And so, by the start of the 21st century,
there were two competing views of hedge
funds. Sometimes the funds were celebrated as the stabilizing heroes who muscled inefficient prices into line. Sometimes
they were vilified as the weak links whose
own instability or wanton aggression
threatened the global economy. The heart
of the matter was the leverage embraced by
A.W. Jones — or rather, a vastly expanded
version of it. Leverage gave hedge funds
the ammunition to trade in greater volume, and so to render prices more efficient and stable. But leverage also made
hedge funds vulnerable to shocks: If their
trades moved against them, they could
burn through thin cushions of capital at
lightning speed, obliging them to dump
positions fast — destabilizing prices.
Then came the crisis of 2007–2009.
Whereas the market disruptions of the
1990s could be viewed as a tolerable price
to pay for the benefits of sophisticated
and leveraged finance, the convulsion of
2007–2009 triggered the sharpest recession since the 1930s. Inevitably, hedge
funds were caught up in the panic. In July
2007, a credit hedge fund called Sowood
blew up, and the following month a dozen
or so quantitative hedge funds tried to cut
their positions all at once, triggering wild
swings in the equity market and billions
of dollars of losses. The following year was
more brutal by far. The collapse of Lehman Brothers left some hedge funds with
money trapped inside the bankrupt shell,
and the turmoil that followed inflicted
losses on most others.
Hedge funds needed access to leverage, but nobody lent to anyone in the
weeks after the Lehman shock. Hedge
funds built their strategies on short selling,
but governments imposed clumsy restrictions on shorting amid the post-Lehman
panic. Hedge funds were reliant upon
the patience of their investors, who could
yank their money out on short notice. But
patience ended abruptly when markets
went into a tailspin. Investors demanded
their capital back, and some funds withheld it by imposing “gates.” Surely now it
was obvious that the risks posed by hedge
funds outweighed the benefits?
This conclusion, though tempting, is
almost certainly mistaken. The cataclysm
has indeed shown that the financial system
is broken, but it has not actually shown
that hedge funds are the problem. It has
demonstrated that central banks may have
to steer economies in a new way: Rather
than targeting consumer-price inflation
and turning a blind eye to asset-price
inflation, they must try to let the air out
of bubbles. If the Fed had curbed leverage
and raised interest rates in the mid 2000s,
there would have been less craziness up
and down the chain. American households would not have increased their borrowing from 66% of GDP in 1997 to 100%
a decade later. Housing finance companies
would not have sold so many mortgages
regardless of borrowers’ ability to repay.
Banks like Citigroup and broker-dealers
like Merrill Lynch would not have gorged
so greedily on mortgage-backed securities
that ultimately went bad, squandering
their capital. The Fed allowed this binge
of borrowing because it was focused resolutely on consumer-price inflation, and
because it believed it could ignore bubbles
safely. The carnage of 2007–2009 demonstrated how wrong that was. Presented
with an opportunity to borrow at near
zero cost, people borrowed unsustainably.
The crisis has also shown that financial firms are riddled with dysfunctional
incentives. The clearest problem is “too
big to fail” — Wall Street behemoths load
up on risk because they expect taxpayers
to bail them out, and other market players
are happy to abet this recklessness because
they also believe in the government backstop. By contrast, hedge funds made it
through the mayhem without receiving
any direct taxpayer assistance: There is no
precedent that says that the government
stands behind them.
The other skewed incentive in finance
involves traders’ pay packages. When
traders take enormous risks, they earn
fortunes if the bets pay off. But if the bets
go wrong, they don’t endure symmetrical punishment — the performance fees
and bonuses dry up, but they do not go
negative. Again, this problem is sharper at
banks than at hedge funds. Hedge funds
tend to have “high-water marks”: If they
lose money one year, they take reduced
or even no performance fees until they
earn back their losses. Hedge-fund bosses
mostly have their own money in their
funds, so they are speculating with capital
that is at least partly their own — a powerful incentive to avoid losses. By contrast,
bank traders generally face fewer such
restraints; they are simply risking other
people’s money. Perhaps it is no surprise
that the typical hedge fund is far more
cautious in its use of leverage than the
typical bank.
The very structure of hedge funds promotes a paranoid discipline. Banks collect savings with the help of government
deposit insurance; hedge funds have to
demonstrate that they can manage risk
before they can raise money from clients.
Banks know that if they face a liquidity
crisis they have access to the central bank