Hedge funds, systemic risk and the market for mortgage-backed securities

Abstract

Abstract In the early 2000s, the market for private-label residential mortgage-backed securities was built upon a pyramid of risk, and at the foundation of this pyramid were hedge funds. Few post-mortems recognise the critical role played by these institutional investors. This paper uncovers this essential piece of the puzzle and demonstrates that it is a natural outgrowth of the inherent operational freedom that defines hedge funds. It breaks these foundational risks down into two components—illiquidity risk and tail risk—and proposes solutions to prevent them from spilling over into systemic crises without eliminating the benefits that society reaps from this unique risk-taking. It concludes with important lessons for securitisation markets to consider during and after the COVID-19 recession.