Courtesy Reuters

Risk-Return Profile

By Richard Christopher Whalen

To the Editor:

Sebastian Mallaby's key assertion is that hedge funds do not increase risk but manage it -- and policymakers, rather than clamping down, should make sure hedge funds have the tools to perform this function well ("Hands Off Hedge Funds," January/February 2007). His argument that the $6 billion loss incurred by the hedge fund Amaranth Advisors was due to the greed and stupidity of individuals and not the attributes of hedge funds' business model sounds remarkably like the mantras heard from lobbyists for the hedge-fund industry.

In fact, hedge funds vastly increase the amount of risk taken in the financial markets and thereby make dangerous systemic events more likely. They often operate with little or no capital and massive amounts of debt to enhance returns to their principals and, as a secondary matter, to their clients. Hedge funds employ instruments such as derivatives to gamble with their clients' money in ways that are rarely disclosed and often impossible to comprehend, even for the people closest to the action.

Because of their speculative nature, hedge funds pose a threat to the safety and soundness of the U.S. financial system. Consider just two issues: market risk and moral hazard. Hedge funds tend to favor the least liquid instruments, such as over-the-counter derivatives contracts, because the spreads on these custom-made assets are wider and thus the fees greater for hedge-fund principals. Indeed, the explosive growth in the OTC derivatives markets is almost entirely attributable to hedge funds and fueled by money borrowed from major derivatives dealers. Hedge funds frequently write credit default protection into their OTC derivatives contracts in order to generate short-term fees. Acting effectively as a reinsurer, a hedge fund sells protection against credit defaults on corporate bonds or collateralized debt obligations, but unlike an insurance company, a hedge fund typically lacks the capital or the reserves to back up its commitments.

As for moral hazard, in the benign credit environment of the past several years, hedge funds have plunged into the world of credit default swaps, writing insurance against defaults for banks, insurance companies, and mutual funds. The problem, however, is that just as a hedge fund's performance is gauged on a quarterly basis, so, too, the trader at the hedge fund is paid based on short-term performance. Thus, many hedge-fund mavens have been busy writing credit default swap contracts, which typically have terms of five years, but then end up leaving their respective hedge funds for greener pastures before the day of reckoning arrives.

What Mallaby and other hedge-fund advocates fail to discuss is that hedge funds and the derivative instruments that they favor actually multiply risk in the financial system. The derivative trades employed by hedge funds often involve 10-, 12-, or even 15-to-1 leverage and thereby create the possibility of truly horrendous systemic events happening down the road. Indeed, were it not for excessive leverage and the existence of the OTC market in energy derivatives (a cash-settlement market with no connection to the physical energy market), Amaranth Advisors could never have accumulated such a large position in natural gas and thereby lost more than 60 percent of its clients' money.

The explosive growth in hedge funds is attributable to a pernicious form of regulatory arbitrage, whereby these lightly supervised vehicles skirt the boundaries of established law and prudent practices. Rather than lauding this as evidence of a healthy market phenomenon, we should consider whether a truly healthy financial sector should depend on such lightly capitalized, speculative vehicles for "risk management." Contrary to what Mallaby suggests, hedge funds are a source of risk and even recklessness that threaten our financial system. These vehicles are unsuitable for the vast majority of investors and justly deserve additional oversight and regulation by financial authorities.

Richard Christopher Whalen

Croton-on-Hudson, New York

Sebastian Mallaby replies:

The critics of hedge funds often make two contradictory arguments. They complain that the funds are secretive and opaque, and they simultaneously assert that they know the funds to be engaged in reckless investment practices. The critics should recognize that the best judges of risk are the funds' stakeholders themselves. Investors and creditors have incentives to rein in excessive risk-taking, and they have more information than most commentators.

The critics err in seeing derivatives as a source of risk rather than as a way of managing it. The recent trouble in the subprime mortgage market is a case in point: money flowed too readily to unreliable borrowers because credit-rating agencies understated the risk of default, and the main restraint on this process came from the new market in credit derivatives. Traders of credit default swaps saw that the subprime market was overheated and bet that it would fall. In so doing, they forced a deflation of a bubble. Far from adding to systemic risk, derivatives served to control it.

The idea that hedge-fund managers write credit default swaps and then run for "greener pastures before the day of reckoning arrives" is, shall we say, eccentric. A central advantage of these swaps is that their prices adjust constantly as new information on the likelihood of default becomes available. Ratings agencies face pressure to avoid downgrading a company that experiences trouble, and so the day of reckoning is indeed deferred. The swaps market is swifter and more brutal.

It is true that hedge funds go bust, Amaranth being one prominent example. But thrifts, banks, and mortgage finance companies have been known to go bust as well. What matters is not the fact of bankruptcies but the knock-on effects for financial stability. And it is hard to see why the system as a whole is more fragile because of hedge funds.

A financial system is most vulnerable when it is dominated by a small number of large institutions. If one megabank blows up, there will be mountains of unpaid debt to other banks; this could cause the other banks to fail, setting off a chain reaction. In the U.S. financial system, two institutions stand out for the risk associated with their size: Fannie Mae and Freddie Mac, the two semiofficial mortgage financiers. The combined bond portfolio of these players is larger than the outstanding stock of Treasury bills and much larger than any hedge fund.

As new players in the financial arena, hedge funds spread risks rather than concentrate them. Insurers used to pay for hurricanes; now they share that burden with hedge funds. Banks used to shoulder the risk that borrowers might default; now hedge funds can help them. And if a financial institution anywhere should hit distress, hedge funds will be among the first to spot a buying opportunity. When Amaranth went bust, the market for energy derivatives was spared disruption because Amaranth's trading book was quickly taken over by two rivals. One was a hedge fund.

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