Real Estate Hedge Funds

Tesanista said …
“This is a great blog! Could you look into Real Estate Hedges? I saw an article on them on the housingbubble2 spot this evening. Do you know anything about them?
True.. I was specifically wondering if you had seen any data on the Real Estate Hedge Funds that are suposed to start trading in the spring of '06 (I think). I would like to find out their makeup and metrics.”

Tesanista,

I have not seen any such data yet. Hedge funds are known for their secrecy. The problem with Real Estate Hedge funds during a down fall is the risk of counter-party fault.

Even if the hedge fund has financial derivatives designed to take advantage of a declining market, the decline may bankrupt the counter-party so fast as to make it impossible to collect any such money.

For example say that I design a derivative which gives me the right to sell real estate for a price set today, but for one year in the future. The underlyer of the derivative is a specific unit of real estate like 1015 half street. The price of the option is 10% the price of the property.

The price of the property declines from say a starting value of $1,000,000 to $700,000. The derivative is 10% of the initial price of the property at a cost of $100,000. Therefore the derivative is worth $200,000 ($1,000,000-$700,000-$100,000).

The hedge fund demands this money from the counter-party, the financial entity on the other side of the derivative. If the counter-party has lost too much money it falls into chapter 11 bankruptcy (protection from creditors, or protection from having to pay the hedge fund).

Now the hedge fund cannot be paid and still looses. This can induce the hedge fund going into bankruptcy.

In reality the government has historically stepped in and assumes the debt from the defaulting financial institution in the name of systemic risk. The government then pays the hedge fund with US government debt or by just creating new money. Both methods of bailouts expand the broad based money supply.

Here is the real trick, when does this lead to broad based inflation?

It is when the money in circulation increases as opposed to the total money supply, then prices for general goods and services increase.

If the money is trapped in loans, loans which are used to purchase assets, they you get asset inflation.

Any money which is created and enters general circulation may also be taken out of circulation by a negative trade balance, investment, or foreign investment.

Therefore a currency may be hyperinflated, and broad based inflation is not felt in goods and services, however assets inflate at a rate much greater than the increase in the money supply.

Therefore as the financial system defaults, and money is created and the money supply is expanded, the ability to get money out of general circulation is diminished. This causes what most common people call inflation in goods and services.

Does this increase interest rates?

Interest rates are set by supply verses demand. So as long as the government can provide policies which induce the expansion of credit, then interest rates can remain low and actually be forced lower if the supply of credit increases and the demand for credit decreases.

How does this further affect hedge fund hedging strategies?

Hedge funds are part of the financial economy, therefore they are very vulnerable to low interest rates. Therefore the government may rig the system to always pay for the counter-party, but the buying power of that money may decrease, and decrease very quickly.

In the end if the government keeps with this policy then the all assets are then owned by the financial economy as the government transfers wealth to the financial economy at the expanse of the real economy via bailouts and increasing the money supply. Much like the system we have today whereas the real economy is now much smaller than the financial economy.

Therefore the strategy for any hedge fund or financial institution is to take as much risk as possible due to a lack of any real downside risk for major players. The only way this will end is if the other countries stop accepting our currency. Then the value of the real economy shall increase again.

The first sign of a currency rebellion will be when other countries refuse to pay the counter-party failures in their financial systems. Since all financial systems are closely connected, this will effect the US very quickly.

Chromatic Dispersion