Hedge funds as heroes
In the autumn of 2008, during the worst global banking crisis since the 1930s, I was interviewed by French television and asked to explain the malevolent role of hedge funds in causing the mess we were in.
When I said that hedge funds were really not at the heart of the matter, the interviewer was shocked and disappointed. She was in London on a mission to tell the truth to her viewers about the malignancy of hedge funds, and her script did not allow for a different version of events.
Some would say that the European Union's determination to drive through a directive regulating hedge funds and private equity is a manifestation of the same blinkered vision.
It's not that a bit of additional regulation might not be useful. More transparency about their activities, formal limits on the amount of debt or leverage they can take on, these could be sensible safety precautions, to limit their potential to wreak damage to the financial and economic system.
But there is a strong argument that proponents of the new directive are missing the big and important points by a mile. Which means that the passionate and obsessive determination of some EU members to see the directive enacted can be seen as a bit silly (at best) - especially at a time when the real flaw in the financial system, the structure and regulation of banks, is a long way from being fixed.
There are two important points.
First, the actual harm that hedge funds and private equity may have wreaked in the creation and course of the credit crunch could probably be much better tackled not by regulating them directly, but by new restrictions on the banks that service them and take credit from them, and on the financial markets where they trade.
There are five kinds of harm that hedge funds and private equity may have caused, all of which are fixable without a directive that imposes new direct constraints on hedge funds and private equity:
1) Some financial institutions, such as Bear Stearns and Lehman Brothers, became dangerously dependent on short term credit provided by hedge funds. But that's fixable by imposing tough new requirements on such investment banks to raise much more longer-term finance that can't be withdrawn on a whim.
2) Many believe that hedge funds have destabilised banks such as HBOS and even entire economies, such as Greece, disproportionately to the fundamental weakness of such banks and economies, by their ruthless financial speculation that such banks and economies were heading for the knackers. Now, to be clear, that hypothesis is by no means proven. Some would say that in such cases hedge funds are the public-spirited early warning system (please don't shoot your computer). But if you think that it's wrong to allow the mafia to take out an insurance policy on your house that delivers the mob a profit when your house burns down, which is how some would see naked CDS shorts on bank debt or government bonds, then ban those insurance policies, prohibit naked CDS shorts. But that's product regulation, not regulation of institutions such as hedge funds.
3) Hedge funds have provided a market for some of the newfangled financial products, such as CDO squareds and cubeds, that decimated the balance sheets of banks. But if you don't like the toxic new products, regulate their development or the extent to which banks can load up their balance sheets with them.
4) Banks have suffered big losses on their loans to businesses acquired by private equity firms. But that is eminently sortable by constraining banks' ability to lend to over-indebted companies and institutions.
5) Finally, the massive rewards earned by the partners in some hedge funds and private equity firms helped to encourage the spread of a pernicious short-term bonus culture in banks. But let's be clear about this. First of all most hedge fund and private-equity partners are at least putting some of their own money at risk (although some would say nowhere near enough), which almost never happens in banks. More germanely, hedge funds and private equity surely can't be held accountable for the abuse of their remuneration system by other institutions.
And then there's the humungous final point, which is the one that the proponents of the EU directive in the French and German governments simply don't wish to acknowledge. Which is that there is a powerful argument - if you believe in capitalism - that hedge funds are in one overwhelmingly important respect a model for how the banking system should be reformed, and absolutely not a financial tumour that needs cutting out.
The fact is that hundreds of hedge funds went bust over the past couple of years. And there wasn't a single one, for all the billions of dollars of investors' money they controlled, which needed to be bailed out by taxpayers.
Why was that?
Well it was probably not because of brilliant regulation by the likes of the Financial Services Authority.
The much more compelling explanation is that they were subject to the direct engaged oversight of their investors and creditors, which limited hedge funds' ability to take unaffordable risks. It never occurred to those providing finance to hedge funds and private equity firms that the state might provide them with a safety net. So those creditors and investors made sure that those hedge funds and private equity firms only speculated what they could afford to lose.
This is the important big contrast with banks, where investors and creditors knew that if everything went wrong, taxpayers would be there to pick up the bill. Which meant that those investors and creditors had less of an incentive to prevent banks from betting not only the farm but the entire landscape.
On that view, we would want banks to become more like hedge funds, not regulate hedge funds out of existence. Or to be more precise, the investment banking bits of the likes of Barclays, Deutsche Bank or BNP Paribas should perhaps be hived off and shrunk, so that there would be no reason for taxpayers to bail any of them out if they ran into difficulties.
Some would therefore argue that if the French and German governments really want to make the financial system safe, they would start by dismantling their enormous complex universal banks. The consolidating power of these sprawling banking conglomerates may pose much more of a threat to future financial stability than hedge funds.