Hedge fund managers may be good at investing money. (Or they may just be the beneficiaries of luck, like successful stock mutual fund managers.) But that doesn’t mean they can think clearly.

Andrew Ross Sorkin comments on the letter by fund manager Daniel Loeb, a former Democratic fundraiser, criticizing the supposed anti-business policies of the Obama administration. The letter includes blather like this:

“As every student of American history knows, this country’s core founding principles included nonpunitive taxation, constitutionally guaranteed protections against persecution of the minority and an inexorable right of self-determination.”

Who, in making a list of America’s founding principles, would put “nonpunitive taxation” first? Oh, right. A hedge fund manager.

More seriously, there is this:

“Many people see the collapse of the subprime markets, along with the failure and subsequent rescue of many banks, as failures of capitalism rather than a result of a vile stew of inept management, unaccountable boards of directors and overmatched regulators not just asleep, but comatose, at the proverbial switch.”

This is just sloppy thinking. I’ve written more than most people about “inept management, unaccountable boards of directors, and overmatched regulators.” I’ve criticized the Obama administration in many more words than Daniel Loeb. But putting the blame on certain categories of people does not somehow absolve “capitalism.” Our capitalist system–which until recently we considered the best, most pure version in the world–allowed incompetent people to become executives (and to run hedge funds), allowed incompetent people to become directors and to avoid any responsibility for their actions, and allowed companies to swamp regulators with battalions of high-priced lawyers and lobbyists.

This is a basic category error. Capitalism is an economic system; managers, directors, and regulators are people. They are not mutually exclusive. If you want to say that capitalism necessarily means universally good managers, responsible directors, and effective regulators, then that’s an argument you have to make (and good luck making it).

Just because you make a lot of money doesn’t mean you know what you’re talking about. Unfortunately, in this country if you make a lot of money, a lot of people listen to you.

(Here’s the full letter. Along the way, Loeb says that the current decline in confidence and economic activity is due to the SEC’s lawsuit against Goldman.)

Wall Street is engaged in a cover-up. Not a criminal cover-up, but an intellectual cover-up.

The key issue is whether the financial crisis was the product of conscious, intentional behavior — or whether it was an unforeseen and unforeseeable natural disaster. We’ve previously described the “banana peel” theory of the financial crisis — the idea it was the result of a complicated series of unfortunate mistakes, a giant accident. This past week, a parade of financial sector luminaries appeared before the Financial Crisis Inquiry Commission. Their mantra: “No one saw this coming.” The goal is to convince all of us that the crisis was a natural disaster — a “hundred-year flood,” to use Tim Geithner’s metaphor.

I find this incredibly frustrating. First of all, plenty of people saw the crisis coming. In late 2009, people like Nouriel Roubini and Peter Schiff were all over the airwaves for having predicted the crisis. Since then, there have been multiple books written about people who not only predicted the crisis but bet on it, making hundreds of millions or billions of dollars for themselves. Second, Simon and I just wrote a book arguing that the crisis was no accident: it was the result of the financial sector’s ability to use its political power to engineer a favorable regulatory environment for itself. Since, probabilistically speaking, most people will not read the book, it’s fortunate that Ira Glass has stepped in to help fill the gap.

This past weekend’s episode of This American Life includes a long story on a particular trade put on Magnetar (ProPublica story here), a hedge fund that I first read about in Yves Smith’s ECONned. The main point of the story is to show how one group of people not only anticipated the collapse, and not only bet on it, but in doing so prolonged the bubble and made the ultimate collapse even worse. But it also raises some key issues about Wall Street and its behavior over the past decade.

This will require a brief description of what exactly Magnetar was doing. (If you know already, you can skip the next two paragraphs.) It’s now a cliche that a CDO is a set of securities that “slices and dices” a different set of securities. But it’s slightly more complicated than that. First there is a pile of mortgage-backed securities (or other bond-like securities) that are collected by an investment bank. The CDO itself is a new legal entity (a company) that buys these MBS from the bank; that’s the asset side of its balance sheet. Its liability side, like that of any company, includes debt and equity. There’s a small amount of equity bought by one investor and a lot of debt, issued in tranches that get paid off in a specific order, bought by other investors. The investment bank not only sells MBS to the CDO, but it also places the CDO’s bonds with other investors. Whoever buys the equity is like the “shareholder” of this company. There is also a CDO manager, whose job is to run the CDO — deciding which MBS it buys in the first place, and then (theoretically) selling MBS that go bad and replacing them by buying new ones. The CDO itself is like an investment fund, and the CDO manager is like the fund manager.

