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Government Should Encourage Investment in "Small Enough to Fail" Hedge Funds, Urges CFR's Sebastian Mallaby in New Book

June 14, 2010
Council on Foreign Relations

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In the aftermath of the global financial crisis, policymakers in the United States and around the world have focused on the problem of "too big to fail" institutions, debating remedies ranging from higher capital requirements to proposals to break up large banks. In his new book, More Money Than God: Hedge Funds and the Making of a New Elite, Sebastian Mallaby, senior fellow at the Council on Foreign Relations (CFR), argues the merits of an overlooked solution: Governments should encourage small-enough-to-fail hedge funds. Between 2000 and 2009, a total of about five thousand hedge funds went bust, but because they were too small to threaten the financial system, not a single one required a taxpayer bailout. Hedge funds "are safe to fail, even if they are not fail-safe," says Mallaby.

The author, director of CFR's Maurice R. Greenberg Center for Geoeconomic Studies, writes that, despite the failure of these five thousand funds, the hedge fund sector as a whole survived the 2007-2008 mortgage bubble extraordinarily well. It largely avoided buying the toxic mortgage securities that triggered the crisis, and often made money shorting them. Meanwhile, banks and investment banks were buying subprime mortgages by the "bucketful," leading to the largest government bailout in history. Mallaby outlines four reasons for this stark contrast:

- Regulation. The capital requirements on banks that accept deposits are intended to shore up the solvency of such institutions but, in some instances, allow banks to run their books in ways that the requirements suggest are safe even when they are not. In this case, "bonds backed by toxic mortgages were given the top (AAA) rating, partly because the ratings agencies were paid by the bond issuers, which dulled the incentive to be critical. Once the AAA seal of approval was affixed to subprime assets, banks were happy to hold them because capital requirements allowed them to do so without putting aside much capital. Regulations and ratings agencies thus became a substitute for analysis of the real risks in mortgage bonds." Conversely, hedge funds are far more likely to make their own risk decisions and thus frequently fared better.

- Incentives. "When [bank] traders take enormous risks, they earn fortunes if the bets pay off. But if the bets go wrong, they don't endure symmetrical punishment—the performance fees and bonuses dry up, but they do not go negative....Hedge funds [on the other hand] tend to have 'high-water marks': If they lose money one year, they take reduced or even no performance fees until they earn back their losses." Additionally, most hedge fund managers invest in their own funds—a powerful incentive to avoid losses. By contrast, while bank traders often own company stock, they do not risk their personal savings in the pools of money they manage. Mallaby concludes that consequently the typical hedge fund is more cautious in its use of leverage: the average hedge fund borrows only one or two times its investors' capital, and those that are considered highly leveraged generally borrow less than ten times, while broker-dealers such as Goldman Sachs or Lehman Brothers were leveraged thirty to one before the crisis, and banks like Citi were even higher by some measures.

- Distraction of multiple profit centers. "The banks' proprietary trading desks coexisted alongside departments that advised on mergers, underwrote securities, and managed clients' funds; sometimes the scramble for fees from these advisory businesses blurred the banks' investment choices." Mallaby points to the example of Merrill Lynch, which is said to have sold $70 billion worth of subprime collateralized debt obligations, or CDOs, earning a fee of 1.25 percent each time, or $875 million. "To feed their CDO production lines, Merrill and its rivals kept plenty of mortgage bonds on hand; so when demand for CDOs collapsed in early 2007, the banks were stuck with billions of unsold inventory that they had to take onto their balance sheets. The banks therefore became major investors in mortgages as an unintended by-product of their mortgage-packaging business."

- Culture. "Hedge funds live and die by their investment returns, so they focus on them obsessively. They are generally run by a charismatic founder, not by a committee of executives: If they see a threat to their portfolio, they can flip their positions aggressively. Banks are complacent by comparison. They have multiple streams of revenue and their funding seems secure: Deposit-taking banks have sticky capital that enjoys a government guarantee, while investment banks felt (wrongly, as it turned out) that their access to funding from the equity and bond markets made them all but impregnable."

More Money Than God argues that the government bailout resulting from the crisis has "compounded the moral hazard at the heart of finance: Banks that have been rescued can expect to be rescued all over again the next time they blow up; because of that expectation, they have weak incentives to avoid excessive risks, making blowup all too likely. Capitalism works only when institutions are forced to absorb the consequences of the risks that they take on. When banks can pocket the upside while spreading the cost of their failures, failure is almost certain."

