Let the hedge funds run the risks

By Steven Pearlstein
Friday, June 18, 2010

Beginning in the late 1980s, traditional banks began complaining that they were losing market share and profits and all their best people to investment banks, which had cleverly constructed an alternative, or "shadow," banking system that was less regulated and backed by less capital. Their incessant whining and well-financed pleading eventually paid off in the late 1990s, when Congress dismantled the Depression-era wall between the two activities and let banks and investment banks merge. And it all worked splendidly -- until, of course, it didn't.

More recently, during the debate about financial regulation, the new megabanks have been complaining that if they are not allowed to continue paying those outlandish bonuses, or if their activities are restricted, or if they are saddled with additional capital requirements and leverage limits, they will lose market share and profits and all their best people to unregulated hedge funds.

You see the pattern here. The consistent line from the banks is that because we can't really stop the things we don't like -- the excessive pay, the conflicts of interest, the lack of transparency, the unbridled speculation and market manipulation -- it's better to have these things go on within banks, where there's at least a modicum of government supervision.

The problem with this argument is that it wasn't the unregulated hedge funds, or for that matter the unregulated derivatives markets, that were primarily responsible for the financial crisis. Rather, it was the regulated banks that caused most of the problems, mainly when they began to think and behave like hedge funds.

That, anyway, is the conclusion of a splendid new book, "More Money Than God" by Sebastian Mallaby, a former Post columnist and editorial writer. Years before the crisis, Mallaby set out to pull back the veil of secrecy on a corner of the financial world that had become immensely rich and powerful and, in the minds of many, rather menacing as well. If there was to be a financial crisis, many people -- including me -- were convinced that hedge funds would be at the center of it.

Mallaby read just about everything there was to read about hedge funds, from newspaper and magazine articles to eye-glazing academic studies. He got his hands on many of the monthly reports send by fund managers to their investors over the years, and he dug up some revealing transcripts from court cases involving the funds. And after several frustrating years of trying, he finally managed to get extensive interviews with many of the most celebrated hedge fund managers and their lieutenants.

The result is the definitive history of the hedge fund history, a compelling narrative full of larger-than-life characters and dramatic tales of their financial triumphs and reversals.

There's A.W. Jones, the one-time communist sympathizer and Fortune magazine writer who opened the first "hedged" fund in the 1950s and almost immediately produced above-market returns through the use of borrowed money and short-selling and a compensation scheme that had Wall Street brokers calling him with all their best tips.

We learn how young hotshots such as Bruce Kovner, Louis Bacon and Paul Tudor Jones turned the art of momentum investing -- trend surfing, as they called it then -- into something of a science, confounding theories that it was impossible for any investor to consistently beat the market average. We ride the roller coaster with Michael Steinhardt, Julian Robertson and Stan Druckenmiller, the early giants of the industry. In George Soros, Mallaby finds an intellectual with a keen eye for the self-reinforcing dynamics of financial markets combined with a steely trader who broke the Bank of England by willing to bet his entire stake on a devalued pound sterling.

Most fascinating of all are the rocket scientists and code breakers recruited by Jim Simon and David Shaw to pore through mountains of financial data in search of the faint patterns in market behavior, or small imperfections in prices, that could generate steady streams of trading profits for their "quant" funds until others caught on.

Mallaby weaves into his narrative just the right amount of economic theory and market history, and he has a wonderful knack for explaining complex trading strategies in simple and elegant prose.

But for me, the most eye-opening aspect of Mallaby's account is how much energy the hedge funds spend in trying to discover one another's trading strategies and how ruthless they can be in trying to profit from one another's miscalculations and misfortunes. Their obsessive secrecy isn't a lifestyle choice, it's a tactical imperative -- no less than those huge bonuses, which serve as insurance against defections.

Mallaby is a market man through and through, so it should be no surprise that he offers a sympathetic account of hedge funds. Despite the book's title, the book is remarkably nonjudgmental about the vast fortunes amassed by hedge fund managers, and he offers a respectful view of their economic role.

But you can't come away from "More Money Than God" without thinking that there ought to be a bright line between hedge funds and banks in terms of what they do and how they do it. As a general rule, the investment and trading strategies used by hedge funds are inappropriate for a regulated financial institution, and no bank should be taking on the kinds of risks that generate hedge fund-like returns. By the same logic, the kind of people who thrive at hedge funds probably don't belong at banks -- and banks should not be offering the big bonuses necessary to attract or retain them.

Indeed, as Mallaby argues, it should be considered progress, not a problem, if regulatory reform forces some of the riskier financial activities out of big banks that are considered too big to fail, and into smaller hedge funds that pose little risk to the financial system. If bankers want to lead the exciting hedge-fund life, earning hedge-fund-like profits and bonuses, let them go work for a hedge fund.

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