Was It The Hedge Funds? (Diane Rehm Show at 11am)

Hedge funds have been nominated as a prime culprit in the current financial disaster.  European governments, in particular, seem keen to impose greater regulation on hedge funds, including more transparency and compliance requirements.  In fact, this is will be one of the main deliverables they seek at the G20 summit on April 2nd.

I’m not opposed to stronger regulation, and hedge funds have obviously disappointed investors – especially with their illiquidity under pressure.  But are hedge funds really responsible for the depth of the crisis?  They were present at the scene of the crime, in terms of buying and trading what we now call “toxic assets,” but surely their role was minor relative to supposedly “regulated” US and European banks.

Of course, many hedge funds have closed down in the past six months, but have any actually failed to repay loans to banks?  I’m searching for examples.

And in terms of political power, during the fall or today, how many hedge funds add up to the influence of Goldman Sachs?

If the debate on Diane Rehm’s show at 11am this morning (current link) is about hedge funds (and private equity) vs. regulated banks as causes of the crisis, I’m taking the banks.

15 responses to “Was It The Hedge Funds? (Diane Rehm Show at 11am)

  1. Stephen Thomas

    My main question is: What is the problem we are trying to solve?
    Is it getting the lines of credit flowing, saving our banking system, having a healthy banking system, keeping housing prices from falling? I realize there may be many problems and symptoms but what do we need to see happen to get back to normal?

    The follow up question is how can we tell if what we are doing is working? What are the sign posts that will show us we are on the right road?

    Lastly, in thinking about this I have come to the conclusion that my main criteria for judging economic health is: Can people who want to and are able to work hard support their families and feed their kids.

    Thank you for your time and consideration.

  2. In addition to his role at MIT, Dr. Simon is a senior fellow at the Peterson Institute for International Economics, which is bankrolled by Peter G. Peterson, the chairman of private-equity powerhouse Blackstone Group. To my mind, this is a relationship that Dr. Simon should disclose on this website, when appearing on PBS/NPR/TPM, and when offering testimony before Congress. I’m not an expert on financial system meltdowns, nor have I worked at the IMF, so I defer to Dr. Johnson’s judgment on banking system matters, but I think conflicts of interest can encourage even fair-minded experts to tilt their advice in ways that favor their benefactors. That said, I am not impugning Dr. Johnson for his proposals and the work he is doing to educate policymakers, members of Congress, and the general public about the behind-the-scene maneuvering that could thwart attempts to restore the banking system to health quickly enough to ensure the US economy returns to growth much faster than would otherwise be the case.

  3. How do hedge funds differ from the individual who refinanced his or her home to invest in resort property that was itself highly leveraged? Were hedge fund managers simply much more adept at finding greater fools enamored with the magic of higher math…like many banks and AIG… to take the other side of their bets?

  4. Spot on comment, Simon. The other thing to point out is the investment banks providing prime brokerage services and lending to the HFs restricted many of their HFs’ leverage to 7:1 or 8:1, while they themselves ran multiples of that (e.g., Goldman and Morgan Stanley were ~ 30:1; Deutsche Bank, a German commercial bank, ran 40:1 at its peak). What made this really interesting is the investment banks and the commercial banks piling on the most leverage were the nexus of the market for trading and creating these now-Level-3 credit-linked and mortgage-based derivatives that sit on their books.

    An aside vis-a-vis leverage: CDSs and mortgage-backs are margined derivatives. Margins are analogous to surety bonds posted among trading counterparts, and are a fraction of the notional value of the traded instrument. They usually are posted with interest-bearing cash-equivalents. Trading on margin, then, is a super-charged exercise in levering up. One wonders whether banks ever properly calculated margin for these derivatives: The complete breakdown of the traded market for them suggests the banks did not, and do not, know how to value these derivatives … or maybe they don’t trust each others’ valuation techniques, which, logically, is tantamount to saying they don’t know how to value these instruments. The underlying itself — the credit against which these swaps were written — was massively levered. How does one figure out what that probability space looks like vis-a-vis payouts and default risks for these derivatives. Derivatives with misspecified margins settling against the credit of massively levered balance sheets of banks and households. Is such a problem even tractable? Can a bank portfolio be modeled as a portfolio of Dirac-delta distributions, any one of which looks like an all-or-nothing wager on a particular credit? What about the knock-on effects of one of those credits defaulting sending another credit into default, and so on ad inf … . What’s that correlation matrix look like? Is this more an epidemiological problem, trying to figure out the rate and extent of the contagion? What about multiple sources of contagion? How do they interact? Does the rate of contagion grow or decay? Given there’s an equal likelihood the derivatives in these portfolios are valued correctly or incorrectly, with either positive terminal value or negative terminal value, the EXPECTED value of the Level-3 assets likely is zero, right? What’s that do to the balance sheet?