Drawing on unprecedented access to the industry, including three hundred hours of interviews and binders of internal documents, Mallaby charts the history of hedge funds, telling the stories of the industry's pioneers, from the undercover anti-Nazi activist, A.W. Jones, to the philosopher-financier, George Soros, to the cryptographer and mathematician, James Simons. He concludes that, if policymakers are serious about learning from the 2007 crisis, they "need to restrain financial supermarkets with confused and overlapping objectives, encouraging focused boutiques that live and die according to the soundness of their risk management. They need to shift capital out of institutions underwritten by taxpayers and into ones that stand on their own feet. They need to shrink institutions that are too big to fail and favor ones that are small enough to go under." To a surprising and unrecognized degree, Mallaby writes, "the future of finance lies in the history of hedge funds."

Mallaby in the Wall Street Journal

In this Wall Street Journal article adapted from the book, Mallaby argues that hedge funds hold the key to a more stable financial system.

Advance Praise for More Money Than God:

"Packed with excellent information and great anecdotes . . . its clarity is an example to other financial authors."
Irish Sunday Business Post

"Engrossing."
Publishers Weekly

"A lively, provocative examination of a little-understood financial realm."
Kirkus Reviews

"More Money than God shines a fascinating light on what is still the most obscure route to becoming a billionaire—the mysterious world of hedge funds. Sebastian Mallaby's rollicking tour of industry legends—famous and otherwise—tells the improbable story of A. W. Jones, the vagabond journalist-sociologist and daring anti-Nazi activist who, after the war, would create the first "hedged" investment fund. From there, we get rip-roaring profiles of investing titans from the full-throated gambler Michael Steinhardt to the bold ťmigrť George Soros and the courtly stockpicker Julian Robertson to the ill-fated intellects of LTCM and the hedge fund stars of the present day. Even as Mallaby entertains he advances an unorthodox yet compelling brief: rich as they are, hedge funds are probably the best vehicles society has for assuming risk. Any who disagree will have to contend with the evidence of the recent Wall Street collapse. If one shudders at the prospect of concentrating risk inside giant banks whose chieftains wager other people's money and cavalierly call for taxpayer bailouts then, as Mallaby points out, hedge funds are a necessary antidote."
—Roger Lowenstein, author of The End of Wall Street

"Sebastian Mallaby takes us into the secretive world of hedge funds and the result is a wonderful story and an education in finance. The book is full of colorful characters playing high stakes' games. Throughout, with his customary intelligence, Mallaby helps us understand this important transformation of the financial industry."
—Fareed Zakaria, author of The Post-American World

"When Alfred Winslow Jones started the first hedge fund, he had no idea where it would lead. Sebastian Mallaby, who must be the keenest student of hedge funds anywhere, now does—and he shares it with you in this crackling good read."
—Alan S. Blinder, Gordon S. Rentschler memorial professor of economics and author of The Quiet Revolution: Central Banking Goes Modern

"A fascinating history. Mallaby combines vivid description of key personalities and episodes with thoughtful discussion of the sources of advantage for different investment styles in different periods of financial history. I enthusiastically recommend this book to colleagues and students in academia and asset management."
—John Y. Campbell, chairman of the department of economics, Harvard University, and partner, Arrowstreet Capital

To order, visit: www.cfr.org/more_money_than_god/

Sebastian Mallaby is the Paul A. Volcker senior fellow in international economics at CFR and a Washington Post columnist. He spent thirteen years at the Economist magazine, covering international finance in London and serving as the bureau chief in southern Africa, Japan, and Washington. He spent eight years on the editorial board of the Washington Post, focusing on globalization and political economy. His previous books are The World's Banker, which was named an Editor's Choice by the New York Times, and After Apartheid, which was a New York Times Notable Book.

Founded in 2000, the Maurice R. Greenberg Center for Geoeconomic Studies at CFR works to promote a better understanding among policymakers, academic specialists, and the interested public of how economic and political forces interact to influence world affairs.

The Council on Foreign Relations is an independent, nonpartisan membership organization, think tank, and publisher dedicated to being a resource for its members, government officials, business executives, journalists, educators and students, civic and religious leaders, and other interested citizens in order to help them better understand the world and the foreign policy choices facing the United States and other countries. Since 1922, CFR has also published Foreign Affairs, the leading journal on international affairs and U.S. foreign policy. CFR takes no institutional positions on matters of policy.

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