Recycled post: The crucial difference between hedge funds and tech companies

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I wrote this more than a year ago, and it strikes me that it’s more timely now than it was then. So in the interest of self-aggrandizement, I’m recycling it (with some minor tweaking):

A little while back, in the august pages of Foreign Affairs, Washington Post columnist Sebastian Mallaby offered a rousing defense of hedge funds. It began:

Imagine two successful companies. Both are staffed by very smart people; both are innovative; both have an impact far beyond their industry, improving the productivity of the capitalist system as a whole. But the first, based near San Francisco, is the subject of adoring newspaper profiles, whereas the second, based in the New York area, is usually vilified.
Actually, you do not have to imagine any of this, because it describes a double standard that already exists. The first company in the story is a technology firm; the second is a hedge fund. As any newspaper reader knows, technology firms are the leading edge of the U.S. knowledge economy; they made possible the productivity revolution of the past decade. But the same could just as well be said of hedge funds, which allocate the world’s capital to the companies, industries, and countries that can use it most productively.

It’s a clever comparison. But for some reason I just can’t entirely buy it. Maybe it’s the result of hanging out too much with Jack Bogle, whose long career in the mutual fund industry left him convinced that the vast majority of money managers are parasites who add no value whatsoever. Maybe it’s the upshot of having spent a few years researching a book (no, it’s not out yet) about the frequent failures of financial markets to rationally allocate capital. Maybe it’s that I harbor deep resentment about the way hedge fund managers and other Wall Streeters have so driven up the price of Manhattan real estate that I can’t afford any but the teeniest slice of it.

Whatever. All I know is, while I’m not opposed to these hedge fund things, I don’t entirely trust them. So when the President’s Working Group on Financial Markets–a Gang o’ Regulators initially created in the aftermath of the 1987 crash–releases a set of “principles and guidelines” arguing that the current non-regulation of hedge funds is working really well, as it did yesterday, I get suspicious.

It’s not that I can point to any particular guideline as being wrong. And I really do like the Working Group’s habit of referring to hedge funds as “private pools of capital,” because it would be so great if everybody started calling hedge fund managers “private pool managers,” or maybe just “pool men.”

But I get the heebie jeebies when I read a line like: “market discipline by creditors, counterparties, and investors is the most effective mechanism for limiting systemic risk from private pools of capital.” Market discipline is swell and all, but the whole reason we have banking regulators and a Federal Reserve system is because market discipline can’t always be relied upon to keep financial markets from going bonkers. I think that’s because it’s possible to make money for years by underestimating the riskiness of a particular lending or investing strategy. The crows come home to roost eventually, but the person who made the fateful decisions and cashed the big bonus checks every year might have moved to Gstaad by then.

That’s one of the things that makes hedge fund managers different from tech entrepreneurs. Sure, there were some dot-com types who took advantage of the stock market insanity of the late 1990s to get rich without delivering anything of value. But in general, tech guys have to deliver a product that people want and need in order to profit. Hedge fund managers, on the other hand, can get rich merely by taking risks that their customers (and often the hedgies themselves) don’t fully understand.

Now, expecting government regulators to understand those risks is a pretty tall order. But at least they have different motivations and time horizons than the money managers, investors, and lenders. The closest thing to a regulator of the hedge fund business is the president of Federal Reserve Bank of New York, a job currently held by the boyish Tim Geithner (all media references to Geithner are required by law to mention his youthful appearance). Lately, Geithner has been pushing New York’s big banks and brokerage firms to more closely examine their exposure to their hedge fund customers, particularly in the burgeoning and opaque market for credit derivatives, and has even been talking to the press about it.

Maybe Geithner’s informal nudging is all we need. I certainly don’t have any better ideas, given as how I’m not entirely clear on what a credit derivative is. All I know is that there are some perfectly good reasons why we journalists are more likely to write adoring profiles of tech entrepreneurs than of pool men, and that those reasons have implications that regulators can’t afford to ignore.