For all the talk these last few years about the risks to investors of "secretive, unregulated" hedge funds, they certainly haven't turned out to be the big problem, have they? [...T]housands of hedge funds lost, in the aggregate, hundreds of billions of dollars last year, and hundreds have shut down. But nobody in government is calling for a hedge fund bailout because hedge funds losses, however painful to investors, don't create systemic risks to the nation's financial apparatus. As it turns out, it was the big regulated entities, the banks and investment banks, that were the problem, not the unregulated hedge funds.
On the other hand, while hedge-fund systemic risk hasn't been a tremendous problem this time around, it has been a big problem in the past. (Long-term capital management, anyone?) And while the "big regulated entities" have managed to cause a lot of trouble, those big regulated entities do own small, unregulated hedge funds that have managed to muck up their share of the market. (Here's a story about one from Goldman and here's a story about one from Bear Stearns.)
More generally, my understanding is that the case for regulating hedge funds never hinged entirely on containing systemic risk. A lot of it hinges on basic transparency issues and a desire to protect the actual investors in the fund. I don't know how convincing that kind of argument should be (if there's little systemic risk, then why not let accredited investors throw their money onto whatever bonfire they want?), but Bernie Madoff has certainly supplied plenty of grist for that mill.
I find Nocera's remark to be an fine example of the sort of oligarchic "belief system" described by Simon Johnson in the May issue. The absurd rationalizations of the "no social risk" thesis are a wildly evolving ideology. First, hedge funds posed no risk because they were too small. Then came Soros' play against the pound. Next, hedge funds posed no risk because they were to so brilliantly hedged. Then came LTC.
Next, hedge funds pose no risk because only smart, rich investors are in them. Then came the Chrysler play and the Carlyle case. In the Chrysler negotiations we suddenly have funds claiming they require favorable consideration because they handle teacher's pensions and other socially vital assets. In the Carlyle case we have an admission that the funds are using second parties to bribe their way to influence over pension funds and other socially vital assets.
Finally, we hear that hedge funds pose no risk because they are basically uncorrelated and subject to the laws of market equilibrium. Given recent events and the obscurity of TARP counterparties, this "white swan" line of reasoning is about as reassuring as the engineers describing why the Titanic could never sink.
As we taxpayers have been reminded recently, we are what ultimately backs the U.S. dollar. That makes our national currency a public utility of a sort. How people use large amounts of our national currency is of the utmost concern to all citizens who depend on the stability of that currency. People who trade and deal in our national currency have public responsibilities, just like people who manage our water supply. Eighty percent of what hedge funds and private equity funds do is increase the water supply by pissing in the reservoirs.
Hedge funds managing over a designated amount should be far more transparent, which basically means they would have no reason or ability to exist. Fine.
That's right the biggest problem in the current crisis were hedge funds and, oh, let's not forget shortsellers. If only we had no hedge funds and shortsellers, we could assure constantly rising stock prices to the infinite benefit of the investing public.
This laughable line of reasoning requires a direct challenge. The original point is very valid: hedge funds overall performed admirably in the current crisis. Often accused of collecting extra returns at the price of insane risks, they have proven to be, as an asset class, superior to anything else out there. The worst offenders tuned out to be the most heavily regulated entities: large commercial banks. The problem was obviously the size. No single organization should be able to concentrate/hide so much risk. Whether a hedge fund or a bank. Yes, one of the main reasons hedge funds performed better was the fact that they were relatively small (and better managed)
The complaints about the hedge fund grow ever more ridiculous: Chrysler creditors demanding their legal rights!? How dare they? More junior creditors should get more, since the government likes them better! Even better, another argument is that since some operations are crooks, everybody is fundamentally a crook (by the way Bernie was not a hedge fund manager). Obviously in highly regulated system we should handily expect much less corruption. That's a well known consequence of tightly regulated systems.
The attacks on hedge funds grow ever more bizzare. I understand you do not like hedge funds, but try and come up with some cogent arguments for a change.
I didn't realize people had such strong feelings about hedge funds.
