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

This article examines the critical role hedge funds played as foundational investors in the private-label residential mortgage-backed securities (MBS) market leading up to the 2007–09 financial crisis. It highlights how hedge funds, particularly structured credit funds, absorbed the riskiest junior tranches of mortgage-backed collateral, enabling senior tranches to achieve high credit ratings and attract more risk-averse institutional investors. The paper identifies two core systemic risks inherent to hedge fund operations—illiquidity risk and tail risk—arising from their operational freedom and investment in opaque, illiquid assets, which can amplify financial instability beyond their own portfolios. It concludes with lessons for investors and regulators, advocating for improved due diligence and targeted regulatory measures that balance the benefits hedge funds provide in market liquidity and price efficiency against the potential for systemic spillovers, especially in light of evolving market conditions post-COVID-19.