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Monday, October 06, 2008

Sebastian Mallaby makes an argument

the key financiers were the ones who bought the toxic mortgage products. If they hadn't been willing to buy snake oil, nobody would have been peddling it.

Who were the purchasers? They were by no means unregulated. U.S. investment banks, regulated by the Securities and Exchange Commission, bought piles of toxic waste. U.S. commercial banks, regulated by several agencies, including the Fed, also devoured large quantities. European banks, which faced a different and supposedly more up-to-date supervisory scheme, turn out to have been just as rash. By contrast, lightly regulated hedge funds resisted buying toxic waste for the most part — though they are now vulnerable to the broader credit crunch because they operate with borrowed money.

Mallaby's argument, to the extent that he has one, is that hedge funds were regulated even less than investment banks and did fine. He is basing his claim on anecdotal evidence.

Since hedge funds are almost un-regulated, we don't know how well they are doing on average. They report once a quarter. Their investors can withdraw funds once a quarter.

Mallaby has made his argument invulnerable to mere facts by claiming that current and future problems for hedge funds are spillover "— though they are now vulnerable to the broader credit crunch because they operate with borrowed money." So the only relevant evidence is that hedge funds didn't fail during the period when their investors couldn't withdraw funds.

Also, hedge funds have limited leverage, because their counterparties don't allow them to lever up. Those would be investment banks. IIRC typically each REPO account of a hedge fund can lever up only 50 fold. This implies a much lower overall leverage. I'd guess that Bear Sterns had higher leverage than any hedge fund.

Finally, of course, hedge funds are highly regulated. They can accept investments only over $100,000 and, so, deal with large agents who should invest in information gathering, and which are few enough to coordinate in avoid a hedge fund run. They aren't covered by other regulations, because that huge regulation makes them relatively stable.

Via Kevin Drum who writes a more thorough refutation of Mallaby's nonsense. The link between specific acts of deregulation and specific financial catastrophes is very clear.

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