I'm glad Mr. Wolyniek finds my line of reasoning laughable. Always happy to contribute to a jolly world. But I fail to see how his responses refute them or even grasp the basic points. One of the frightening things about the current generation of financial boosters is the combination of large financial responsibility and tiny historical perspective. I admit my argument is entirely incoherent to everyone who views the world as a mass of "asset classes." My argument is not that hedge fund managers are crooks or that they should not pursue their legal rights. Indeed, they must. It is their fiduciary duty. And I understand that some people can get higher returns and large fees through hedge funds and private equity funds. Which is good, for them. Modestly sized, reasonably transparent hedge funds are fine. But my argument is broad and structural. Does Mr. Wolyniek actually assert that the problems made apparent in LTC have all been fixed? Or that very large hedge funds can collude to short national currencies? Or that hedge fund advances were enmeshed in the larger banking debacles? Or that the prospect of massive earnings based on company collapses might distort market incentives? I was unaware that these were even controversial propositions, let alone "bizarre." They are bizarre only to an ideological perspective in which hedge funds are axiomatic and central, the earth around which the sun orbits.
LTC problems? Yes, in the hedge fund world nobody runs 100:1 leverage anymore. That was the preserve of banks, especially large commercial banks in the US and Europe, which did run 60:1 leverage. Hedge funds typically do not run anything more than 4:1, there are exceptions, but they do not matter, since as has been clearly demonstrated hedge fund do not pose any systemic risk (they are too small).
Very large hedge funds can short national currencies, but they have not been known to collude (very hard to do). How were the hedge funds enmeshed in the larger banking debacles? Some of them were as stupid as the banks, by betting on the housing bubble? Sure, and some were betting just the opposite. The big difference is that the banks did it systematically and crashed the financial system with excessive leverage. The hedge funds did not.
They might not be controversial position in the sense that the accusations are being repeated over and over again. Which, does not make them true.
What this crisis clearly show that large money-center banks can be very dangerous to the system. In general it shows the dangers of size, as in concentration of the risk instead of diversification (e.g. AIG). It also shows that unregulated hedge fund do not represent any significant danger to the system.
Both Alexander and Wolyniec make persuasive arguments.
Alexander states:
"Hedge funds managing over a designated amount should be far more transparent, which basically means they would have no reason or ability to exist. Fine."
It seems intuitively true to me that company finances (especially large companies) should be transparent. What do you think, Mr. Wolyniec? If the hedge funds were forced to operate in a transparent fashion, would this really destroy their ability to operate efficiently?
Alexander also states:
"Or that very large hedge funds can collude to short national currencies? ...Or that the prospect of massive earnings based on company collapses might distort market incentives?"
Doesn't short selling help discover the real value of an asset? Doesn't the short seller profit by figuring out the real value of an asset before the rest of the market? Why isn't this a good thing? Doesn't intelligent short selling discourage and deflate these incredibly wasteful bubbles before they balloon to catastrophic proportions?
Well, transparent in what sense? The government tracking positions in real time? No way. Very bad idea, just look at Chrysler.
Investors demanding more information? Obviously, it's available right now, if anybody demands.
In general, I am in favor of restrictions on the size of the market participants. The money-center banks should be broken up. Hedge funds in the same way should not be allowed to become very large.
Some very large companies' finances are not transparent at all: as long as they are private. It should be no different for hedge funds.
Would transparency hurt hedge funds? To some degrees yes, since at minimum it would reduce the incentive to come up with superior ways to manage risks, and as this crises CLEARLY showed, hedge funds, as an asset class, posess a superior ability to manage risk.
The underlying idea in the attack on the hedge funds is that what they do is somehow extract undeserving money from investors, and bring no social value. The big lesson from this crisis is that risk management is crucially important, and hedge funds do it better than anybody else. If this is of "no social value", I don't know what is.
Only in the Luddite hallucinations of the left (see Krugman) can we go back to the world when we can have boring, simple, highly restricted financial world and highly competitive, innovative economy at the same time. You want to go back to the financial world of the 50's, you are gonna get the monopolies of the 50's, and if you wonder what the long-term consequnces of such choices are, just read about the history of Argentina from the 30's onward.
I believe that LTC and the Soros play on the British pound are two high visibility cases on the dangers of hedge funds, among many lesser and more sordid examples. In the various runs on Asian currencies, some, such as Krugman (and non-Krugmans) have observed that "collusion" between funds can be entirely tacit. Since there is so little public information on hedge fund strategies it is nearly impossible to know if quiet phone calls are made or rumors generated by short sellers. Opacity is half the value.
