A Case for Tighter Regulation of Hedge Funds
Robert Waldmann
One of the puzzling aspects of the European debate over how to increase financial regulation after the crash was the idea that hedge funds should be regulated more. This is odd as they didn’t destabilize the system. I just assumed the Europeans can’t stand unregulated people making huge amounts of money. Now I have a rationalization. The idea is that all the smart investment bankers set up hedge funds leaving behind the fools. Then the smart hedge fund managers bet against the fools and destroy the investment banks. So the problem is that hedge fund managers make too much money compared to you poor long suffering traders at investment banks.
I am not joking.
The argument came to my mind when I think of restricting the compensation of investment bankers. I agree with all many disinterested people that driving smart people out of finance is a feature not a bug. However, driving smart people from investment banks to hedge funds might not be such a great idea.
Fortunately there is a useful regulation of compensation of investment bank employees which wouldn’t drive them to set up hedge funds. It is requiring bonuses to be paid in shares which can’t be sold for years (say 5 years). This forces the investment bankers to think of the long term. Notably this is the way in which hedge fund managers make money – they do not cash out most of it – the investors aren’t as dumb or in on the scam as investment bank CEOs or as diffuse as investment bank shareholders.
In any case, restrictions on compensation have to be designed recognizing the facts that financiers can choose whether to work for investment banks or set up hedge funds and that it is not socially optimal for all of the smart ones to set up hedge funds.
Robert,
Your bug is in wanting to rig another economic system.
On compensation value goes where it’s most valued. What the problem with that?
On social value I think the fact that when two parties freely enter into a trade without coercion that fact that they do so is proof that this activity is socially valuable.
The Hedgefunds were instrumental in destroying the Lehman Brothers and the Iceland banks. Destroying a firm may make you money, however nothing ‘economic’ is created from it, and the ordinary taxpayers ends up on the hook to bail out the ‘too big to fail’ firms.
The basic problem lies with the amount of money a Hedge fund can move around, and the amount of money can overwhelm a firm regardless of fundamentals. Somewhere down the line, you have to ask : does it make sense to allow a few people to make an enormous amount of money destroying the economy? What useful purpose does it serve?
Instead of working on compensation, the most meaningful reform will stop the banks from lending money to the Hedge funds. Remove their ‘clout’ from leverage, and they are simply ordinary investors. It’s the willingness of the banks to give them 30:1 leverage which makes them dangerous.
Cantab,
The problem is that a third party (the US taxpayer) was effectively held hostage by one of the other two parties. If we were just talking about some small-enough-to-fail hedge funds and small-enough-to-fail and not smart-enough-to-succeed financial houses, then no one would care. It wouldn’t be a topic anymore than when the local Kwikee-Mart down the street goes belly-up.
Slugs,
The problem is that a third party (the US taxpayer) was effectively held hostage by one of the other two parties.
They were never held hostage. What happened was that the treasury and the FED thought maybe by injecting all the money into the system we could get out of the economic slowdown on the cheap.I supported them while they were doing it but now i’m not so sure.
I would not have been heart broken hearted had AIG not been able to make good on all its credit default swaps. The potential for the counter party to fail was something the financial types were all taught in school.
I think there might have been a more reasonble middle ground between what they did and the mistakes the FED made at the start of the Gread depression. Tarp was ham handed since it forced even banks that were not in trouble to receive funds. And now they’re doing a bait and switch since they promised the money would be paid back with interest but instead some want to spend more on the counter productive stimulus.
Ronin8317
Nobody has to give a hedge fund their money but for those that do wish them good luck and call it a day. The could have invested in t-bills and sat out all the ups and downs.
Cantab, what if two people voluntarily agree to embezzle money from a bank ? This is not socially valuable. You are assuming that managers must act in the interest of shareholders. If this were so there would be neither need for regulation of compensation nor for laws against embezzling. Only when you begin to try to explain the difference between taking money out of a safe and putting it in one’s pocket and standard practice on Wall Street will we have something to talk about. So far, you have argued that there is no need to regulate how much cash money bank employees take home in their shoes after work.
