Why hedge funds are less risky than banks
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!