According to the story, in 2006, when the subprime-backed CDO market was starting to slow down, Magnetar started buying the equity layer — the riskiest part — of new CDOs. Since they were buying the equity, they were the CDOs’ sponsor, and they pressured the CDO managers to put especially risky MBS into the CDOs — making them more likely to fail. Then Magnetar bought credit default swaps on the debt issued by the CDOs. If the CDOs collapsed, as many did, their equity would become worthless, but their credit default swaps on the debt would repay them many, many times over.

The key is that Magnetar was exploiting the flaws in Wall Street’s process for manufacturing CDOs. Because the banks made up-front fees for creating CDOs, the actual human beings making the decisions did not particularly care if the CDOs collapsed — they just wanted Magnetar’s money to make the CDOs possible. (No one to buy the highly risky equity, no CDO.) Because the ratings agencies’ models did not particularly discriminate between the contents that went into the CDOs (see pages 169-71 of The Big Short, for example), Magnetar and the banks could stuff them with the most toxic inputs possible to make them more likely to fail.

Now, one question you should be asking yourself is, how is this even arithmetically possible? How is it possible that a CDO can have so little equity that you can buy credit default swaps on the debt at a low enough price to make a killing when the thing collapses? You would think that: (a) in order to sell the bonds at all, there would have to be more equity to protect the debt; and (b) the credit default swaps would have been expensive enough to eat up the profits on the deal. Remember, this is 2006, when several hedge funds were shorting CDOs and many investment banks were looking for protection for their CDO portfolios.

The answer is that nothing was being priced efficiently. The CDO debt was being priced according to the rating agencies’ models, which weren’t even looking at sufficiently detailed data. And the credit default swaps were underpriced because they allowed banks to create new synthetic CDOs, which were another source of profits. So here’s the first lesson: the idea that markets result in efficient prices was, in this case, hogwash.

By taking advantage of these inefficiencies, Magnetar made the Wall Street banks look like chumps. This American Life talks about one deal where Magnetar put up $10 million in equity and then shorted $1 billion of AAA-rated bonds issued by the CDO. It turned out that in this deal, JPMorgan Chase, the investment bank, actually held onto those AAA-rated bonds and eventually took a loss of $880 million. This was in exchange for about $20 million in up-front fees it earned.

But who’s the chump? Sure, JPMorgan Chase the bank lost $880 million. But of that $20 million in fees, about $10 million was paid out in compensation (investment banks pay out about half of their net revenues as compensation), much of it to the bankers who did the deal. JPMorgan’s bankers did just fine, despite having placed a ticking time bomb on their own bank’s balance sheet. Here’s the second lesson: the idea that bankers’ pay is based on their performance is also hogwash. (The idea that their pay is based on their net contribution to society is even more absurd.)

So who’s to blame? The first instinct is to get mad at Magnetar. But this overlooks a Wall Street maxim cited by TAL: you can’t blame the predator for eating the prey. Magnetar was out to make money for its limited partners; if it had bet wrong and lost money, no one would have bailed it out. Although I probably wouldn’t have behaved the same way under the circumstances, I have no problem with Magnetar.

I do have a problem with the Wall Street bankers in this story, however. Because losing $880 million of your own company’s money to make a quick buck for yourself is either incompetent or just wrong. And allowing Magnetar to create CDOs that are as toxic as possible — and then actively selling their debt to investors (that’s where the banks differ from Magnetar, in my opinion) — is either incompetent or just wrong. But even so, I don’t think the frontline bankers are ultimately at fault. Maybe they were simply incompetent. Or maybe, they were knowingly exploiting the system to maximize their earnings — only in this case the system they were exploiting was their own banks’ screwed-up compensation policies, risk management “systems,” and ethical guidelines.

