<p>Balto-
My mistake on CDO’s, as you point out they are collateralized debt obligations, credit default obligations are another type of instrument and I confused the two, but it was clear from my posting that I was talking securitized mortgages, I simply mistranslated to the wrong CDO…</p>
<p>As far as Bear Stearns goes, the hedge funds weren’t the canary in the coal mine, they were what ended up bringing them down, their losses were large enough and their exposure big enough to drive them to bankruptcy…yes, there were other issues there, but their hedge funds, that had gambled to a ridiculous level with CDO’s and also on borrowed money, were just too large for them to survive. Bear also had exposure from their investment banking portion and in trading, but the hedge funds are what gutted the company. </p>
<p>As far as the flash trading goes I am aware that the initial ‘bad basket’ or whatever you want to call it came from a mutual fund, it could also have come from all kinds of different types of portfolio trading. My point, or at least the one I was making, was that hedge fund trading, triggered by that initial ‘bad basket’, was large enough to help create the cascade that took down not just equities, but pretty much other markets like Forex and the like as well, and it is because hedge funds trade across all markets, that is where their name comes from, that is what their investment strategy is, using models to hedge risk and arbitrage across markets. </p>
<p>I don’t have any particular love or hate of hedge funds, that was never my point, nor do I love or hate mutual funds, which have had their own problems and issues as I pointed out. My point about hedge funds is I believe they do bring systemic risk, that the combination of their size, the way they trade and the fact that most of what they do is secretive and is not subject to the kind of trading rules that govern more regulated areas of the industry. Someone in a hedge fund could, for example, engage in market timing (which among other things can cause huge swings at the market close, not to mention hurt other participants). Hedge funds are also unique, because their trading goes across many markets, their trading involves forex, otc derivatives, options equities, commodities, otc commodities, equities and so forth, many of which involve very different regulators, not to mention that their trading also goes across international boundaries, that have their own regulations, and this is quite different then with other types of trading/investment funds. When hedge funds represented a relatively self contained universe of a relatively small group of limited partners of high wealth, that kind of arrangement was okay, because their leverage on the broader markets and impact was limited; but with their growth, and also that these have become in effect de facto general purpose funds they have grown too big to duck the regulations that impact other firms.</p>
<p>And also, obviously, with the light regulations on hedge funds there is more room to cheat, and one thing that history has shown us time and again on the markets, that unregulated trading eventually leads to a meltdown (unregulated or not bothering to regulate are pretty much the same thing in outcome; I agree the SEC and other bodies need to actually do their jobs, which means among other things convincing free market types that regulation isn’t evil and not all financial people act rationally. The SEC has been gutted over the previous 20 years, and most of this decade seemed to operate more in the mode of ‘get out of the way’ then do their job).</p>
<p>Want a prime example of this? Credit Default Swaps, that once upon a time were relatively small fry on the markets, were for all intents and purposes unregulated, and most of their trading was done bilaterally, which boils down to a private contract done over the phone. There were no clearing houses required, no escrow positions to cover possible losses, and there weren’t even requirements that a particular instrument could only have one CDS against it, these were private agreements…and when the CDO market blew up, the many CDS’s issued against them became do, to the tune of hundreds of billions of dollars. AIG’s bailout was primarily because they had gone wild in the CDS market, issuing literally well over a hundred billion in them, made some decent money in them before the CDO market crashed, and then found itself failing and needing a huge bailout. If CDS’s had been traded on exchanges [or more importantly, cleared through a regulated clearing house), if there had been reporting rules and capital rules on issuing them, on debt standards, of escrow accounts against failure, the mess wouldn’t have happened. As with hedge funds, when these were small, exotic instruments trading them bilaterally over the phone was okay, and if they failed, it was unlikely to threaten major assets of the economy; when they started becoming huge, covering transactions in the multi billions of dollars with huge positions, leaving them unregulated led to the meltdown we saw. </p>
<p>Like I said, I am not anti anything, I think hedge funds have a major role to play in the markets and will, but there are things that need to be addressed with them. Mutual funds, for example, are not leveraged (I am not sure why, if that is tactical on their part or regulation) but even to this day hedge funds operate with a large amount of leverage, which among other things if they fail can mean a major problem with the commercial banking system, since they are allowed to lend money to hedge funds, something I don’t think they should be allowed to do, or at least limit their exposure so they aren’t leveraged 65 or 70 or more to 1. Likewise, hedge funds have basically no rules on shorting markets, which can help destabilize markets due to the size of their positions and the way they trade.</p>
<p>Yeah, regulation isn’t a panacea, regulators generally are keeping up with the day before yesterday rather then today, and generally have everyone trying to cut them off at the knees, but they can effect change as well. Thanks to data being available in the late 1990’s , an academic study of markets and pricing concluded that the OTC equities markets were maintaining high spreads, which generated an SEC investigation that led to major changes in the markets (among other things, they caught market makers on tape threatening other market makers if they undercut their bid/offer prices on the broadcast quote, threatening to deny them order flow on other stocks if they undercut this one), and led to more consolidation of market trading that brought down spreads and gave people better prices then they had been able to receive, among other things. Letting something like hedge funds or any trading fund with the kind of impact they have with very light regulation is a major risk, and how do you enforce regulations when there aren’t any? More importantly, without the regular reporting rules other trading firms have, how do you detect when things are problematic? As with the credit default swap market, there was no way to detect the problem until it was too late, and regulating after the fact doesn’t help the mess it leaves behind <em>shrug</em>.</p>
<p>The downside of securities markets as a whole is that for the most part they do operate in an efficient and orderly way, but to do so there needs to be framework around it. Rational self interest, as Mr. Greenspan found out, simply doesn’t work when greed sets in, and expecting markets to behave rationally and orderly has been at the root of a number of meltdowns, there needs to be a framework to make sure that markets operate efficiently and without taint, because frankly there are any number of greedy, ethically challenged people that when they can rake in big bucks, don’t care about the impact down the road, cause they figure they will be out of it by the time it implodes. The problem with these clowns is they don’t realize that by doing what they are doing, they are planting the seeds of destruction for themselves, whether it is people on the left who see financial markets as inherently evil and whatnot, or people like the tea party types who see Wall St as these evil bankers out to screw virtuous folks like themselves, and yet whose basic premise is to in effect let them do what they want, and if they fail, let them fail (without bothering to figure out what that would do to all those honest, virtuous souls like themselves). </p>
<p>As far as hating or liking mutual funds or hedge funds, that isn’t the point. Mutual funds have gotten in trouble before, so it wouldn’t surprise me if they have been involved in skullduggery, any more that it doesn’t surprise me when brokers and specialists and so forth have gotten caught cheating. My point about hedge funds is unlike mutual funds, they operate in a space where there is little transparency or regulation governing what they do, that the way they operate it is a lot easier to cheat then it is at a mutual fund and it is lot easier for them, due to regulation or lack thereof, to operate with a lot of borrowed money (that can take down banks), and to do other things mutual funds are not allowed to do…all I am saying is hedge funds have gotten too big, have become too big a part of markets, to allow them to operate the way they have, that they cannot operate in secrecy or be allowed to risk the economic system as they presently can IMO. These are no longer ‘gentleman’s funds’ of a few well heeled LP’s, these are now funds that attract a lot of ‘regular’ investment money and also leverage themselves at huge ratios using borrowed money, and that is dangerous and some of their trading activitity can cause huge swings in market direction, often to benefit themselves (if you are able to drive down the broader markets and have huge positions shorting the market, guess what happens to the value of those…).</p>