The political flavor of the month is to push back against even the Obama adminstration’s mildly reformist inclinations on finance (e.g., Peter Weinberg in today’s FT is a nice example). And, of course, once you hire a lobbyist, he or she tells you that “winning” means stirring up Congress in favor of the status quo. Measured in these terms, the hedge fund industry has had a string of notable recent victories effectively preventing tighter regulation.
Advocates have a point, of course, when they argue that big banks rather than hedge funds were primarily responsible for crisis. But this misses where we are in the long-cycle of regulation/deregulation. Look at this picture (source: WSJ; more on Ariell Reshef’s webpage).
If we’re at the top of the long deregulation wave and likely headed for tighter control of the financial sector – if not this year, then soon – where do you want to be in the political equation?
You can resist change, but this is just asking for trouble. You know that individual (lightly regulated) funds – whether or not these are officially “hedge funds” is irrelevant – will have high profile trouble. The latest alleged tunneling details in the case of Danny Pang are a precursor to broader social fascination with this phenomenon – you know that a dozen screenwriters are already at work. Sooner or later, there will be a more focused backlash against specific practices revealed or implied in this kind of case.
At the same time, the broader Treasury attempt to respond with only milder controls over big banks will likely also run into trouble (see my latest Economix column), so more social pressure will appear from that direction also. Big banks repeatedly get into serious scrapes, but their political clout consistently allows them to deflect attention onto others. The idea that big banks and hedge funds have some natural congruence of political interests in this space is simply wrong.
In fact, if hedge funds dig in too deeply with “the crisis was not our fault” position, that is just asking for trouble – and to be scapegoated – down the road. It would be much smarter to get out ahead of the political dynamic, and to propose ways to measure, control, and regulate risk.
Voluntarily keeping hedge funds “small enough to fail,” without endangering the system, would also make sense – particularly if accompanied by a complementary political strategy that emphasizes that it is big banks that have done almost all the damage.
By Simon Johnson
The Baseline Scenario 
As usual, Simon Johnson is “spot on.” Who will be big finance’s natural political allies going forward? They have hurt every other industrial group in America, so it cannot be other businesses (even big ones) forever. It certainly won’t be small business owners who are getting crushed by the relative lack of credit currently available to them and their customers.
In fact, this crisis for the average American is a little like what happened in Asia ten years ago. Asians loved the money lavished on them by the West through loans and so forth. But they never imagined the money would be “hot” to the point that it could and would be withdrawn when it was needed most.
This is way Asians invested in foreign assets (mostly debt instruments) in the United States and elsewhere earlier this decade. Now they are the ones holding the winning hand.
Business owners and consumers may soon come to the same conclusions about big finance–the latter is NOT their friend. Even the craveness of our two political parties for campaign contributions from them may not be enough to force politicians to go after the guys in the black hats sooner rather than later. Finally, the fact that Obama sides with the bad guys currently says volumes about his status as a “change agent.” He was elected because special interests were far less afraid of him than Hillary or McCain.
“Advocates have a point, of course, when they argue that big banks rather than hedge funds were primarily responsible for crisis.”
But this is a very small sample, and doesn’t tell us anything about the future. My guess would be that if banks are more tightly regulated, we’ll see more capital flow to to less-regulated hedge funds.
And the fact that hedge funds emerged relatively unscathed is immaterial to the argument of whether they should be better regulated. Up to this point, financial regulation seems to be implemented as a response to disasters that have already occurred; we aren’t very good at anticipating problems. This is probably because there is no political will to regulate until it’s too late, but we should be working constantly to try to create some.
The LTCM fiasco demonstrated that hedge fund blow ups can have a serious effect on markets. LTCM’s Fed-engineered bailout came perilously close to unraveling. Had that happened last October it could have had the same type of effect that Lehman did.
The heavily regulated banks go down in flames and our treas secretary invents a plan for the unregulated hedge funds to help bail them out, and the result?
Of course the result is that hedge funds are the culprit in the whole financial mess, and need to be heavily regulated. lol
Yet another example of the upside down idiocy going on in this country. Maybe hedge funds are causing global warming, too.
As a Financial Illiterate I have some questions.
Say I loan Simon Johnson $100.00 and I expect to be paid back $110.00 as return on investment. The extra $10.00 is to compensate me for the risk that Simon might not pay me back.
If I then enter into a CDS for the $110 that Simon owes me where is the risk?
If there is no risk why does Simon have to pay me the $10.00 return on investment (compensation in case that Simon might not pay me back)?
I’m curious.
Regards
Marisan
You forgot that you had to pay for the protection.
Pricing of the CDS and counterparty risk are costs.
No free lunch.
So I increase the return on investment to cover the costs of the protection.
Again, where is the risk?
Marisan, I really don’t mean to be condescending or insulting. But if you can’t figure out that when you give someone else (including family relatives) your money, there is ALWAYS risk involved, just go back to watching Oprah Winfrey and your favorite reality TV show and try and forget about it.
Ted K,
It appears that you are a member of the class that has a major impact on me and my family (without appearing to be condescending OR insulting)
I thought the idea of CDS’s was to mitigate risk in the loaning of money. You appear to say that mitigation of risk is only for the Masters of the Universe not for members of the peasantry such as me or my family.
I suggest that you go back to reading the Wall Street Journal and ignore the effect that the decisions (and greed) of the Masters of the Universe has had upon the peasants such as I.
For your information I don’t watch Oprah Winfrey or Reality TV shows and I wish to hell I could forget all about it.
Hedge funds…. manipulators extraordinaire. Way too big. BTW, many of the top key fund players have Mafia roots and connections. For THE exposé of this link, see http://www.deepcapture.com
The risk is that Simon won’t pay you back, and then whoever wrote you the CDS won’t be able to pay.
The CDS shifted the risk to entity that sold you the CDS. If Simon defaults, he will find the yield on his future bonds going up.
Yes, you now have no risk. You took the cost of the risk (the price you paid for the CDS) and moved on. Whatever happens from this point, you are hedged.
The original bond still has a risk in it. Whoever, buys it without an insurance is still exposed to the probability of a default. It is as if you conditionally sold the bond to insurer.