Felix Salmon

Why hedge funds are less risky than banks

By Felix Salmon
August 23, 2010

I’ve been waiting for a good critical review of Sebastian Mallaby’s tome on hedge funds, and the longer that we go without one, the stronger Mallaby’s pro-hedgie case would seem to be. Now, Noam Scheiber comes along in the New Republic, and his criticisms of Mallaby are pretty unconvincing:

The Financial Times reported earlier this month that “many star traders across Wall Street and the City of London are … decamping for hedge funds in their droves amid a crackdown that will sharply curtail banks’ riskier activities.” So some of the same folks who brought you the financial crisis will henceforth be working their magic with more leverage and less regulation. How reassuring.

As Mallaby is at pains to point out on a regular basis, hedge funds in fact have less leverage — a lot less — than banks. Many have none at all; those who do lever up tend to do so only by a factor of two or three, compared to leverage ratios in the 30 to 40 range for many investment banks and even commercial banks, in Europe.

These numbers aren’t precise or perfectly comparable, it’s true: there’s no simple and universally-adopted measure of leverage which includes all the clever ways that investors can get outsized exposure to certain assets. And indeed it’s almost impossible even to directly compare leverage numbers between European and US banks. But the fact is that the first and biggest loser, when an overlevered hedge fund fails, is its prime broker. And since the LTCM blowup, prime brokers turn out to have done a very good job of curbing any attempts by hedge funds to take overlarge risks.

Scheiber is worried that people like Morgan Stanley’s Howie Hubler — who lost $9 billion at what was essentially an in-house hedge fund — will simply now repeat their failures at standalone funds, if banks are barred from taking those kind of bets. But that misses the point. Hubler could put on those bets only because there was no prime broker breathing heavily over his shoulder, and because he had the full faith and credit of all of Morgan Stanley backing him up. The same is true of CDO losses at places like Merrill Lynch and Citigroup. And it’s also true of the pair of Bear Stearns hedge funds whose implosion marked the beginning of the crisis — when their prime broker sensibly withdrew, Bear Stearns itself stepped in to take losses on them.

Hedge funds, especially big hedge funds, need more regulation than they get right now, as Mallaby readily admits. They might not have caused this crisis, but they still pose a potential systemic risk, and someone needs to be looking not only at the risks that individual funds take, but also the risks that they pose collectively. After all, given their extreme secrecy, they simply don’t know when they’re entering a crowded trade — as many of them discovered painfully during the quant meltdown of 2007.

But in general there’s one thing that the hedge fund system does well, and that’s confine hedge fund losses to the investors in those funds. Hedge funds will blow up occasionally, and that’s fine; the investors in those funds will lose money, and people betting against those funds will make money, and there will be few if any systemic repercussions. Even if the losses exceed the amount invested in the fund, those excess losses will be borne with few systemic implications by the fund’s prime broker.

Scheiber worries that “the hedge fund industry will never fulfill its promise if its rank-and-file has a Hubler-esque weakness for market fads”. But the way that the hedge fund universe is set up, there’s really no such thing as a rank-and-file. And Hubler wasn’t jumping on to a market bandwagon: in fact, he thought he was betting against subprime bonds. He just funded that bet in a very unfortunate manner. His story is not, I don’t think, a cautionary tale for hedge fund managers. Instead, it’s Exhibit A in the annals of why the Volcker Rule makes a great deal of sense.

Update: Scheiber responds, saying that I “way overstate the benefits” of hedge funds. I didn’t think I’d come up with any benefits at all!

5 comments so far | RSS Comments RSS

kind of a silly comparison. a lot of the products that hedge funds hold have a lot of leverage packaged inside them. a lot of hedge funds hold a lot of swaps too, where the concept of leverage is not necessarily valid.

Posted by q_is_too_short | Report as abusive

I don’t think the comparison is silly at all. The fact that hedge funds were less leveraged than banks says alot about how fast and loose credit got. Consider also that hedge funds also have lock up provisions that prevent massive overnight redemptions. I’ve reviewed funds with 90day, 180day, even 365day withdrawal ristrictions… that’s alot more stable than short term paper!

I am impressed with how quickly the banks have delevered through capital raising, asset sales and earning retention. Consider that 12/31/07 Goldman had assets of 42.8 billion and assets of 1119.8 billion for a leverage ratio of 26X. As of 3/31/10 they are at 12X. That’s impressive!

Investment banks like Goldman should absolutely be allowed to run private equity and venture capital operations. They should just have had higher capital requirements put on them.

If you offered them the choice to dump their private equity or have a leverage cap of 8X I think they would much prefer to keep their sexiest business lines and run with less leverage. I also think that is what would be best for the financial system as a whole.

Great topic Felix… I’d love to see more in this area!

Posted by y2kurtus | Report as abusive

It is clear from Bookstaber’s account that Meriwether & co never appreciated how heavily they leaned on Salomon’s balance sheet during their time there. That is understandable – human nature, really. But the trouble is that power within banks accrues to the divisions that are nominally the most profitable. Given power, a division is able to define the terms of profitability to its own benefit – a positive feedback loop. Thus, despite all the lip service paid to RAROC, this sort of transfer pricing is seldom done accurately. So I think you are in the right here – one benefit of a Volker-style separate is to concentrate minds on the subject of leverage and capital.

Having said that, I think you are underestimating the potential for hedge funds to cause systemic problems, even so. If any important financial service other than term investment (such as liquidity provision, for example) is given to hedge funds, then the system will be damaged when the provision of service is removed. The reason a bank is considered systemically important is not that its failure would cause other institutions to fail, *causing losses* but that in failing, the *withdrawal of lending* would propagate.

Posted by Greycap | Report as abusive

Wasn’t LTCM basically a hedge fund? It supposedly was rescued due to the systemic risk it imposed.

Posted by maynardGkeynes | Report as abusive

y2kurtus, I think y2kurtus nailed the difference. Leverage isn’t and never was the issue. The main issue was liquidity, a large portion of the banks liquidity was at the extreme short end whereas their assets were long term and illiquid. Throw in the fact that hedge funds didn’t have to follow the same accounting rules that put the banks assets in a circle of death.

One should also not forget that this whole crisis had a proximate cause in a few major hedge funds failing. Hedge funds also acted as the transmission mechanism for crashing marks. Just because we are spending time beating up big bad banks and because somehow the incompetent hedge funds who failed became “victims” of slick sell-side salesmen doesn’t make them this of a systemic risk.

Posted by Danny_Black | Report as abusive

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