In which case the real blame belongs to those who created that system and made it possible. And that would be the bank executives who failed at managing compensation, risk, or ethics, endangering or killing their companies in the process. And that would be the regulators and politicians who allowed these no-money down no-doc negative-amortization loans to be made in the first place; who allowed investment banks to sell whatever they wanted to investors, with no requirements or duties whatsoever; who allowed banks to outsource their capital requirements to rating agencies, giving them an incentive to hold mis-rated securities; who declined to regulate the credit default swaps that Magnetar used to amass its short positions; who allowed banks like Citigroup and JPMorgan Chase to get into this game with federally insured money; and who failed at monitoring the safety and soundness of the banks playing the game.

The lessons of Magnetar are the basic lessons of the financial crisis. Unregulated financial markets do not necessarily provide efficient prices or the optimal allocation of capital. The winners are not necessarily those who provide the most benefit to their clients or to society, but those who figure out how to exploit the rules of the game to their advantage. The crisis happened because the banks wanted unregulated financial markets and went out and got them — only it turned out they were not as smart as they thought they were and blew themselves up. It was not an innocent accident.

ProPublica has a long and detailed story of Magnetar, the hedge fund that helped fuel the subprime bubble by providing the equity for new subprime collateralized debt obligations — precisely so that it could then go and short the higher-rated tranches. In other words, Magnetar wanted to short some really, really toxic CDOs. But either there weren’t enough toxic CDOs to short, or they weren’t toxic enough. So they provided the equity necessary to manufacture more toxic CDOs. Then they shorted them. Yes, the math works out.

Yves Smith told the story of Magnetar in her book ECONned. The ProPublica story adds a bunch of details. But the best part is that This American Life is doing a story on Magnetar in this weekend’s radio show, which I’m sure will be great.

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

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.

My recent article on Risk Management for Beginners closed with some unrigorous speculation about the peculiar incentives of fund managers, who are consistently well compensated in decent and good years and, in bad years, lose their clients’ money and move on to start a new fund. Steven Malliaris and Hongjun Yan have a paper on this topic entitled “Nickels Versus Black Swans:” “nickels” being the typical hedge fund strategy of making a small but consistent return with a small risk of a huge loss, and “black swans” being Taleb’s preferred strategy that makes a small but consistent loss with a small risk of a huge gain.

Simplifying the model, the problem with a black swan strategy is that by the time the huge gain rolls around, you the manager have already been fired (your clients have withdrawn their money) because of your consistent losses. The result is overinvestment in nickel strategies and underinvestment in black swan strategies – even when the latter have a higher expected return. This result holds even when you assume that the investors are sophisticated, because the key factor is the reputational concerns of the fund managers themselves.

Malliaris and Yan also show that the system can reach multiple equilibrium points: the system can be in one equilibrium where most hedge funds are pursuing suboptimal strategies, and then suddenly shift to another quickly, meaning that the hedge fund industry does not allocate capital as efficiently as one might imagine. This might help explain why (a) everyone is saying that AAA-rated mortgage-backed securities are underpriced yet (b) no one is buying them.

This paper might be seen as simply translating common sense into mathematics. Seen another way, though, it helps explain why individually rational behavior (by fund managers) does not produce the efficient outcomes you learn in first-year economics.

• large hedge funds should provided data to regulators so that they can measure systemic risk
• the largest hedge funds (and other institutions engaged in similar activities) should be directly overseen by the Federal Reserve
• financial regulation should function on functions, such as providing liquidity, rather than institutions, which tend to change in ways that make regulatory structures obsolete
• a Capital Markets Safety Board should be established to investigate failures in the financial system and devise appropriate responses
• minimum requirements for disclosure, “truth-in-labeling,” and financial expertise be established for sales of financial instruments (such as exist, for example, for pharmaceuticals)

Lo also has a talent for explaining seemingly arcane topics in language that should be accessible to the readers of this site. The testimony is over 30 pages long, but it’s a good read. Here are a couple of examples to whet your appetite.