    The argument could be made the HFs and banks were “recycling” the excess liquidity being provided by the Fed and central banks eleswhere, looking for higher-value-added investments, as Dr. Alan Greenspan more than once suggested during the 1990s and 2000s. For a long time it appeared as if the banks were successful. If so, maybe the problem’s behavioural. It could be argued a bull market in virtually every asset class worldwide — fueled by the loose monetary policies around the globe — was mistaken for genius at these banks, which kept levering up and registering higher ROEs (thus demonstrating their genius). The higher ROEs justified the banks paying ever-increasing bonuses as the bubble inflated — “look at all that value added and value creation,” etc — and gave them comfort. These bonus payouts and the promise of continued bonuses year to year provided the most powerful incentive of all to load up on highly profitable, albeit complex, products that are now, at best, level-3 assets marked to model. And it made each bank trading desk’s “nut” that much higher going into the new bonus year: The incentive to allocate more V@R and headcount to these markets, to load up on more of these instruments, was built in, as was the survival-mandate to trade ‘em up. So much for “risk management.”

    One wonders if these derivatives and securities even meet the formal requirements for “assets” qua assets: There is no value being determined by a market-clearing process; They could ultimately pay off, or they ultimately could be extinguished at a negative price — i.e., an investor (or government entity) would have to be paid to take them off the balance sheets of the banks. Where on the balance sheet, then, do these instruments actually belong?

    It took the Invisible Hand to finally slap some sense into everyone.

  5. I was a hedge fund manger in the 1960s and 1970s; and I never have understood what a contemporary hedge funds is, other than a generic term for just about any sort of investment partnership. Once such entities became available to and fashionable with institutional investors, rather than just sophisticated individuals, the outcome was inevitable.

  6. MH: I believe there is full disclosure of Simon’s background. http://baselinescenario.com/about/

    …but I think the purpose of this blog is to educate and to discuss the financial crisis…and also to welcome opposing views.

    But anyway, on topic: I think Goldman is much worse than all the hedge funds put together. The fact that they would be selling massive amounts of securities to their clients that they were completely opposed to buying themselves…is not ethical. I think Baselinescenario posted the article from Dec 2007 about how “Goldman Won Big On Mortgage Meltdown” but I can’t seem to find it. The more I know about Goldman…the less I like them….and really…read Lloyd’s (Blankfein) article from a few weeks ago–about how everything is A-ok….its scary.

  7. Honestly, the whole concept of money making money is problematic to me. Without something to truly substantiate one’s wealth how can we not always be heading for a disaster.

    We focused on ridiculuous math equations and complex financial “instruments” as opposed to actually producing something tangible of real value to increase our pocketbooks. The big banks and investment banks squeezed the economy dry and now there is no money.

    That guy building fences, he’s out there working hard and producing something tangible in return for money. Those charlatan investment banks, insurance agencies, and big banks are out there pushing money around to make more money. They haven’t done anything good for us and now the world economy is in the tank.

    Nothing in life comes for free and if money, our currency, is the symbolic lifeblood of all “tangible” assests we have been bled dry.

    We have built a white collar society that is a vampire in the world economy. We have IT jobs, professional service jobs, bank jobs, etc. that produce nothing of real value as an end product . An end product truly produced by declining struggling middle class or outsourced/offshored labor.

    We have done this so that we can buy mutual funds, stocks, overvalued properties, and a host of other money-making-money artificialities that when looked at carefully are nothing but inflated value assets.

    You don’t get sumthin for nuthin.

  8. Goldman selling securities they never underwrote? Anybody, such as myself, that worked in the corporate bond market for over 10 yrs knows that Goldman was notorious for underwriting everything and providing zero secondary market support. Recent events are not indicative of GS’s historical behavior.