2slugs even without the US Treasury, there are already third parties — the shareholders of banks. There are already extensive regulations designed to protect shareholders in all US states. In some countries such regulations are not effective, basically because judges can’t apply broad principles like “shareholder interests.” Such countries have stunted stock markets.
Talk about your greater fool hypothesis! 😉
the vast majority of hedge funds were leveraged between 2:1 and 4:1 at the beginning of the crisis.
ok they provided equity funding for other highly leveraged transactions, and that is a problem, but that points out the problem with measurements of leverage in general.
in any case ronin you are basically right, the brokerages (prime brokerages, etc) are the ones which maintain the amount of leverage HFs can have.
in the event of a HF crash they end up owning the portfolio.
many (not all) hedge fund strategies (equities and soon cds trading for example) are now easy to completely move offshore to any country that has good internet connectivity.
i don’t just mean bermuda, cayman, isle of man and other well known tax havens, i mean places with shabby legal systems and hole-ridden tax codes, that includes much of the “developing” world. lots of asia, latin america, etc.
by the way, you can’t just drive a whole population of people into hedge funds.
hedge funds scale with the dollars that go into investing in them. that’s way down.
If we impose more regulations on the financial sector it will just wither and die. Everybody will move somewhere else…finally ending up in Bali perhaps. And then what would we do? We simply can’t impose any regulations on these wonderful people who make the world work the way it should. If we do, we will all suffer the terrible consequences. No banks, no finance, no loans, no profits, etc., etc. Unthinkable.
Robert,
I think your fundamental mental model of the situation is wrong which has you looking in the wrong places for solutions. The system was designed to match borrowers with lender and it did it so well it actually created a bubble. Its falling prices that causing the problems. Most of the derivative contracts are after all a zero sum game. One person gains and the other loses. So all the financial trading is not the cause of the problems.
Embezzlement is a crime so we really don’t need new laws to enforce it. Most in industry follow pretty strict codes of ethics and most companies have compliance departments watching out for under handed activities. I don’t see the industry asking the government to protect them against their employees. Therefore we don’t need government plants sitting in our corporate offices like the political officers in the old Soviet Union.
The danger in the big push for regulation is that it is likely to slow down the flow of credit too drastically. Thus the reason people won’t get that loan for their new home will be because the democrats killed the financial markets. But this won’t happen.
So the dance continues.
I’m all for the concept of uncontrolled earings in what ever form those earnings may take. Just revise the tax tables so as to tax the heck out of anything over $500,000 per annum. All categories of income to be included. The economy and society has to get something worth while from those who think they are worth gazzilions per annum. I don’t recall any investment banker or hedge fund manager discovering a cure for cancer, polio or mental illness. Making rich people richer doesn’t qualify as an economic or societal good.
Jack,
Just revise the tax tables so as to tax the heck out of anything over $500,000 per annum. ‘
Why not just keep the same rate and as their income goes (t*income) goes up too. This should be enough.
Finally, the dawn begins. The so called “financial market” has been conscripted, Yes, the investment banks and their collaborators have taken control of the market. How can anyone think otherwise when your broker makes 80 % of their nut through proprietary trading, For goodness sake. They are stealing from customer accounts, duh
What a bunch of (Oh no my wife is coming). I just want to puke at how dumb everyone is.
I think it is stupid to allow very smart people to make a lot of money by destroying the economic. The basic problem is that all banks can be destroyed by shorting their stock. Their stock is part of their capital requirement. Once their stock value goes below a certain point then the FDIC will kill them. Easy money. All that is needed is an economic downturn which will happen sooner or later. You then short the bank stock and fed the press negative news and views on the banks. You start with the weakest one. One the FDIC kills a few the entire thing will snowball.
Since 2006 117 hedge funds have exploded. There is nothing immaculate about them.
http://hf-implode.com/
Too many people on Wall Street have made way too much money playing with other peoples property. (You down with OPP?)
