Hedging

The world is awash in books on the economic crash, and I have read only a couple, which I have reviewed here. In the last week I tried another one: More Money Than God, by Sebastian Mallory, about the rise of hedge funds. Mallaby, a financial writer, has worked very hard to put together the story of hedge funds since the 1970s, relying, inevitably, on a few spectacular figures, including George Soros, Paul Tudor Jones, and the operators of Long Term Capital Management, which famously crashed and required a Fed rescue effort in the 1990s. For the first time, I have some understanding of what hedge funds do and how they do it--and why they now attract so much of the best brain power that our country has to offer. Unlike Mallaby, however, I was not convinced that they are performing a socially useful function. Indeed, I think they are a profound symptom of what is wrong with us, and represent a problem requiring a solution--one that might not be hard to apply, were any of the necessary will lacking.

A hedge fund, of course, is a private, unregulated entity that invests in all sorts of things, from common stocks to bonds, foreign currencies, and, more recently, commodities--a development that Mallaby does not discuss. The operators of hedge funds use their own and other peoples' money, charging 2% a year to customers who give them their money, as well as a substantial share of any profits. Some of them are now handling billions of dollars. And their appeal becomes rather simple as soon as one grasps a simple fact. Hedge funds might more properly be called edge funds. They do sometimes hedge, that is, bet in effect on both sides of a trade to insure against losses, but they spend most of their time looking, like other gamblers, for an edge. An edge consists of any information, or analysis, tending to show that a certain tradable instrument is valued too low or too high at a particular moment. Because they dispose of so much money and use so much leverage, hedge fund managers have been able to score hundreds of millions of dollars of gains based upon a relatively small anomaly. Some of their simplest strategies involved identifying pairs of stocks--say, two domestic US airlines--whose value tends to move in parallel, and buying or shorting whenever one of them seems to be out of whack. One extremely successful firm, Renaissance Technologies, relied on analysts who knew very little about how markets actually worked, much less about what firms actually provided, but who could treat market statistics the way some analysts treat baseball statistics: they simply looked for patterns that would allow them to predict market movements without any sense of the underlying factors involved. For some time, at least, these tactics worked.

What ordinary citizens need to understand, however, it seems to me, is that hedge funds to not simply make money out of market trends. At critical junctures they have exaggerated those trends, on several occasions with consequences affecting the lives of many millions of people. In 1992, pioneering hedger George Soros and his collaborator Stanley Druckenmiller made perhaps a billion dollars (and other fund managers made about three times that) by betting against the pound sterling. The British at that time, like all governments inside the European Union, had committed themselves to maintaining the value of sterling within certain limits, and Soros and Druckenmiller were convinced that they could not. They sold pounds short in extraordinary volume--but such was the size of their position--perhaps $10 billion worth--that this inevitably started a run on the pound and made their preferred result not only more likely, but far more costly to the Bank of England, which, sadly, wasted billions of pounds in a futile effort to stop it. Variations of this story pop up repeatedly in Mallaby's book: many hedge funds take such large positions that they critically move the market. In addition, when they become over-extended, as they often do, any sign that they might have to unload positions to raise money threatens the value of their holdings as well.

Do hedge funds, which are designed to identify prices that are too high or too low, help maintain equilibrium in markets? The answer, frequently, at least, is no, and I suspect that I, ignorant though I may be, know the answer. To begin with, when the financial world is really in a frenzy, falling all over itself to acquire tech stocks in the late 1990s or subprimes just a few years ago, nothing will stop it. Several funds were nearly wiped out shorting tech stocks because, to quote John Maynard Keynes, the market stayed irrational longer than they could stay solvent. That was not the fund managers' fault. And yet, it seems to me, there is another reason why we cannot expect fund managers to stop the worst anomalies: because they generate the largest profits. Fund manager John Paulson (not to be confused with former Secretary of the Treasury Henry Paulson) made several billion dollars shorting subprimes in 2007. Much of this money came from the credit-default swaps--that is, insurance on subprimes--that he had purchased. Mallaby does not explain to us where that money came from, but I would not be surprised if was part of the many billions of AIG assets which the federal government decided to make good. That was not a socially useful profit.