On the incentives within an investment bank:

Consider, for example, the case of a Chief Risk Officer (CRO) of a major investment bank XYZ, a firm actively engaged in issuing and trading collateralized debt obligations (CDO’s) in 2004. Suppose this CRO was convinced that U.S. residential real estate was a bubble that was about to burst, and based on a simple scenario analysis, realized there would be devastating consequences for his firm. What possible actions could he have taken to protect his shareholders? He might ask the firm to exit the CDO business, to which his superiors would respond that the CDO business was one of the most profitable over the past decade with considerable growth potential, other competitors are getting into the business, not leaving, and the historical data suggest that real-estate values are unlikely to fall by more than 1 or 2 percent per year, so why should XYZ consider exiting and giving up its precious market share? Unable to convince senior management of the likelihood of a real-estate downturn, the CRO suggests a compromise—reduce the firm’s CDO exposure by half. Senior management’s likely response would be that such a reduction in XYZ’s CDO business will decrease the group’s profits by half, causing the most talented members of the group to leave the firm, either to join XYZ’s competitors or to start their own hedge fund. Given the cost of assembling and training these professionals, and the fact that they have generated sizable profits over the recent past, scaling down their business is also difficult to justify. Finally, suppose the CRO takes matters into his own hands and implements a hedging strategy using OTC derivatives to bet against the CDO market. From 2004 to 2006, such a hedging strategy would likely have yielded significant losses, and the reduction in XYZ’s earnings due to this hedge, coupled with the strong performance of the CDO business for XYZ and its competitors, would be sufficient grounds for dismissing the CRO.

In this simple thought experiment, all parties are acting in good faith and, from their individual perspectives, acting in the best interests of the shareholders. Yet the most likely outcome is the current financial crisis. This suggests that the ultimate origin of the crisis may be human behavior—the profit motive, the intoxicating and anesthetic effects of success, and the panic selloff that inevitably brings that success to an end.

On the role of regulation in a free-market economy:

Why are fire codes necessary? In particular, given the costs associated with compliance, why not let markets determine the appropriate level of fire protection demanded by the public? Those seeking safer buildings should be willing to pay more to occupy them, and those willing to take the risk need not pay for what they deem to be unnecessary fire protection. A perfectly satisfactory outcome of this free-market approach should be a world with two types of buildings, one with fire protection and another without, leaving the public free to choose between the two according to their risk preferences.

But this is not the outcome that society has chosen. Instead, we require all new buildings to have extensive fire protection, and the simplest explanation for this state of affairs is the recognition—after years of experience and many lost lives—that we systematically under-estimate the likelihood of a fire. In fact, assuming that improbable events are impossible is a universal human trait (see, for example, Plous, 1993, and Slovic, 2000), hence the typical builder will not voluntarily spend significant sums to prepare for an event that most individuals will not value because they judge the likelihood of such an event to be nil. Of course, experience has shown that fires do occur, and when they do, it is too late to add fire protection. What free-market economists interpret as interference with Adam Smith’s invisible hand may, instead, be a mechanism for protecting ourselves from our own behavioral blind spots.

Sometimes the news jumps off the page, and sometimes it seeps through.  Now, about two hours after looking at today’s weekend papers, I realize that something is stuck in my mind, rather like a tune that you can’t get rid of.

I read, in at least two places, various versions of the following proposition.

1. Hedge Funds, if they get into trouble, will not be rescued by the government

2. Big Hedge Funds are not in trouble

Statement #1 is presumably false.  There is no way that any responsible government could let a large Hedge Fund fail at this point.  The system is too fragile and the risks too obvious.  In fact, the Europeans ratcheted up the pressure in this regard during the week, with their increasingly undiplomatic condemnations of the US for not saving Lehman. (Just wait until they figure out what really happened in the “rescue” of AIG.)

Statement #2 is interesting.  I’m not taking a view either way on this; I much prefer to be agnostic and see what the data bring in.  But I did note a story that mentioned that the US government had been asking financial institutions about their exposure to particular (named in the story) Hedge Funds.

Now, I don’t know about you, but when a representative of the federal government comes to my house, shows me identification and asks questions about a neighbor (yes, it has happened), I start to wonder – what exactly is this neighbor doing to attract the attention of the government (a notoriously distracted organization, except when it is very focused)?

I worry about the US crisis managers, particularly at the Treasury, who used to like to catch dominoes, until they found out how dangerous that could be – because you tend to knock over other dominoes.  Then they switched to broader, more systemic and systematic approaches, which we have called for and applauded here (most recently, on Friday, they adopted the recommendation – from us and others – to recapitalize insurance companies).  I really hope these crisis managers are not going back to their old ways.