Many hedge fund and private equity managers are ethical people, no doubt, but you do not create powerful social institutions and regulatory regimes based on that assumption. Trust but verify. Wasn't it Reagan himself how said that? It is annoying to hear pundits say that our very serious current problems were based ad hominem on "greed and misjudgment." Those rather universal characteristics of our species are precisely what we are supposed to assume. We do have clear case evidence of problems in large private speculative funds, as I have mentioned. It is also incontestable that such funds channel billions and even trillions of dollars into market activities that are essentially speculative, massive, and swift. By speculative I mean betting on prices, arbitraging price gaps, and remaining relatively liquid and remote from physical assets or earnings ratios. Worse, in some cases funds can actively impact the markets where they have prior knowledge--which would have been possible for anyone in the Chrysler deal by placing bets on a bankruptcy they were in a position to force. Who knows?
A certain amount of this is fine. But it is a structure that almost automatically blows bubbles. Much of it is mathematically fancy pump and dump, as far from actual "productive investment" as money can get. Even if funds are small there is no way to know until after the train crash how and when large leveraged sums can get weirdly correlated. Long, long history advises extreme skepticism. After all, the French Revolution was fueled in large measure by the first great American real estate bubble and crash under John Law's prototypical "derivatives," and the same scenario has been repeated hundred of times.
The assertion that hedge funds serve a valuable social function by correcting price gaps and "spreading risk" sounds very nice, but I am not aware that there is the slightest credible evidence for this neoclassical bromide. Yes, the industry itself does produce studies. So did the tobacco industry. The economics professors who produce such studies have a funny way of ending up in hedge funds. It sounds a lot like ideological rationalization, and that's putting it politely. Managing risk is, of course, exactly what the hedge funds at Bear Sterns and elsewhere were presumably doing. As it turns out, it was Paulson and the taxpayers who formed the "hedge" against all those positions.
Most market brutalists will disagree with me, but I see a national currency, backed not by gold but by taxpayers, as a public asset on which all workers depend. Banks and their partners do not, in my view, have a natural right to use their charters and limited liabilities to do anything with the national currency just because it makes money and violates no current law. We are facing, I believe, a very serious historical situation in which many of those who were most responsible will suffer the least. Sorry to say, but for the moment the financial sector must be regarded as guilty until proven innocent.
I am someone who would even go so far as to say that very large disparities of wealth are in themselves dangers to a democracy, signs of instability. We need to take a very careful look as hedge funds and private equity funds and regain a reasonable level of control over our national currency. Too many hubristic traders are out there designing complex paper claims they insist are backed by "dollars." I would like to know more about what they are doing, yet it seems that they cannot by nature operate transparently (Trust us, no need to verify).
To me my concerns sound more like simple common sense than "Luddite hallucinations of the left," an amusing characterization worthy of old Phil Gramm the Toxic Texan himself. (Hot tip to all short sellers: If you want to know which sector of the economy will collapse next, just follow Phil Gramm.)
I do not see any problems with the Soros play: the underlying economics did not support keeping the pound in the ERM band. Soros bet that it was not sustainable. It was not.
As to LTCM obviously it underscores the dangers of extreme size married to super high leverage. The obvious lesson here is that this combination can be dangerous as the current failure of the banking system clearly illustrated. However it is not specific to hedge funds. In fact, regulated entities, which exhibit those twin dangers have turned out to be catastrophic for the system, while in point of fact LTCM did not cost the taxpayers a dime, apart from some gentle pushing of the NY Fed.
The short-seller paranoia is becoming really tiring. The solution to a control problem is not a highly regulated police state, but highly competitive markets, with no super large participants. The leftist illusions of power never die: no matter what the evidence, or, as in this case, lack thereof is. Somebody, maybe made some possible phone calls to some other imagined participants. Jesus, this is sad. Who knows? is the extent of the evidence? An whatever anybody produces on the topic is a giant conspiracy? "Mental capture", huh? No wonder, Barney Frank is talking about United Workers Front.
I know it's very hard to understand that there is no seperate financial and real economy. The current crisis is CLEARLY obvious evidence to the contrary.
