Every so often over the past few months, as yet another hedge fund or private-equity legend came unstuck, I wondered how Sebastian Mallaby’s book was doing. After writing an astonishingly upbeat article on hedge funds for Foreign Affairs, he decided to turn it into a book, just before the leveraged-finance bubble burst.
Conveniently, Mallaby’s now popped up, in Foreign Affairs again, to tell us how he’s doing. And the answer is: don’t worry! Nothing’s changed! Hedge funds are still great and wondrous things! "The turmoil since last August has largely vindicated the funds’ virtues," he writes. "The central argument of my 2007 essay holds true today."
How can Mallaby spin this? One way is by making a distinction between hedge funds, on the one hand, and banks, on the other:
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. It is banks that created subprime mortgage securities. It is banks that mispriced them… 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.
Ahem. This is a classic apples-to-oranges comparison: he’s comparing the decline in hedge fund assets to the decline in bank stock prices. Did he maybe look to see what had happened to banks’ assets, in order to make a more apples-to-apples comparison? If he had, he would have found, most likely, that they hadn’t fallen at all – and certainly not by 2.7% in one quarter. Alternatively, did he look at listed hedge funds’ stock prices, in order to get an oranges-to-oranges comparison? Well, Fortress Investment Group fell by 20% in the first quarter, and don’t even get me started on Carlyle Capital.
Mallaby continues:
Hedge funds, for the most part, have weathered the storm remarkably well. Their occasional failures have stemmed mainly from errors that were not of their own making. 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. Forced sales have driven down the value of the hedge funds’ remaining holdings, undermining their creditworthiness and triggering a further calling in of loans, further forced sales, and further losses. This vicious circle 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.
No, Sebastian, the trigger wasn’t subprime losses in the banking system, it was excess leverage in the hedge-fund system. If that hadn’t been there, the vicious cycle would never have happened.
Mallaby does concede the leverage point, attributing it to Brad Setser. But he still doesn’t believe in doing anything about it:
A regulatory cap on leverage could do damage, since the proper cap varies depending on a fund’s investment strategy. It would also be hard to enforce: after all, the Basel ratios are notoriously malleable. And starving well-managed hedge funds of credit is likely to reduce the efficiency of markets.
I don’t think anybody’s proposing simply applying Basel ratios willy-nilly to hedge funds, and certainly there would be problems with enforcement. But what is this damage that Mallaby talks of? It’s far from clear. And it’s just funny to see Mallaby talk about lower leverage reducing the efficiency of markets, just after he’s given a detailed explanation of how it’s excess leverage which causes vicious circles and their consequent inefficiencies.
Mallaby also seems to think that hedge funds can affect broad market levels, rather than just arbitrage away inefficiencies:
Hedge funds do not engage only in crowded trades. They have also acted as contrarians, betting against the crowd and so dampening the market’s volatility. When the subprime bubble was inflating, several hedge funds, notably an outfit called Paulson and Co., bet that it would pop. These funds not only made astronomical profits, they also prevented the bubble from growing even bigger than it did.
I doubt even John Paulson would buy that one. If one hedge fund buys a bunch of credit protection on mortgage-backed bonds, does Mallaby seriously think the entire housing bubble is going to stop growing? And once again it beggars belief to think that the actions of highly-leveraged hedge funds reall act to dampen the market’s volatility. Think back to last summer, when all the quant funds started unwinding their positions simultaneously and volatility spiked even as the broad stock market was largely unscathed. Clearly that was hedge funds causing volatility, not dampening it.
But Mallaby goes even further: not only can hedge funds stop asset prices from rising, he says, they can also stop them from falling.
Now that the bubble has burst, hedge funds will likely serve as opportunistic buyers of distressed assets, putting a floor under their value.
Hm. Did Warburg Pincus put a floor under the value of MBIA when it bought in for $1 billion at $31 a share? It certainly doesn’t seem that way now that MBIA’s stock is trading at $12. (And no, I don’t think there’s much of a difference, for these purposes, between hedge funds and private-equity shops.)
Mallaby does make one good point: that the Fed is now indirectly supporting the entire hedge-fund industry, at least insofar as it’s leveraged. But then he immediately backpedals:
The Fed has now offered to lend investment banks emergency money via its discount window, so it is backstopping these banks’ lending to hedge funds–and hence indirectly underwriting the high-wire acts in hedge land. If it turns out that this policy shift is costing taxpayers’ money, there may be a case for limiting hedge-fund leverage (just as the Basel capital-adequacy ratios are supposed to limit banks’ leverage). But for the moment the argument for regulation looks weaker than the argument for a hands-off approach.
The problem is that Mallaby never really makes the argument for a hands-off approach: he’s very long on bald assertions, and short on empirical evidence. He promises more of the latter in his book; I look forward to reading it. But so far he’s got more of a conclusion than a real argument.