NCPA - National Center for Policy Analysis


April 14, 2008

The chaos in financial markets has embarrassed many on Wall Street, and hedge funds have come in for their share of criticism. Yet the truth is that the turmoil has largely vindicated the funds' virtues, says Sebastian Mallaby, director of the Center for Geoeconomic Studies at the Council on Foreign Relations.

The most striking fact about the ongoing financial mayhem is that it is concentrated not in lightly regulated hedge funds but in more heavily regulated commercial and investment banks:

  • March 31 proclaimed the closing of the worst month for hedge funds since the collapse of the infamous Long Term Capital Management in 1998.
  • But the average fund tracked by the Chicago-based firm Hedge Fund Research declined by a mere 2.4 percent in March, bringing the cumulative fall for the first quarter of 2008 to 2.7 percent.
  • By contrast, the bank-heavy financial services component of the S&P 500 fell 12.3 percent in the first quarter.

Hedge funds occasional failures have stemmed mainly from errors that were not of their own making, says Mallaby.  Because banks have mismanaged themselves so thoroughly, they have had to mobilize capital by calling in loans to hedge funds, forcing the funds to sell off positions precipitously.  This has caused a few funds to go bust, but the trigger was not reckless behavior in unregulated hedge land.  It was subprime losses in the regulated banking system.

The smattering of bankruptcies has illustrated another hedge-fund virtue: unlike the bankruptcy of a bank, hedge-fund crashes generally do not destabilize the wider financial system, says Mallaby:

  • The prospect that even a medium-sized investment bank such as Bear Stearns would go bust panicked the Fed into risking $30 billion of taxpayers' money to secure a rescue.
  • But the collapse of hedge funds such as Sowood Capital or Peloton Capital has not triggered official intervention; the lesson is that the financial system becomes vulnerable when it is dominated by institutions that are too big or pivotal to fail.

Source: Sebastian Mallaby, "Blame the Banks," Foreign Affairs, April 9, 2008.


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