Hedgefunds are just another way to play with other peoples money while having to bear little risk.
College student managed funds have outperformed Wall Street managed funds. Don’t make me bore you with links.
What we faced last year was not an ‘economic slowdown’. The investment banks and hedge funds were able to bring the world to the blink of total global financial meltdown. When Lehman Brothers failed, it caused Reserve Primary Fund to ‘break a buck’, and the secondary affect caused a bank run on money market funds, and a total collapse of the commercial paper market. At that point in time, nobody had any idea what is going on : not the banks, not the hedge funds, not the Fed, not the Treasury. CEOs of banks were personally approving transactions with another bank for fear the other party will go under. In such a climate, the Government is left with 2 choices : flood the bank with money, or nationalize everything.
The ‘flow of credit’ has absolutely NOTHING to do with how much the bankers are being paid. It has to do with whether the money can be raised cheaply. Nobody wants to invest in mortgage security right now. That is why the money for housing loans dried up, and paying some employee a few million dollars extra will not change anything.
Worse than that: index funds outperform managed funds. Over any time period of importance managed funds (run by anybody) lag the market. (Berkshire Hathaway, if you regards it as a fund, might be the ONE exception).
http://seekingalpha.com/article/177875-the-truth-about-goldman-and-aig-becomes-clearer?source=email
http://economistsview.typepad.com/economistsview/2009/12/we-face-a-real-challenge-in-dealing-with-that-feeling-that-the-crisis-is-over.html?utm_source=feedburner&utm_medium=feed&utm_campaign=Feed%3A+EconomistsView+%28Economist%27s+View+%28EconomistsView%29%29
It’s very much a dogs to their vomit situation. You won’t be able to keep Wall Street from reverting to its old way. You can try but even Volker here is full of “we should and we hope and we must try”, etc. In other words, none of this reform is really certain, and even if it is enacted it can be removed again very quickly. Only naive Americans think the plutocrats have lost. A skirmish perhaps, but not the battle. They hold the US economy in a vise-like (perhaps I should say vice-like?) grip.
http://www.youtube.com/watch?v=_gekaEzqj5g&feature=related
Today the government would tell us they have to bail out Duke & Duke. Why not like in the movie sell their seat on the exchance, sieze all thier firm’s assets and all personal assets of the failed executives. The Dukes go out of business and some other firm comes in an takes their place. That’s the way the market is supposed to work.
What I see is vampires with a large volume blood supply. Where is the blood coming from?
Accordingly to Jim (mad dog) Cramer the hedgies can manipulate any stock they want any time they want, usually without even direct communication. Just watch the market for what the other hedgies are doing.
One more reason not to buy individual stocks.
I seems you should be able to ride out these manipulation periods.
China?
The value/importance of hedge funds isn’t just investment return, it is that the fund returns are not correlated with the stock or bond markets, hence the name “hedge fund.”
Here is a good primer:
“The primary aim of most hedge funds is to reduce volatility and risk while attempting to preserve capital and deliver positive returns under all market conditions.”
Benefits of Hedge Funds
Many hedge fund strategies have the ability to generate positive returns in both rising and falling equity and bond markets. Inclusion of hedge funds in a balanced portfolio reduces overall portfolio risk and volatility and increases returns. Huge variety of hedge fund investment styles – many uncorrelated with each other – provides investors with a wide choice of hedge fund strategies to meet their investment objectives. Academic research proves hedge funds have higher returns and lower overall risk than traditional investment funds. Hedge funds provide an ideal long-term investment solution, eliminating the need to correctly time entry and exit from markets. Adding hedge funds to an investment portfolio provides diversification not otherwise available in traditional investing.
http://www.magnum.com/hedgefunds/abouthedgefunds.asp
http://www.nytimes.com/2009/12/14/opinion/14krugman.html
What Krugman fails to grasp is that Wall Street has not suffered much at all from the disaster so why should it not be happy to repeat it? Only the “little people” have suffered much, the biggies have gotten off almost unscathed.