I am sorry, but all this talk about national currency and limited liability and all that jazz you mention verges on the edge of the absurd. Banks should not be using money unsupervised? What's that supposed to mean? Control of our own currency. You should just come out and say it: markets should not be deciding things, but the governments. It's a well-known road to freedom and prosperity.
Well, this has been an interesting conversation in which the middle ground is not yet discovered, so probably nearing an end. Though I do completely agree that the separation of "finance" and "real economy" is illusory. I would like to ask Mr. Wolyniek, in all sincerity, what books I might read to better grasp his view of things, though, please, not the capitalist bodice rippers of Ms. Rand or the noble but slightly outdated Austrians. And yes, I admit, I am wholeheartedly a conservative leftist both perplexed and alarmed by the great wave of libertarian fantasies that now pass for intellectual conservatism. To me, the "market" versus "government" worldview is even more "tired" than the heartless attack on the nation's hard working short sellers. I have tried to discover in history some example of this marvelous "free market," but on closer inspection it is invariably a construction of laws, coercions, and interest groups at least as extensively planned as one of Stalin's five year programs. I have no doubt the utopian "free market" plan can work in theory. Any economic plan will work, just as long as you don't care how many of the "losers" suffer. Stalin's plans were among the most productive ever. But, middle ground! I do believe Mr. Wolyniek is not a bomb-hurling Murray Rothbard who demands his own currency. He seems to at least agree that hedge funds shouldn't get too big and should not collude, if it is possible to prevent such things. Good, I am a timid sort who loves peace and harmony.
Wolyniek made good points about limiting the size of hedge funds and the value of short selling (NYU Stern Business school endorses short selling to facilitate price discovery). He did not make a strong case re: transparency. The fact that non public companies operate in secrecy is not proof that this is a good thing. Things like XBRL make real time transparency a realistic goal.
"The "market" versus "government" worldview is ..."tired"" could not be more incorrect. Power is a zero sum game. The more power the government has, the less power the rest of us have. Governments are inherently corrupt and inefficient. The idea that we should depend on politicians to make the major decisions in our lives is insane. Markets are inherently efficient, the trick is to maintain competition by limiting the size of participants and preventing price fixing. Regulation and transparency are necessary because many people are crooks. A more free market oriented approach (i.e. paying bounties for catching crooks) to enforcing regulation might be more efficient than the current approach (which is susceptible to regulatory capture).
@ Steve
Why do you seem (perhaps I'm misunderstanding your point) to indicate that private hedge funds need to provide transparent real-time information? And to whom, the SEC? HAHA, gimme a break! That sounds like Richard Bookstabber who, despite being extremely smart(er than I), misses the point on topics such as this. Also, it depends on what your goal is, from a regulatory point of view. Usually, it comes down to Politicians/Regulators/whiney investors with "up up up" mentalities being jealous of HFs and/or pissed about being powerless to regulate/control them. This, of course, is not a valid reason to regulate the alternate asset industry. Those who presume they pose systematic risk, engage in illegal activities, etc have failed to provide any meaningful evidence that I've seen to support such claims.
@ Nelson, re: LTCM
Prime brokers allowed LTCM's leverage to grow so wildly out of control. Today, many (if not all) would have cut them off well before they got to 300:1. You cannot use Soros and/or LTCM - both extremely isolated instances - to support your otherwise weak claims for increased regulation of Hedge funds. If you want to rationalize hedge fund regulation, SHOW.ME.THE.DATA! All you've done now is engage in (well crafted) rhetoric, but you've failed to provide anything remotely resembling concrete evidence to support your points. I'm not looking to argue, quite the contrary, but if you want to argue for increased hedge fund regulation - as lefties/regulati are wont to do - I implore you to submit evidence to support your rhetoric. If you can, please do.
Anal_yst
http://1-2knockout.typepad.com
I have nothing against private hedge funds. My argument is that there should be more transparency with companies (including private companies).
I don't think you got my argument. I said:
"A more free market oriented approach (i.e. paying bounties for catching crooks) to enforcing regulation might be more efficient than the current approach (which is susceptible to regulatory capture)."
The idea is that by providing as much info in computer processable formats like XBRL and taking a bounty oriented approach, we can encourage private entrepreneurs (which is not the SEC) to participate in catching the crooks. This will also facilitate the production of software to look for anomalies in the reported data.
