Hedge Funds: The Next Big Headache for Obama?

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On financial reform, it’s one week down, one week to go. Lawmakers are in the middle of hammering out differences between two Wall Street regulation bills, one passed by the House and one by the Senate, aiming to have a final bill over to President Obama before he attends the G-20 summit in Toronto this weekend.

As they clamp down on consumer protections and proprietary trading, however, there’s one corner of the financial world with which they might want to use a light touch. According to Sebastian Mallaby, author of More Money Than God: Hedge Funds and the Making of a New Elite, hedge funds are the best risk managers around, meaning as Congress squeezes out risky behaviors from the big financial conglomerates, we would all be best served letting small unregulated hedge funds pick them up. NEWSWEEK’s Katie Paul spoke with Mallaby about the case for hedge funds.

As Congress considers its regulatory overhaul, why do you think hedge funds need to be looked at differently than other financial organizations?
The basic approach on the Hill is to look at who took too much risk and to squeeze them so they take less risk in the future. If you squeeze risk out of the big banks, the risk will migrate elsewhere, and you need to think about who will take it on. Finance will continue to be risky, because it is based on uncertain promises about an unknowable future—currencies will carry on fluctuating, interest rates will continue going up and down, excruciatingly difficult decisions will still need to made about how to allocate capital among thousands of companies, which may or may not use that capital well. The question is: who should take that risk? I say, hedge funds have shown themselves to be better at taking that risk than almost any other type of financial vehicle. They were the one group that didn’t take a penny of taxpayer bailout.

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Hedge funds are largely unregulated currently, but there are some minimal guidelines. Could you explain briefly under what restrictions they currently operate, and how that might change with the new legislation?
The basic thing is that the hedge funds themselves are not regulated, but their activities often are because they trade on regulated markets. They’ve always been subject to insider trading rules and other antifraud provisions of the law. But they haven’t been registered with the SEC. That changed a few years ago when the SEC began to require registration, but it was struck down by the courts, so it became voluntary. In the emerging legislation, we’re going to see a rule that says if you have $100 million of equity in one hedge fund, it’s got to be registered with the SEC.

You propose a three-tiered system for regulating hedge funds, letting the smallest ones operate relatively unchecked, imposing some controls on mid-size ones, and requiring stringent checks on the largest funds. How does that square with Congress’s proposal?
In my view, the $100 million hurdle is crazy. It’s much too low. I propose a hurdle of $120 billion, to start. At $100 million, a fund is systemically insignificant. It could blow up, and it won’t matter for capital markets or even for other funds doing business with it. Forcing a hedge fund of that size to register just jams up the SEC with paperwork and distracts them from going after the real guys who might cause trouble. It also raises the barrier to entry for small hedge funds, which is the opposite of what public policy should do, which is to encourage smaller entrepreneurial boutiques. If you don’t like too big to fail, then small enough to fail should be preferable.

You talk a bit in the book about hedge funds that sometimes behave like investment banks, and vice versa. How do they compare?
The origins of today’s modern investment banks—Goldman, Lehman—were in private partnerships. These were not publicly traded companies, so they were not managing others’ money, but managing their own money. That’s rather like a modern hedge fund. They pay a lot of attention to risk control, because they have their own money in the game. For investment banks, however, the ones that survived as private entities got bigger and bigger, and eventually issued stock in themselves. That changed the incentives. Once you’re managing other people’s money, you worry less what you might lose. That led to the creation of these globe-spanning companies, which in the end all failed in one way or another in 2008. We should learn from that history, and recognize that hedge funds have stayed very good about managing risks.

Should hedge funds be barred from going public, in that case?
I’m not in favor of ruling it out, but I am in favor of leaning against it by creating more stringent regulations for the funds as they get bigger. It’s completely wrongheaded to force registration of small funds. You should be completely hands off until they get really big, and then you should start imposing very boring, onerous, expensive regulations on them for getting so big. Instead of banning going public, you create a cost for going public.

Beyond the $100 million cap, do you support the Volcker rule?
In principle it pushes in the right direction. My argument in favor of hedge funds is that too big to fail is bad, and small enough to fail is good. By extension, I don’t particularly favor hedge funds inside big banks, because the parent company is too big to fail. You saw that in the 2008 crisis, when parent companies were bailing out their hedge funds. That encourages the hedge funds to take on huge risks, because they know they’ll be rescued by deep-pocketed parents. I’m in favor of the Volcker rule because it tells banks they can’t own hedge funds. It also goes a step further, to say can’t have undeclared internal quasi-hedge funds—in other words, proprietary trading desks. My worry there is implementation, because it’s difficult to draw the line between legitimate client-related hedging and a big bet taken with its own capital. The first part of the rule is unambiguously good. The second part is good in principle but tricky in practice.

Why do you consider it a good thing when a hedge fund trades with its own funds, but bad when a bank does proprietary trading?
When a hedge fund trades with its own money, it’s literally the personal savings of the hedge-fund manager, who nearly always puts his or her own money into the pot. That really focuses the mind. It’s a totally different proposition at a proprietary trading desk within a big bank, because it’s the shareholders’ money, not the trader’s money. The incentive for the traders is to take as much risk as possible, because if they get it right they get big bonuses, and if they get it wrong the worst case scenario is that the stock goes down, which doesn’t impact them directly.

In moving this risk out of the Goldman Sachs and Morgan Stanleys of the world into hedge funds, how do you prevent hedge funds from becoming the behemoths you just broke up?
There’s no guarantee against them following the same trajectory as the investment banks in the future—of gradually getting bigger, going public, relaxing their risk controls, and eventually posing a risk to the system. But for the moment, they’re not behemoths. They’re the one part of the financial system that wasn’t bailed out in 2008.

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