Hedge funds

James Mackintosh

Barack Obama has decided to side with a state solution, if not yet a well-thought-out one, to preventing bank failures bringing down the world economy. But there is a market alternative: fix the banks so the bondholders keep bank risk-taking under control – and bear the costs if they fail in that task.

This important debate is not being framed as a state vs market discussion, but it should be. Remember state control has a dismal record in general, and in the finance sector in particular. Regulators entirely missed the bubble, missed the banks’ reliance on short-term financing and missed the fact that so much regulatory arbitrage was going on. Don’t expect things to be much different in 20 years if a state solution is accepted.

The problem is the banks (and potentially non-banks) being too big to fail, creating perverse incentives to take risks and leaving the taxpayer paying for mistakes. The state solution accepts banks are too big, but tries to control that through regulations, restrictions on what they can do (no prop trading or hedge funds), and potentially a cap on size.

A working market solution would obviously be better, as it would be pretty much immune to the high likelihood of regulatory capture – but can a market solution be made to work? I think so.

James Mackintosh

Barack Obama is finally taking on Wall Street, apparently prompted to action by the voters of Massachusetts. But he’s taking the wrong approach.

There are hundreds of competing ideas on how to stop the banks needing trillion-dollar bail-outs. Obama has chosen three, but they are the wrong three:

1. No proprietary trading
2. No owning or “sponsoring” hedge funds or private equity
3. A cap on size for deposit-taking banks

This is not to defend the banks: they made some stupid decisions, helped out by an unending appetite for cheap debt from consumers and a global debt bubble created by China’s surplus, America’s over-consumption and Alan Greenspan’s Federal Reserve. It is right that the banks should be reformed, to prevent future bail-outs.

But these actions fail to get to the root of the problem. The banks had acted just like any other borrower when presented with cheap debt (and dumb regulators): they borrowed as much as they could (often leaving them an astonishing 50 times geared), and found ways to use it from which they thought they could make money. Lenders to the (big) banks exercised no control, because they thought – correctly – that they would be bailed out if the banks failed.

The best way to fix this problem is to find a way to allow the banks to fail. If this can be put in place, the market will itself control the banks, by increasing their cost of borrowing when they take bigger risks (more transparency may be required). If investors fail to control the banks they invest in, the bank can be left to go bankrupt – as smaller banks already do. Bondholders would lose the bulk of their money, as their bonds convert into equity, either by making all (or perhaps just most) bonds explicitly convertible, or through laws requiring conversion if a bank fails.

James Mackintosh

So it is Barack Obama vs Wall Street, and both sides are pulling no punches. But while Obama has singled out the banks, hedge funds are seriously threatened too. Here’s Obama:

My resolve to reform the system is only strengthened when I see a return to old practices at some of the very firms fighting reform; and when I see record profits at some of the very firms claiming that they cannot lend more to small business, cannot keep credit card rates low, and cannot refund taxpayers for the bailout. It is exactly this kind of irresponsibility that makes clear reform is necessary.

Banks which have Federally-insured deposits or access to cheap Federal Reserve funds (such as Goldman Sachs) will be banned from trading for their own account or owning hedge funds or private equity, while those choosing to become pure investment banks will have a ceiling on assets.

According to the White House announcement the proposal would:

1. Limit the Scope-The President and his economic team will work with Congress to ensure that no bank or financial institution that contains a bank will own, invest in or sponsor a hedge fund or a private equity fund, or proprietary trading operations unrelated to serving customers for its own profit.

2. Limit the Size- The President also announced a new proposal to limit the consolidation of our financial sector. The President’s proposal will place broader limits on the excessive growth of the market share of liabilities at the largest financial firms, to supplement existing caps on the market share of deposits.

This is great news for the hedge funds: they will face less competition from the banks, which do much the same thing with their own money, often on a larger scale. But it is also terrible news: the banks will have to dump holdings in huge numbers of hedge funds, including some of the world’s biggest. On top of that, they won’t be able to buy any more, removing the most common exit route for hedge fund managers wanting to cash in. For private equity this does not seem so serious, although the big private equity groups will benefit from the lack of competition from all the banks’ PE arms.

There appears to be worse news for the denizens of Greenwich, Connecticut and Londons’ Mayfair. According to the Wall Street Journal’s story:

Under the proposed rule, commercial banks would be prohibited from owning, investing in or advising hedge funds or private equity firms. Bank regulators would not be simply given the discretion to enforce such rules. They would be required to do so.

Apart from the problems of dumping their hedge fund stakes – of which there are hundreds, notably JP Morgan’s Highbridge, Morgan Stanley’s FrontPoint and Goldman Sachs Asset Management – a ban on “advising” hedge funds would appear to kill much of the lucrative banking business of prime broking, servicing hedge funds (assuming the WSJ isn’t just mixing up “advising” and the ban on being a “sponsor” of a fund, whatever that means).

If lending money to hedge funds can survive as a non-advisory, purely automated business, it could be good news for the biggest funds which can do much of the work in-house, by driving down the price of loans even further.

But for the small and mid-sized hedge funds, having no prime broker to hold their hands and introduce them to potential investors will require a major culture change, or a move onto a hedge fund platform.

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Christopher Cook is an FT editorial writer. Before joining the FT in 2008 as a Peter Martin Fellow, he worked for three years for the Conservative party.

Lorien Kite is deputy comment editor, a post he took up in 2009 after four years as a commissioning editor on the analysis page. He joined the FT in 2000.

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