I don't have an "up, up, up" mentality since I believe short selling provides a valuable service (i.e. price discovery).
In general, the more transparency there is, the less regulation is required.
@ Steve
Forgive me, didn't get to finish my thought.
I've thought about the private enforcement issue myself, but no matter how open I try to be, my best guess is that rewarding vigilant "identification" of "criminal enterprise" would be a slippery slope, at best. This is not to say the status quo is any better, but just that outsourcing financial bounty hunting is a practice ripe for massive abuse.
Also, and this is why I mentioned Richard Bookstabber, your suggestion to use XBRL (etc) to provide real-time data will never happen. If you force private firms to provide such information in anything even approaching real-time they'll re-domicile offshore (or whatever) to avoid such stringent and often expensive reporting standards. This is to say nothing of the privacy issue. What if you just limit data access to say, regulators and academics, and only in non-identifiable format? Good luck keeping the information private, or in convincing those who are required to report data to do so.
In a dream world, its not a bad idea. However, in the realm of reality, I just don't see it happening.
However, there is one solution - that I presented to Mr. Bookstabber at an FT Alphaville event a while back - which I believe is practical, possible, and likely to produce better results than our current system.
Its a matter of incentive structure (as most everything tends to be). There are vastly asymmetric incentives to find a way to game the system than there are to catch someone gaming it.
Why, or how, should we expect a relatively inexperienced Lawyer at the SEC to be able to identify, understand, and prosecute sometimes sophisticated financial schemes when those perpetrating them stand to make millions (if not orders of magnitude thereof), while the lowly SEC agent will bring home what, $150,000/year? Create a better incentive structure (and thereby attract a higher-caliber sleuth/regulator), and most results should improve.
I admit this idea is far from perfect, but all things considered, I think it strikes a balance between practicality and possibility.
Anal_yst
http://1-2knockout.typepad.com
As you have surely guessed, you are dealing with someone who has little knowledge of finance. I do not accept that that precludes my opinion, just as you surely have opinions on foreign policy or genetic engineering. It seems to be only in finance and economics that the "vulgar" understanding is dismissed from the polity. Greenspan, among many others, has a frightening way of distinguishing between majority opinions on economics that are "democratic" and majority opinions on economics that are "populist," meaning those that do not conform to neoclassical doctrine. If we are to be governed by a technocracy, I'd at least like one that can avoid major collapses of our economy. As to hedge funds, again. To the technically informed I probably have little of interest to say. But it seems kind of circular to argue that hedge funds should not be regulated because there is so little data on them, when opacity is precisely the issue. What sort of data am I supposed to provide? What would be the smoking gun? Since hedge funds are a misnomer by now, I am basically concerned about the amount of private, unregulated speculation in all sorts of entities, of which "hedge" funds alone represent... what? Two trillion dollars at present? Originally, there was a fair amount of concern, since such funds were obviously created to avoid the old regulatory regime. Most of the reasons originally proffered for their "exception" to these old public concerns have long since been exceeded, notably in the area of pension funds. I also do not accept that LTC and Soros were "exceptions," since we simply do not know, and I see no reason such things could not happen again (and again) in a slightly different form. As I understand it, there is also no clear way to separate out the role of hedge funds in the banking crisis, which is hardly over. The collusion potential is I also quite obvious to the "vulgar" onlooker. It just seems common sense to me that the capacity to marshall billions of dollars and to place short bets on almost anything, with ever increasing accuracy, from the collapse of national currencies to bankruptcies (or even political events) offers too many unsavory temptations. Why should the average citizen care? Because many of us depend on the value of our national currencies and pensions and such. I am not opposed to clever people creating investment funds. But I would like to see far more limits and transparency. I believe, given the long history of speculative tragedies, that the funds have a certain burden of proof. I don't know enough to opine on short selling. But when the other Paulson made--what was it?--three billion on the mortgage downturns, I do not see that this somehow helped society by alerting us to the risk. Where is the data on the equilibrium function of short selling? Well, to be perfectly honest, I don't suppose I would believe the data anyway. Since the Black-Scholes "breakthrough" it is a little hard for those of us who can't follow finance to understand how advanced the risk mitigations have become. I suppose we just have more faith.