empty pocketsThere are many stupid things you have to believe if you want to be taken seriously in financial matters. One of these is that free markets, those managed by brilliant Wall Street operators, allocate capital to its highest and best use. Apparently the highest and best use of $1.4 trillion dollars is hedge funds.

The whole point of hedge funds is speculation. Here’s a description from a paper by Michael King and Philipp Maier published in the Journal of Financial Stability (sorry, no link available, you can find this journal on-line at your public library):

A typical hedge fund is a private investment company that manages the funds of a limited number of wealthy individuals and institutional investors. A high minimum investment requirement, restrictions on withdrawals, and the limited audience (wealthy, “sophisticated” investors) allow hedge funds to remain unregistered and leave managers free to pursue proprietary investment strategies that would be imprudent for a more widely held mutual fund. Hedge funds use aggressive trading strategies designed to earn positive returns in all market environments, such as short sales, leverage, program trading, arbitrage, and the use of derivatives.

By wealthy and sophisticated, they mean any household with a net worth exclusive of house and personal property (cars and TVs) of $1 million. At the end of 2008, that was about 6.2 million households, about 5.5% of all households.

Hedge funds hire mathematicians and physicists, give them big computers and in return, they get formulas that use past financial market data to predict the future. Of course, real psychics are prosecuted for doing this. Why should you invest in a business, do all that hard work, and take actual risks, when you can hire geniuses to preserve capital, reduce volatility and risk, and deliver positive returns regardless of what happens to the little people in the financial markets?

And it isn’t just the $1.4 trillion, there’s leverage. About 80% of hedge funds borrow money from banks and others to increase the rate of return on their money. Hedge funds don’t report the amount of leverage, but King and Maier cite an estimate of average leverage for these companies of about 1 to 1 in December, 2006, when the money in hedge funds was a lot higher; it was an estimated $1.75 trillion at that date. The largest lenders to the hedge fund industry are huge banks, that provide brokerage services, loans, and are the counterparties to hedge funds. That means that another $1.75 trillion was pulled out of the lending pool and put into speculation, for a total of $3.5 trillion.

That is the highest and best use of money? Dumping it into the hands of a bunch of speculators to see if they can make money with derivatives and other junk investments? Let’s pretend it’s true that the best thing rich people can do with their money is to speculate with it. How does that “trickle down”? It doesn’t. That money is gone from the pool that might be invested in productive activity, a real concept no matter what professional economists and financial elites say.

King and Maier concede that failure of hedge funds can cause financial instability. But guess what? They don’t want to regulate hedge funds. They don’t explain any benefit from hedge funds, leaving us to assume that they believe that markets allocate money to its highest and best use and that any interference with that magic is evil and bad for you. They believe this so deeply it doesn’t dawn on them to discuss this critical issue.

Our authors reject the possibility of requiring transparency in the trading activities and positions of hedge funds. That would create a moral hazard, they argue, because management would assume that regulators would act if they thought there was too much risk. Even worse, it might expose the proprietary trading strategies of hedge fund managers.

Their solution is to rely on hedge fund counterparties, the too big to fail banks that provide all kinds of services to them, and compete with them by operating their own hedge funds.

The Journal of Financial Stability is my new favorite place to look for absurd rationalizations of the system that produced the Great Crash of 2008, and the Great Recession.

photo courtesy of  Phoney Nickle