Delanceyplace.com 1/9/09--More Hedge Funds

In today's excerpt-Nobel-prize winning economist Paul Krugman describes the activities of hedge funds. The collapse of 2008 was largely due to the overleveraging of mortgage lending markets, which was enabled by a variety of non-bank institutions that operated at very high leverage ratios, including those hedge funds that invested in mortgage loans:

"Hedge funds don't hedge. Indeed, they do more or less the opposite. To hedge, says Webster's, is 'to try to avoid or lesson loss by making counterbalancing bets, investments, etc.' That is, one hedges in order to make sure that market fluctuations do not affect one's wealth.

"What hedge funds do, by contrast, is precisely to try to make the most of market fluctuations, The way they do this is typically to go short in some assets--that is, promise to deliver them at a fixed price at some future date--and go long in others. Profits come if the price of the shorted asset falls (so that they can be delivered cheaply) or the value of the purchased asset rises, or both.

"The advantage of this kind of financial play is that it can deliver a very high return to the hedge fund's investors. The reason is that the fund can take a position much larger than the amount of money its owners put in, since it buys its 'long' position mainly with the cash raised from creating its 'short' position. lndeed, the only reason it needs to have any capital at all is to persuade the counterparties to its asset shorts that it will be able to deliver on its promises. Hedge funds with good reputations have been able to take positions as much as a hundred times as large as their owners' capital: that means that a 1 percent rise in the price of their assets, or decline in the price of their liabilities, doubles that capital."The downside, of course, is that a hedge fund can also lose money very efficiently. Market movements that might not seem all that large to ordinary investors can quickly wipe out a hedge fund's capital, or at least cause it to lose its shorts--that is, induce those who have lent it stocks or other assets to demand that they be returned.

"How big are hedge funds? Nobody really knows because until quite recently nobody thought it was necessary to find out. Indeed, despite occasional warnings from concerned economists, and even despite the events I'll describe shortly, hedge funds have been left virtually untouched by regulation. Partly that's because hedge funds--needing only a limited amount of capital, from a small number of people--can and do operate 'offshore,' establishing legal residence in accommodating jurisdictions to free themselves from annoying interference. To police their operations wouldn't be impossible, but it would be difficult. Moreover, for a long time the general consensus, at least in the United States, was that there was no need."

Paul Krugman, The Return of Depression Economics, Norton, Copyright 1999, 2009 by Paul Krugman, pp. 120-122