    On HF’s as buyers of toxic assets. Yes, they have been buying plenty of toxic assets. If it weren’t for the HF’s the lower quality tranches would never have been bought and thus the higher quality tranches of CDO’s would never have seen the light of day.

  9. Prof. Johnson:

    Nice one about regulating financial products the same as nuclear power.

    Watch out for the Radioactive Toxic Waste!

  10. pythagorus wrote-We focused on ridiculuous math equations and complex financial “instruments” as opposed to actually producing something tangible of real value to increase our pocketbooks. The big banks and investment banks squeezed the economy dry and now there is no money.

    This is a bit of a nit pick but I would point out that
    the financial sector is of /some/ value. The problem
    is as a sector, the have been incredibly over-valued
    and as a result of their control of vast sums of money,
    have WAY too much political influence. This prevented
    those relative few(?) who did see the meltdown coming
    from being listened to by people in position to do
    something about it.

  11. This post brings up an several questions of interest to me, ones that perhaps Simon or James might address in the beginner comments or as topics in future posts. Even though commercial bank lending was up a couple percent in the 4th quarter, banks and other depository institutions only supply about 22% of the credit to the US Economy. The shadow banking system, insurance companies, foreign banks, and other financial intermediaries supply the rest. I think that this picture has been altered by the absorption of the investment banks in to the commercial banking system (if that correctly describes what has happened). My question is how removing (by nationalizing or by any other means) the toxic assets held by the largest banks by itself going to get credit flowing again. Are there not other issues with disposal of toxic assets held by hedge funds, private equity firms, insurance companies, etc? How has the conversion of investment banks to regulated banks affected the capacity of credit markets to lend? Will the present models of bundling and securitizing and reselling loans in the secondary markets work again as before, or is some fundamental change (for instance in assessing risk or reporting transactions in the secondary markets) necessary? It appears to me that the Treasury Financial Stability Plan stopped short of addressing these issues.

  12. bewinderedandindespair

    Brilliant show Simon!

    I just don’t understand how that all of America is buying into the idea that our country should pay the bets (via AIG) I think if the mantra ‘we have to save the world by passing out money to AIG and the sacred group of 8 (really just GS, MS and C) at the TARP 1 meeting and beyond.

    Why is it that so few people even get what has happened and continues to happen (Bernake gave the big pre-pass out more money show today.)

    Diane Rhem brought up Madoff why can’t thepublic get shaken out of their trance and see a few investment banks and bank C have madeoff with a trillion and counting?

    I am hoping you and yours, will find a way to save America’s future.

    All my best.

  13. Enough hocus pocus. There are 15 trillion in residential mortgages of which 10 trillion were written since 2000. Housing prices have fallen to 2003 levels, which means 9 trillion are under water. Your government is about to loan two to three trillion at 2% to the hedge funds which will buy mortgages from the banks at deep discounts. They will buy the mortgages at an inflated price to repair the banks’ books, the government will eat a big enough piece on top of that to get the hedge funds to pony up chump change as equity, buy them from the government at another deep discount with borrowed money from your government. The result will be a five trillion dollar transfer from middle class taxpayers to offshore usurers. Each rescued hoomeowners will get a $5000 principle write down and everyone will applaud this prop to real estate prices, which will not matter until houses decline enough to become affordable to those who have not been rescued but will be taxed to support the hedge fund windfall beacuse the Chinese will not keep buying Treasury bonds at 3% forever, particularly when their trade surplus disappears. It is all Ponzi finance and inequitable redistribution all this IMf and Fed gobblydygook about systemic risk is just nonsense. We support financial monopoly and usury and speculation and this Louisiana boy idiot calls it free enterprise. It is free for the political class and the rock of Sissyphus for everyone else.

  14. http://www.portfolio.com/views/blogs/market-movers/2007/07/02/when-mortgage-derivatives-get-included-in-cdos

    Interesting post from a while ago on portfolio.com, re how standard MBS were further levered up.

  15. If Dr. Johnson can educate policy makers and/or members of Congress I suggest that he would also be excellent at teaching CAT HERDING. Anyone who can educate that bunch of recalcitrant retards in Congress earns my respect