Another Confused-but-Useful Newspaper Story on Hedge Funds

Michael Giberson

The Washington Post has a confused-but-useful article on hedge funds on this morning’s front page. From the second paragraph:

Hedge funds hold unparalleled sway over the financial markets, as confirmed by the recent unraveling of $20 billion in Bear Stearns funds. Portrayed as the new masters of the universe by author Tom Wolfe, hedge-fund managers are responsible for more than a third of stock trades and control more than $2 trillion worth of assets, according to industry researchers.

One fundamental problem the article fails to confront is explaining the supposedly vast and mysterious power hedge funds hold over the market in the presence of inconvenient facts like the “recent unraveling of $20 billion in Bear Stearns funds.” If these things are so powerful, why is it that we have a constant stream of funds going belly up? Here the author seems to think that the unraveling of the Bear Stearns funds somehow confirms the unparalleled sway hedge funds are asserted to have over financial markets. Huh?

A less serious analytical matter, but also suggestive of the general confusion of the piece, is the reference to Tom Wolfe’s Bonfire of the Vanities. That book, Wolfe’s first novel, was published in 1987. The “masters of the universe” in that book were bond traders, not hedge fund managers. While hedge fund managers of 2007 may bear some relation to the bond traders of twenty years ago, it seems a little confused to say the book portrayed hedge fund managers. Besides which, the book is set in New York City, while the article notes that the center of the hedge fund universe is Greenwich, Connecticut. Don’t the fact checkers at the Washington Post have access to the internet?

The article does allow that “the trouble at Bear Stearns is revealing that the system may not be as crash-proof as once thought.” But when was this “once thought”? Last year when Amaranth went down? Ten years ago when Long Term Capital Management tumbled? These aspects of the broader picture are mentioned in the article, but somehow hedge funds still get tagged as ominous, mysterious, and perhaps dangerously powerful entities.

Many questions about hedge funds have been raised for which the answers are unclear “even to top economists” (as the article puts it). And even scarier to some Washingtonians, “no federal agency is empowered to regulate or watch their activities.”

The article quotes Richard Bookstaber, author of A Demon of Our Own Design, on the dangers of mixing too much leverage with complex financial plays in the market. (I commented on Bookstaber’s book in two posts in April: First post, second post.) My inclination is to agree with Bookstaber that no one really knows how to value properly many of the complex financial derivative instruments that these large investment pools are trading. But that observation is not the show-stopper that some people think it is. Innovations are by their nature difficult to value well, but that only means that investments in innovative products will remain irreducibly risky. So is driving a car.

In addition to mentioning many of the relevant historical moments from the brief history of hedge funds, the article usefully describes the role that hedge funds have played in mortgage market and providing insurance to homeowners in post-Katrina New Orleans. The article doesn’t seem quite to have the big picture organized, and is simply confusing in parts, but nonetheless does assemble a number of interesting explanations about what is happening in one important corner of the investment world.