is often multi-layered, with trades becoming correlated through leverage, leading to forced selling and undermining diversification. Reduced bank capital post-GFC pushed leveraged trades towards hedge funds, creating a potentially safer but less buffered system.
Central banks are increasingly wary of leverage's systemic risks, with the BoE planning to curb fund borrowing levels in the gilt market. Despite some skepticism about the sustainability of this dynamic, many allocators consider leverage a critical factor when assessing managers.
Written by urgent.news from Hedgeweek's reporting — not their text. Machine-written — may contain errors; check the original before relying on it.
