Ackermann told his audience that there is an increasing recognition, at the highest levels within the banking system, that important liquidity providers like hedge funds are still hesitant to lend money to banks. He also recognized that the market for long-term funding for banks is slowly beginning to open up, and argued that the securitization market would not disappear. “After a while, confidence will come back,” he said. “It may be a different story, but transparency will be the key. That development is not a bad one. Clients are coming back, and we will see those markets becoming more active again, especially credit.”
In the short term, he warned investors to expect several factors to weigh on the banks’ short term profitability, including further write downs and loss provisions, and regulatory changes. He also ran his rule across structured products. “The more standardized products, the key drivers of the past growth in financial markets, like derivatives, securitizations and structured products, they will stay,” he said. “They are being blamed a little bit for the crisis, because they are difficult to handle, and it is probably true to say that some of their investors lacked the necessary expertise, the ability to assess risk, and also failed to see the deficiencies in the market infrastructure.”
Leverage – “a vicious circle?”
Ackermann criticized the high levels of leverage that contributed to the crisis, including the liquidity levels that were “sloshing around the global financial system.” This encouraged risk taking, and led eventually to the costly adjustment process we are now enduring. “High leverage made it difficult to control the crisis, as once it started you got into almost a vicious circle in the sense you were marking down the crisis as a result of excess supply into the market and no demand on the other side.”
Deleveraging means less business can be written, less liquidity, and hence higher margins in some market segments, he explained. “Hedge funds were among the greater beneficiaries of the availability of cheap credit, especially from the prime brokerage business. Their growth was nothing less than phenomenal. Hedge funds have grown almost fifty-fold since 1990, to nearly $2 trillion. To be fair, the availability of cheap funds was not the only reason for their success, but it undeniably helped them to achieve such a globally impressive level of profitability. Perhaps it is also telling that so many, but not all hedge funds, are struggling now. That credit is no longer cheap. On average the hedge fund industry is estimated to have suffered losses of 15-18%.”
Ackermann accepted that hedge funds were not the cause of the current financial crisis, but the lack of liquidity from banks and brokers forced a process of deleveraging in the wake of the Lehman collapse as hedge funds unwound their positions. “I think what weighed on hedge funds’ performance was the combined force of the difficult market environment – many hedge funds were active in exactly those narrow market segments that were hit by the evaporation of liquidity.”
He observed that investors trying to raise cash were trying to reduce the risk content of their portfolios, reducing debt and forcing funds of hedge funds to redeem.
Speculation still surrounds the real impact of the temporary ban on short selling of financial institutions. Said Ackermann: “It is well to speculate which of these factors had the greatest impact, but there is some evidence that nervous investors played a role – the changed composition of the hedge fund investor base seems to have played an important role. The original core of very wealthy individuals has given way to funds of funds which now account for 45% of investors, up from 5% in the 1990s. Perhaps these investors have been less willing or able to ride out their losses? This development has also been aggravated by the fact that many funds of funds had monthly liquidity as opposed to quarterly or longer. How will hedge funds fare in a world where money is flowing less freely? I think, like the investment banks, they will operate with less leverage, although leverage does not have the same import for all hedge funds or hedge fund strategies.”
Ackermann also predicted consolidation in the hedge funds industry, with about 50% vanishing eventually. In the first half of 2008, more than 350 hedge funds closed down, he said. It was probably the first year in the history of the industry when more funds were closed than were launched. Smaller funds, particularly those with less than $700 million in AuM, account for 75% of the number of operational hedge funds and face the highest risks in these difficult times. Consolidation will be driven by funds losing the trust of their clients, locking in investors beyond contractual periods, and not providing information on financial conditions. “I think, ironically, the difficult market environment may revive the importance of the original hedge fund,” he said.
Ackermann sees the current market environment as being ripe with opportunities for the adventurous hedge fund manager. He sees opportunities in the more complex assets, and the withdrawal of other players offers a less liquid environment that could provide arbitrage opportunities. “This may lead to a bifurcation of the industry, into one specializing in market-traded assets, building on the trading acumen of hedge funds, and the other in liquid assets, appealing to a broader investor base.
“The assumption is probably not too far-stretched that hedge funds will take several years, if at all, to return to the pre-crisis assets under management levels. However, there should be increasing opportunities that will pay off once markets recover and economic growth results. In my view, we will see hedge funds returning in the second quarter of this year.”
Ackermann recognized that there are political factors the industry will have to grapple with in the year ahead, including the short-selling bans, more stringent oversight demands from banks lending to hedge funds, and tougher demands for transparency. He pointed out that the EU is currently consulting on the issue, and said he expected legislation once the new parliament is sitting in the summer. Apart from the hedge funds industry itself, Ackermann sees such legislation having wider implications for European financial markets.
“Hedge funds provide liquidity in many market segments; not all, but most crucially in those which are more complex and less liquid,” he said. He revisited the beneficial effects of hedge funds’ involvement in the financial system, citing efficiency, smooth and continuous price signals and the ongoing tradability of assets. “Maintaining the liquidity of financial markets will be a major concern in any event over the coming years – we cannot afford to damage, in my view, a major source of market liquidity and a major pillar of financial market architecture. I hope that legislators will keep that in mind as well.”
Dr Josef Ackermann has been with Deutsche Bank since 1996 when he joined as a member of the German bank’s management board. In 2002 became a spokesman for the board and chairman of the group’s executive committee, finally being named Chairman in 2006.