I use Oliver Stone's movie Wall Street (the original, not the lamentable sequel) to illustrate the influence of Boomers like Gordon Gecko on financial markets. The tragic hero of that movie--tragic for us, not for himself--is Lou Mannheim, played by Hal Holbrook, a GI nearing retirement in the mid-1980s who tries to teach Xer Bud Fox the virtues of staying in the market for the long haul and identifying stocks with real value. That kind of strategy, carefully executed and assisted by sound national fiscal policy, enabled brokers to make a handsome, but not spectacular, living over the course of their careers. Hedge fund managers are gamblers who simply aren't interested in that kind of outcome. They dream of gigantic scores. Their goals, and their lives, are addictive. They often have to get up early in the morning to react to what markets in Asia and Europe are doing. Many of them finally retire when they suddenly realize that they have no time or energy to enjoy their millions or spend any time with their families. In Politics and War, in a chapter on the French revolutionary and Napoleonic Wars, I pointed out how destructive such behavior was when it became normal for European political leaders who felt free to redraw the map. I do not think it is less destructive in the economic world. Soros himself apparently had an epiphany after his sterling coup, abandoned high-stakes gambling, and began turning to philanthropy and genuine efforts to create a better world. He wrote recently that we live in increasingly irrational world. Hedge funds, I think, reflect that.

Mallaby believes in hedge funds. He notes, correctly, that their behavior was neither so reckless nor remotely so expensive as that of the big banks in the last crisis. He also cites studies claiming that hedge funds, as a group, have turned impressive profits over the last few decades, although he has to admit that such data are slippery because many losers have gone out of business without a trace. Gambling is an inherently unstable activity, and the mathematical theory of gamblers' ruin holds that every gambler will inevitably go broke sooner or later, especially if he keeps playing for higher and higher stakes. John Paulsen, the big winner in the subprime sweepstakes, has lost about 40% of the value of his fund this year. His days, too, may be numbered. Amazingly, neither in this book, nor, as far as I can see by scanning the titles of his recent columns in the Financial Times, does Mallaby have much to say about the impact hedge funds are having on the world economy right now. I would speculate (if you will pardon the term) that they have a good deal to do with the new commodities boom that has sent prices skyrocketing again, and it is inconceivable that they are not trying to profit hugely from the Greek crisis and the pressure on the Euro. If past experience is any guide, this will not help the European or world economy.

The United States, and to a lesser extent the rest of the western world, is in big trouble because of a crisis in values. The idea of a safe, steady income, so influential at almost every level of society in the middle of the last century, is now hopelessly passe. (I am here to tell you that such an income can still provide a very happy life.) Hedge funds and megabanks are still gobbling up an astonishing portion of the brain power coming out of American universities and professional schools every year--brain power that could plan better cities, improve American manufacturing, teach students who want to learn, perhaps even reform government. Clearly we will go through more financial catastrophes before we do any fundamental rethinking of where we are and how we got here. That is why I am increasingly inclined to believe that the men and women who really will put things on a new and much sounder footing may not yet have been born.

Europe, however, is still in certain respects a hold-out. In one of the more affecting passages of the book, Mallaby describes how certain funds became interested in the German economy in the 1980s and 1990s, both before and after reunification. Initially, looking at the balance sheets of German companies, they found their stocks to be drastically undervalued. But they discovered that German companies had different values: they were actually more interested in keeping more people at work than in maximizing the bottom line. Germany, of course, still focuses on such things because Germany, more than any other modern nation, experienced the consequences of catastrophic political and economic failure, whose memory survives even though the adults who lived through Nazism are now dead. The western world now depends on Europe to keep sanity alive during the current crisis, just as, 80 years ago, it depended on the United States.