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 book, More Money Than God: Hedge Funds and the Making of a New Elite, CFR Senior Fellow Sebastian Mallaby argues that governments should instead 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.
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 compared with the banking industry. 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. 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."
- 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."
- 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."
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 to a surprising and unrecognized degree, "the future of finance lies in the history of hedge funds."
A Council on Foreign Relations Book
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