Hedge funds and bailouts

The term “hedge fund” sounds so innocent because hedging is protecting against risk. But hedge funds are precisely the opposite: largely unregulated, they are pools where millionaires put their cash, to then have it leverage (borrow) lots more money, in order to make speculative bets in the financial markets in a way that makes the whole financial system a lot shakier. Dean Baker rips into the role of hedge funds and last week’s financial alarm bells:

Fed Bailouts and the Bubble Boys

The whining from Wall Street is growing louder. Those brilliant high-flying hedge fund managers are now facing the prospect of financial ruin. It seems that they are holding hundreds of billions of dollars of mortgage debt, some of which is worthless, and much of which is worth considerably less than it was a few weeks ago. Since the hedge funds are heavily leveraged (they borrowed heavily to buy assets), many of them could be wiped out.

Given the gravity of the situation, the hedge fund crew is doing what all good capitalists do when things go badly: run to the government.

Specifically, they want the Federal Reserve Board to bail them out with lower interest rates. They hope that this will buy them the time needed to dump their mortgages on less well-informed investors.

The hedge fund folks say that this is the Fed’s job, that it must step in as the lender of last resort and restore order to the market. That ain’t necessarily so.

To understand the current picture, it’s necessary to distinguish between different types of financial meltdowns. The first is an irrational panic. In this case, investors simply flee for the doors for no obvious reason. The result can be an economic catastrophe driven by fear alone. This is essentially what happened in the East Asian financial crisis ten years ago. There was a massive capital flight from South Korea, Thailand, and Malaysia — economies that were performing solidly by almost any measure – for no obvious reason.

If there had been an international lender of last resort at the time, it would have stepped in and provided capital and sought to assure investors these economies were fundamentally sound. As it was, all we had was the I.M.F. (that’s another story), so these economies had to go through the wringer, experiencing sharp recessions before bouncing back at the end of the decade.

Dean could elaborate on this point: the “bailout” funds provided by the IMF went to Western banks who were owed money when the financial crises hit. These were loans taken on by Asian states, which had to be repaid by the people who did not benefit from the bubble in lending (in addition to conditions of structural adjustment of their economies), in order to cover the butts of those who did benefit and were financially exposed. Privatize the gains, socialize the losses.

The other sort of meltdown occurs when assets have genuinely lost much of their value as when a fraud is exposed. The best recent example of such a meltdown was the collapse of Enron in the fall of 2001. In this case, Enron had gone from a company with a market valuation of $70 billion, to being essentially worthless in a very short period of time.

There actually was an effort at a federal bailout of Enron. A former Treasury secretary, who had taken a top job at Citibank, called a Treasury staffer to see if he could stop the credit rating agencies from downgrading Enron’s debt. At the time Citibank held several hundred million dollars of Enron debt. While the staffer refused to intervene, if Citibank had gotten its wish, it would have had the opportunity to dump its Enron debt on less informed investors before the price collapsed.

These examples should frame the debate on a bailout. If the assets held by the hedge funds are sound, and it’s just an issue of stemming a momentary panic, then the Fed should step in as lender of last resort and try to stabilize the market. However, if the issue is just one of giving the hedge fund crew time to dump their bad debts, then the Fed has no business getting involved.

A quick look at the evidence strongly argues for scenario # 2. The problem is that homes are worth less than the value of the mortgages. This is the main fuel for the surge in defaults. This process will only get worse as house prices continue to decline. With the inventory of unsold new homes more than 50 percent above its previous peak, and the number of vacant ownership units nearly twice the previous record, there can be little doubt about the future direction of home prices.

One final point: the hedge fund crew may try to take the homeowners hostage, arguing that the only way to keep millions of low and moderate income homeowners from being thrown out on street is to bailout the hedge funds. This is not true. Congress can just pass legislation that allows homeowners who default to remain in their house as renters, as long as they pay the fair market rent (as determined by an independent appraisal) for their home.

We must be careful not to confuse the plight of distressed homeowners with the plight of the hedge fund crew. As we all know, you can never give in to hostage takers, especially if they run hedge funds.

6 comments

  • it is quite ironic that the hedge funders of the world are calling for lower interest rates, given the traditional viewpoint of those holding all the money. who will win out, those hedging, or those with all the cash. I put my money on those with all the cash, as the central bankers have seemed to side with the inflation hawks for oh so long. for those of us that work for a living and pay a mortgage these are particularly strange bedfellows, but then again we are in for another stupendous ride through some quite irrational capitalist global economic times. Will history ever tire of deriving such unproductive cultural manifestations of creating value i.e. the current form of short run margin trading and hedging.

  • I agree with Dean’s sentiments, but wonder to what extent the banks which sponsor many of the hedge funds are exposed to this crisis via the loans to the hedge funds which have operated with so much leverage. If the hedge funds default on their loans, there is surely a risk of losses spreading from the hedge fund investors – who deserve to lose every penny at stake – to unwise financial lenders to them. Also, the banks seem to have invested a lot in sub prime loans on their own account. In short, there is more than a supposed danger of a crisis to the banking system as a whole which necessitates some kind of intervention.

  • “Also, the banks seem to have invested a lot in sub prime loans on their own account. In short, there is more than a supposed danger of a crisis to the banking system as a whole which necessitates some kind of intervention”

    That shows why banks should not be “investing” at all, no? Wasn’t it like that for 50 years or so after the Great Depression?

  • Dean starts by saying “Hedge Funds are facing financial ruin.” Is this accurate?

    Let me count the ways that it is not.

    1. There are 10,000 reported hedge funds and probably closer to 15,000 total in existence. Of all of those only around 100 have reportedly closed in 2007.

    2. Hedge Funds employe literally hundreds of distinguishable strategies only some of which use leverage. Even if one whole strategy took 20 hedge funds off the map that would be a blip on the radar of this $3 trillion industry.

    3. Speaking of the size of the industry and hedge funds facing financial ruin. Hedge funds gained $275 billion in the first 3 quarters of 2007 vs. mutual funds gaining only $70 billion. Are mutual funds facing financial ruin as well? Hedge funds are growing 3x as quickly

    4. Last month a report came out from the Institute of Private Investors. surveyed the ultrawealthy and 25% reported that they would be increasing their allocation to hedge funds, not decreasing it.

    – Richard

  • I think the hedge fund criticism is indeed, hedges who hedge (leverage).

    “2. Hedge Funds employe literally hundreds of distinguishable strategies only some of which use leverage. Even if one whole strategy took 20 hedge funds off the map that would be a blip on the radar of this $3 trillion industry.”

    No. Investors would panic and exit hedge funds en masse. The sector is a function of marketing itself over stocks, bonds, and mutual funds.

    Hedge funds are rational as long as their “surplus capitalization” equals the lost capitalization caused by investors unwilling or unable to short stocks. I don’t know if hedge funds are bubbles yet, but they are growing so fast the point of irrational exubarance won’t be noticed under long after the boom-bust. Hedge funds encompass many different portfolio strategies.

  • Somebody already mentioned home-owners could rent. If homeowners would lose their jobs or unfinished education because of losing their mortgages, a bailout would make sense. But there are probably other solutions.
    The homes-as-assets argument doesn’t hold water; if homeowners wouldn’t lock in interest rates why subsidize further loans? There is a whole bunch of asset-less renters that have little sympathy for this “crisis”, but don’t want their public education and health treasury looted.

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