Do Hedge Funds Need More Regulation?

One of the sort-of targets of current financial regulation efforts in Washington are hedge funds. I say "sort-of," because they certainly aren't by any means a central focus, but they won't emerge unscathed. At the very least, the government will likely require stricter oversight of these investment vehicles that cater to ridiculously wealthy individuals. But does the role they played in the crisis warrant greater regulation?

Most hedge fund managers would probably answer: what role? That's essentially Peter Thiel's response. He's the president of Clarium Capital Management hedge fund, and the founder of PayPal. He addressed this question during an interview for the Big Think's "What Went Wrong" series.

He says:

I think part of the reason for this misplaced focus on hedge funds can be traced back to the long term capital disaster in 1998 where excess leverage threatened the entire financial system and the place where leverage showed up was in this unregulated vehicle, e.g., long term capital, but then all of a sudden impacted everybody else in unforeseen ways. And so, in some ways, since '98, the regulators have been fighting the last war and worrying about hedge funds that were excessively leveraged and would blow up the system.

I think hedge funds were not excessively leveraged; even the funds that used significant leverage did so in a way that was relatively transparent and known to their investors and were perceived as high risk. The problem is not with leverage, but with hidden leverage and hidden leverage existed in places like the large money center banks, AIG, the insurance companies, and perhaps the biggest of all were Fannie Mae and Freddie Mac, which were seen as relatively safe because of some kind of implicit government guarantee, but were in reality long term capital on a much bigger scale. And the real long-term capital was Fannie Mae. It was not the hedge fund industry.

Given his inherent bias in favor of hedge funds, this response probably isn't surprising. But I don't think the fact that he's pro-hedge fund should lead anyone to dismiss what he says.

In fact, I mostly agree with Thiel. He doesn't think that hedge funds were overleveraged, but he believes other sorts of financial institutions were. My recollection of the problems during the crisis confirms that. No hedge fund got a bailout. I also don't recall big banks complaining that hedge funds were causing them to fail because the funds couldn't make good on loans.

Actually, the resilience of the hedge fund market has surprised me. Sure, some have failed, but given how poorly the market did in 2008, any fund with too much leverage would have quickly folded if it had made truly awful bets. Yet, most funds are still intact. Indeed, the banks evidentially made much worse bets and had more hidden leverage, since virtually all the big ones would have failed without government intervention.