Blame the Banks

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The chaos in financial markets has embarrassed many on Wall Street, and hedge funds have come in for their share of criticism. Gleeful headlines trumpet bad results and outright blowups in various corners of hedge land. In March, the eminent commentator Martin Wolf that the hedge fund model was so flawed that the entire sector might end up on the scrap heap. Yet the truth is that the turmoil since last August has largely vindicated the funds' virtues. The central argument of my 2007 essay holds true today.

The most striking fact about the ongoing financial mayhem is that it is concentrated not in lightly regulated hedge funds but in more heavily regulated commercial and investment banks. It is banks that created subprime mortgage securities. It is banks that mispriced them. And it is banks that filled their own coffers with this toxic paper, losing hundreds of billions of dollars. A somewhat breathless March 31 proclaimed the closing of the worst month for hedge funds since the collapse of the infamous Long Term Capital Management in 1998. But the average fund tracked by the Chicago-based firm Hedge Fund Research declined by a mere 2.4 percent in March, bringing the cumulative fall for the first quarter of 2008 to 2.7 percent. By contrast, the bank-heavy financial services component of the S&P 500 fell 12.3 percent in the first quarter.

Hedge funds, for the most part, have weathered the storm remarkably well. Their occasional failures have stemmed mainly from errors that were not of their own making. Because banks have mismanaged themselves so thoroughly, they have had to mobilize capital by calling in loans to hedge funds, forcing the funds to sell off positions precipitously. Forced sales have driven down the value of the hedge funds' remaining holdings, undermining their creditworthiness and triggering a further calling in of loans, further forced sales, and further losses. This vicious circle has caused a few funds to go bust. But the trigger was not reckless behavior in unregulated hedge land. It was subprime losses in the regulated banking system.

Moreover, the smattering of bankruptcies has illustrated another hedge-fund virtue: unlike the bankruptcy of a bank, hedge-fund crashes generally do not destabilize the wider financial system. The prospect that even a medium-sized investment bank such as Bear Stearns would go bust panicked the Fed into risking $30 billion of taxpayers' money to secure a rescue. But the collapse of hedge funds such as Sowood Capital or Peloton Capital has not triggered official intervention. Granted, a blowup at a very big hedge fund would be different: when Long-Term Capital Management teetered on the brink ten years ago, the Fed got embroiled in the crisis. But the lesson is that the financial system becomes vulnerable when it is dominated by institutions that are too big or pivotal to fail. The proliferation of hedge funds is on balance a decentralizing and therefore healthy force (although a few prominent funds are big enough to rock the system).

The vicious circle of hedge funds selling assets and driving their value down triggered much told-you-so talk among the funds' critics. An old complaint is that hundreds of supposedly independent funds are engaged in copycat, or "crowded," trades; if one of them blows up and has to dump its positions, the adverse market move will trigger more explosions in the others. There is no doubt that some hedge-fund trades are crowded, and that contagion of this kind happens. But the question is whether hedge funds are more susceptible to contagion of this sort than other kinds of players.

Again, the turmoil of the past eight months vindicates the hedge funds. The most crowded trades have had to be unwound, and the upshot is that some hedge fund investors have lost money. But the financial system has not suffered as a result of these losses. Crowded hedge-fund trades turn out to be less of a problem than crowded bank purchases of subprime debt. Contagion has been a phenomenon not of hedge funds but of regulated lenders. Everybody knows that the banks hold copycat positions, so an announcement of losses at one lender has caused markets to hammer others.

Besides, hedge funds do not engage only in crowded trades. They have also acted as contrarians, betting against the crowd and so dampening the market's volatility. When the subprime bubble was inflating, several hedge funds, notably an outfit called Paulson and Co., bet that it would pop. These funds not only made astronomical profits, they also prevented the bubble from growing even bigger than it did. Now that the bubble has burst, hedge funds will likely serve as opportunistic buyers of distressed assets, putting a floor under their value. Already, a big hedge-fund called Citadel has bought the failed Sowood Capital and a fifth of the faltering broker, E*TRADE; and a fund called TPG-Axon Capital has injected capital into Merrill Lynch. SEC Commissioner Paul Atkins has recognized that "hedge funds are likely to be an important part of the solution to the subprime crisis."