In defence of hedge funds | FT Alphaville

In defence of hedge funds

…kill the bad HFnds + heavily regulate the rest.

That’s Dick Fuld, recounting the position of the US Treasury towards hedge funds. The phrase comes from an email between Fuld and Lehman’s general counsel, Thomas Russo, made public by congress last Monday.

It’s breathtaking not because it shows just how fixated and narrow-minded Lehman’s management were when it came to blaming all their woes on hedge funds – a fact already well known – but because it seems to show the US Treasury were thinking the same way too.

Little wonder, one supposes, when you think about it.

Paulson is as much the product of a sclerotic, class-ridden and arrogant banking fraternity as Fuld was. The US Treasury – just like Lehman – has spent months holding onto the mantra that the banks are not to blame. Fear and fear alone was causing trouble for the banks, was the parroted line. The whole wrong-headed architecture of the Tarp was prefaced on the same worldview: more liquidity and more confidence was needed, not more capital. As Felix Salmon at Market Movers writes:

America’s banks — and the world’s, for that matter — have had de facto unlimited access to very cheap Fed liquidity for many months now. That hasn’t induced them to lend.

It has taken Paulson two long weeks to come around to the idea that the banks need recapitalising. That’s two painful weeks to face up to the fact that actually, the banks’ problems were not mere fictions conjured by the scurrilous iconoclasts of Greenwich, CT, but were real, palpable, and destabilising.

And yet, it seems, the hedge funds are still in the target sights of regulators. As the BBC’s business editor Robert Peston writes today:

G Brown will, for example, in the coming days put on his Wyatt Earp costume, and will ask the financial gunslingers to hand over their weapons…

…my own conversations with politicians and regulators are indicative that the tide has turned massively against this trillion dollar industry.

Peston reports that authorities on “both sides of the Atlantic” are going to come down hard on hedge funds.

…the industry as a whole hasn’t even begun to address the central charges against it: namely, that it helped to stoke up the credit bubble by providing a market for toxic investments; and that it has brought disorder to the puncturing of that bubble, through the poisonous combination of deliberate strategies to destroy the credibility of weaker financial firms, and through massive automatic sales of assets in a falling market.

We have to disagree with the charges on all three counts.


Firstly – on “providing a market for toxic instruments”. Let’s take mortgage-backed CDOs as an example, since they are the archetypal ‘toxic’ instrument at the heart of the current crisis. This explanation is a little simplified, but hopefully it catches the gist of the matter. It’s right to say, as Peston does, that hedge funds were often the happy buyers of the lowest tranches: the mezz and equity pieces that support above them a far greater number of AAA-rated senior tranches and are nominally considered the “toxic” pieces.

Alas, the “toxicity” of CDOs is nothing to do with the equity or mezz pieces. The problem with CDOs is that the senior, AAA-rated pieces were mispriced. Consider: relatively speaking, who has lost more in the current market: buyers of BBB-rated equity pieces, who always knew what they were buying was risky, and got paid accordingly, or buyers of AAA-rated super-senior pieces, who thought the paper they were holding had a near-zero chance of defaulting? Answer: AAA. Take a look at this graph, which we’ve published before. It shows the current distribution of ratings on a sample of 469 ABS CDO tranches, all of which were originally rated AAA. Less than 25 per cent have held their ground.

rated cdo tranches

Many in the market – particularly hedge funds – knew that the AAA CDO tranches were artificially secure and accordingly mispriced. There was, in technical parlance, a “correlation” problem waiting to happen in CDOs. Which is why the smart money stopped buying the senior pieces a long time ago. Banks still wanted to issue CDOs though – something they couldn’t do without any AAA tranche buyers. To keep the money-machine turning, they found otherways to shift the AAA. They kept it on their balance sheets and hid it with derivative contracts issued by monolines (negative basis trades). Or else they loaded the tranches into huge, opaque funds backed by commercial paper markets (ABCP conduits). These actions allowed the CDO market to truly develop into a bubble over 2006/07. Had the banks not have artificially created AAA buyers, many of the riskiest CDOs would never have been created.

When defaults did eventually tick up and damage CDO structures in a far more violent way than predicted, these actions by the banks in artificially propping the AAA market had two profound effects. Firstly, those banks that had kept AAA-rated CDO pieces on their own balance sheets had to take huge writedowns and suffered from crippling capital impairment charges. No-one knew exactly how much bad AAA debt banks had hidden and thanks to shoddy reporting, it has taken 18 months to come clean. This has had a profound and lasting effect on market confidence. Secondly, those that had stuffed the AAA-rated tranches into funds backed by commercial paper, caused the fear to instantly spread to the highly conservative commercial paper (CP) market. Being one of the biggest and supposedly liquid markets in the world, this instantly turned the crisis into a systemic problem. And not a hedge fund in sight.

Secondly – on “the poisonous combination of deliberate strategies to destroy the credibility of weaker financial firms”.

That’s right, it’s the backed-into-a-corner logic of Dick Fuld. The arguments against bashing short-selling are legion. For the sake of brevity, we’ll only flag a couple of points. Firstly, as noted above, the real reason for an utter lack of confidence in banks is this kind of thing. Confidence has not evaporated overnight, it’s been whittled down by months of obfuscation.

Secondly, as should be clear, you don’t need shorting to make people panic about banking confidence. Here’s how the FTSE fared after the FSA banned shorting financials (indicated below by the vertical blue line:


Volatility has increased hugely and, after an initial rally, the market simply continued on its secular trend. It would be more germane, perhaps, to see what the CDS markets did as a proxy for real perceptions of default risk. It’s a similar picture. Spreads on the banks blew out to incredible levels last week.

Thirdly – on “massive automatic sales of assets in a falling market”. What drives these sales? Two things, generally. The first, redemptions. Just as the banks are experiencing a run, so are hedge funds. If hedge funds caused the crisis in financial confidence, then boy, are they suffering from it. The second thing that might cause asset sales would be margin calls. Margin calls made by, guess who, the banks. Oftentimes too, those margin calls are made utterly indiscriminately.

It is invidious to blame hedge funds for causing so much instability in the market. Investment banks are the architects of this crisis.

If politicians weren’t already in bed with the bankers (as in Paulson’s case) then by dint of this week’s recapitalisations, they very much are. And it’s beginning to show in the way they are handling things.

Following Paulson’s recapitalisation model, there’s talk of the Treasury here reviewing the way it’s underwriting banks’ equity offerings – possibly making the terms less punitive.

Part of that is supposedly about trying to entice investors to buy the stock – and reduce the amount the Treasury is left holding. But it’s also giving shareholders a dividend they don’t deserve. It’s another sop to the banks. If institutional investors are going to buy, they’ll do so presumably on the basis that long-term, the shares in banks are hugely undervalued; not simply on the expectation of a piddly dividend from a penny stock over the next three fallow years.

Enter then, the hedge funds. You can’t blame your bedfellows, so it makes sense to go after the Monsters of Mayfair or the Gordon Gekkos of Greenwich.

They make easier villains anyway. The sequel to Wall Street – Money Never Sleeps – is coming out soon. Here’s betting Gekko will be a hedgie.