The good part is that they can make huge amounts of money, but they can also be very risky. Here is the problem, there is an incentive for many of these institutions to invest in hedge funds because of their very large returns. This increases risk in four ways: 1. Many of these investments are not well understood even by the investors. There is a huge amount of risk to our financial system by mainstream institutions being too heavily invested (think 1920's stock market crash). 2. The vast amounts of money and secretive nature make them more conducive to market manipulation. 3. They are basically unregulated. 4. There is pressure from institution to institution to be competitive. If one bank sees a 20% return a year over 5 years by using a risky hedge fund, it becomes increasingly difficult for other institutions to continue to invest more conservatively.
The other problem is that they are running out of large investors to invest in their funds and are starting to look at upper middle class people to fuel continued growth. This presents huge problems...
Here is the key, don't think of hedge funds like a mutual fund. They can literally invest in anything, which means they can invest in things like subprime mortgages (AZ Republic). Look at the example of Conseco Insurance which went bankrupt because of risky subprime lending(although this is not hedge fund related per se, it shows the danger of these schemes). Of course, who can forget when Orange County California went bankrupt because of derivitives investing, which is used in a lot of hedge funds. How about the case of Metallgesellschaft AG of Germany and Barings PLC of England both losing over a billion dollars in the derivatives market in a very short time. At Barings, the trader hid the loses for fear of losing his job... derivatives can be highly profitable, but extremely risky. Derivatives can be almost anything and are frequently so complex that you need a math professor to explain them (seriously...).
This quote from the AZ Republic article sums another area of risk:
"Wall Street firms and money center banks financed the leveraging up of hedge funds that purchased the exotic and illiquid fixed-income securities produced by the very same Wall Street firms and money center banks," he said in a note to
clients.Given the already apparent fallout in the subprime mortgage market, lending standards have shot up and the market for such investments has deteriorated. But that won't erase what already is out there, which is ugly and could get worse.
At the heart of this is a difference of opinion between the belief that market is inherently rational or whether society has an interest in protecting the public from some of the irrational behaviour that crops up from time to time that could disproportionally hurt unsuspecting members of the public. There is also the issue of bailouts paid with tax dollars that would be sought after a meltdown.
There are a few things here that I think are germane: 1. The market can be irrational in the short-term which can cause a lot of pain to the general public. We should do a cost/benefit when considering regulation of markets with a bias towards the public interest. 2. Industry cannot seek to kill regulation and expect bailouts when they lose a bet. 3. There is a national security aspect to this that is not being addressed. Many of these hedge funds are being heavily funded by people like the Saudis and the Chinese are entering the private equity market. Investment is good, but we should do our best to control risks to our economy.
That is it for my borefest of an entry...
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