The Financial Products That Blew Up The Global Economy Are Sliding Into The Shadow Banking System

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The products that threw banks around the world into free-fall, dragging the global economy down with them, are not gone — they’re just moving into hedge funds, Bloomberg reports.

Because hedge funds are far less regulated than your average bank, they’re considered a part of the shadow banking system.

Additionally, because hedge funds are far less regulated than your average bank, they can pick up the assets that governments are forcing banks to get rid of — things like distressed corporate debt, mortgage backed securities, and all sorts of fun credit derivatives.

They’re picking up the traders Wall Street is being forced to get rid of as well. People on the Street have been talking about this for a while, and they, like Bloomberg, are calling it a brain drain.

The thing is, all of this has been happening relatively slowly. Bloomberg says hedge funds have only picked up $108 billion of these assets since 2009, which is nothing compared to what Wall Street has on its balance sheet. JP Morgan alone had an average of $413.4 billion in trading assets in Q1, says the report.

That said, however, for hedge funds, slow and stead will likely win the race.

From Bloomberg:

They attracted $41.4 billion from pension plans, wealthy individuals and other investors in 2012, the most since 2007, after a combined $57.4 billion of net inflows in the two previous years, HFR data show. The three-year total was a record.

Hedge funds focusing on fixed-income arbitrage boosted returns by 51 per cent last year, while fixed-income, currencies and commodities-trading revenue at the nine largest banks rose 14 per cent, excluding accounting charges, according to data compiled by Bloomberg.

The strategy, once employed by Long-Term Capital Management LP, focuses on exploiting pricing inconsistencies between assets rather than making bets on the market’s direction at a time when Berkshire Hathaway Inc. Chairman and CEO Warren Buffett and Goldman Sachs President Gary Cohn are predicting losses for fixed-income investors when interest rates rise.

Things ended very badly for Long-Term Capital Management, but hey, it’s a new day right?

Bloomberg specifically mentions three hedge funds that are really leading this march, BlueCrest, Pine River Capital and Millennium Management LLC. Together they have over $67 billion in assets.

You can bet governments around the world are happy about this. It means risk is being transferred away from systemically important institutions.

These hedge funds have to be thrilled as well. They’re making a killing off of mortgage backed securities. The best performing hedge fund of 2012 was Deepak Narulla’s Metacapital Mortgage Opportunities, which returned 37.8%.

Last June, Anthony Scaramucci told CNBC that Pine River was doing great things with mortgage backed securities and seeing 12% returns. Not bad, and probably getting better.

For the full story on this, head to Bloomberg>

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