There is no substitute for good timing. No one knows that better than those who write about financial markets.
Bad timing, on the other hand, can be funny in its own way. A copy of a popular business magazine, for example, arrived the day after stocks had decided to take a little bath. On its cover, in large type, was the title of a featured article, “Is the bull market just beginning?”
Only a few days before the market’s hiccup, the president’s Working Group on Financial Markets announced their decision that hedge funds did not need regulating. The timing of the decision was awkward at best – not as funny as the “bull market” headline, but still unfortunate. When stock prices began to fall in markets around the globe, in fact, some analysts looked immediately to hedge funds – suspecting them of either causing or aggravating the downturn.
It does not appear that hedge funds had a hand in this market glitch. It seemed instead to be caused by investors’ choosing to reallocate assets, mostly from stocks to bonds, to fit their changed perceptions of risk and economic outlook. Still, hedge funds remain on the “usual suspects” list, in part because of their mystery-math computer models that drive their market positions. These models, and the complex nest of financial derivatives they weave, have never really been tested in a full scale global market correction, and so remain a question mark in terms of being a force for good.
The Securities and Exchange Commission has been calling for closer scrutiny and regulation of hedge funds. Its latest proposal would further restrict participation to those investors with at least $2.5 million in net worth, excluding the value of their home. Current requirements call for $1 million in net worth from any source, or an annual income of $200,000.
The SEC has not had much luck with its regulatory proposals recently, though, and is not likely to fare much better with this one. And the truth is that the SEC’s idea of restricting participation is not as relevant as it would have been a few years ago. Hedge funds have not just grown; they have morphed into a different organism.
At their inception, hedge funds were an investment form that allowed wealthy investors to play at high-stakes tables and take on managed, sophisticated risks that were not generally available to the public. Now the funds’ engine of growth is their appeal to institutional fund managers. A recent McKinsey &Co. study indicates that by the end of this year institutional investors, including pension funds, will account for over half of the money flowing into hedge funds.
The immense size of hedge funds – $1.4 trillion at last count – presents our economy with what is called “systemic risk.” The U.S. Treasury Department’s undersecretary for domestic finance, Robert Steel, defines this risk as “the potential for financial distress in a particular firm or group of firms to trigger broad spillover effects in a financial market or system.”
Systemic risk is essentially the “domino effect” dressed in more respectable clothes. When a hedge fund goes down, there is a risk that it will bring down its creditors and its trading partners along with its investors. Its creditors are often banks these days, and its trading partners are key Wall Street financial institutions, so the impact could be disastrous.
Another effect of systemic risk is to harm people who had no stake in the deal. Because of the raw size of hedge funds, this means pretty much all of us. Even if we have no actual connection to a hedge fund, if a large one goes down and rocks our financial markets, our economy will suffer and so, eventually, will we.
The president’s Working Group on Financial Markets is led by the Treasury Department and has decided to issue guidelines instead of proposed regulations. The group’s belief, shared by Federal Reserve Chairman Ben Bernanke, is that the self-interest of creditors, trading partners and investors who do business with the hedge funds will “provide the very best protection against systemic risk.” In other words, the market is its own best regulator.
This is a very popular idea on Wall Street and, generally, in the business community, but it is flawed by its over-reliance on self-interest. For hedge fund participants pursuing their own self-interest, risk is perceived, calculated and balanced against reward. But third parties, like the public, get to share only the risk half the equation. They have no stake in the reward.
A policy based on this kind of imbalance of risk and reward deserves to be reconsidered, not applauded. And maybe we shouldn’t wait for the next thud before we do it.
James McCusker is a Bothell economist, educator and consultant. He also writes “Business 101” monthly for the Snohomish County Business Journal.
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