Market Myth Four: Financial Markets Thrive when Regulation is Kept to a Minimum

People in the U.S. love to gamble; we spend billions on state lottery games, in Las Vegas and other gaming meccas, as well as betting on horses, football, and basketball. Moralists debate endlessly as to whether this is a harmless pastime or the mark of a declining civilization. But as John Maynard Keynes reminded us during the Great Depression, "When the capital development of a country becomes the by-product of a casino, the job is likely to be ill done." The role of hedge funds in the recent meltdown of the home mortgage market is a powerful reminder of his wisdom.

Market fundamentalists have reconstructed U.S. capital markets along the lines of a casino for the last two and a half decades. With the help of huge flows of money from the wealthiest households, financial “engineers” have created a whole set of largely unregulated investment vehicles that promise returns that are much higher than ordinary stocks or bonds. Using their political clout in Washington, D.C., they have been allowed to do exactly what Keynes warned against.

Hedge funds - large pools of money that are free to pursue very risky investment strategies because they fall under a loophole in the system of financial regulation - are one of their key achievements. They now have more than one trillion dollars under management in the U.S., and there is substantially more overseas since many of these funds operate through tax havens like the Cayman Islands. Their success in earning high returns has led both banks and pension funds to become business partners with, and investors in, these risky vehicles. One of the key factors in the collapse of Bear Stearns, the venerable Wall Street investment bank, was that several of their hedge funds suffered huge losses.

Hedge funds are free to borrow unlimited amounts, and in recent years, banks have fallen all over each other to offer them as much credit as they want. Thus, hedge funds can invest 100 million dollars in some very risky asset when they only have $10 million on hand. Why would they do this? If a subprime mortgage bond were paying interest of 12% per year, and the bank was willing to lend to the hedge fund at 5% per year, the hedge fund makes $700,000 additional profit for every extra $10 million they borrowed. But, of course, when those mortgage bonds went South, many hedge funds could not repay their loans and the global financial system began to seize up.

Hedge funds have been putting billions of dollars into asset classes that only a few people understand. For example, in 1995, a 34-year old mathematician from Cambridge University working at J.P Morgan invented something called a Credit Default Swap. Basically, a CDS is a way for owners of debt to insure themselves by paying a third party - usually a hedge fund - to assume the risk of default. This sounds good in theory, but in practice, CDSs were often traded recklessly among hedge funds and institutions, regardless of whether the new buyer actually had the ability to assume the risk they are taking on. They eventually came to have a staggering market value of over $45 trillion, and they helped fool the market participants into believing that they were protected if things turned bad.

The current recession is a direct result of major financial institutions being exposed to the risks created by hedge funds and these exotic financial instruments. Even firms as large as Bank of America have been impacted because of their substantial loans to hedge funds. Heavy losses among these major global banks have forced them to raise tens of billions of dollars in new capital, much from foreign governments.

The U.S. financial landscape currently resembles a glitzy Vegas casino, and the gamblers at the table are making bets large enough to bring down the house. J.M Keynes was right, and Treasury Secretary Paulson’s “market-based” reforms are not enough to straighten up these gambling addicts. The U.S. needs to regulate hedge funds, just like any other responsible asset class, and it should reinstate mandatory separation of investment and commercial banking activities. Not everyone, after all, wants their future to be riding on the fortunes of a casino.

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“Global Hedge Fund Assets surge to $1.5 trillion, US accounting for over $1 trillion” Metrics2.com. May 30, 2006. (accessed April 11, 2008)

http://www.metrics2.com/blog/2006/05/30/global_hedge_fund_assets_surge_to_15_trillion_us_a.html

Kohler, Alan. “Credit default swap vertigo.” Business Spectator. Feb. 28, 2008. (accessed April 11, 2008)

http://www.businessspectator.com.au/bs.nsf/Article/Credit-default-swap-vertigo-C3S5W?OpenDocument