By Q1 2009, the hedge fund sector had experienced trading losses of around $ amounting to one fifth of their total assets (He, Khang and Krishnamurthy, 2010), a scale that would have wiped out almost all banks given their leverage. Yet many hedge funds have survived. And none has been bailed out with taxpayers’ money. Because hedge funds have so much lower gearing, or leverage, than banks they have been able to absorb much bigger falls in asset values. Close to 3,000 hedge funds have closed, that is liquidated, since mid-2007 2 – but they have done so with a quiet whimper rather than with an alarming bang. Falls in the value of assets that hit the wealth of institutions – but not their existence – do much less damage than falls that wipe out firms and cause bankruptcy. So sharp asset price variability, per se, is not the most serious problem. It is the combination of (and the interrelation between) high debt – or leverage – and variability in asset prices that is problematic. 2  “Global Hedge Fund Industry Report”, Hedge Fund research Inc, Q2 2010. BIS Review 133/2010  3  I believe that an important way to help preserve financial stability is to have policy instruments directed at debt gearing (or leverage) and to be used in the light of what has happened to asset values.
But the economic outcomes have been dramatically worse. A key difference here is that property price rises – unlike big rises in equity prices – are invariably accompanied by big increases in debt. So when property prices fall they are more likely to create solvency problems – and funding problems associated with heightened solvency risks – than when equity prices fall. My colleague Adam Posen recently presented evidence that big falls in equity prices in themselves generally do much less damage than big falls in house prices. He found that the average output loss after real estate booms cumulates to over 5% of GDP over five years, and in 75% of cases at least 2% of output is lost. For equity price booms and busts, there is no output loss on average over five years, and following them only 25% of economies experience a loss of more than 4% (Posen 2009). What has happened to the hedge fund sector during this crisis is also illuminating. In Q4 2007, total assets held by hedge funds were around $ and aggregate equity capital (or what the industry refers to as assets under management, AUM) was around $ This implies that the hedge fund sector had an average leverage of around 2.8, compared to typical banking sector leverage ratios at that time of 30 or more.