Stop the Hedge Fund Casinos

This piece initially appeared in The Sunday Times of London, on August 19.

The Federal Reserve Board, acting as America's central bank, sliced half a percentage point off the discount rate it charges banks for loans earlier this month. Its primary purpose was to lift the confidence of investors and consumers in the United States and around the world that America's central bank would do whatever is necessary to keep the American economy going.

Ordinarily, central banks shouldn't bail out speculators. It's bad policy to make money cheaper -- and investments less risky -- after investors have been hoisted with the petard of their own foolishness. That only invites more foolishness next time.

Yet there's precedent: in September 1998, despite growing evidence of inflation, the Fed lowered interest rates in order to forestall a global credit crisis after Russia defaulted on its loans (many had been underwritten, foolishly, by several large Wall Street investment banks). Weeks later the Fed pressured banks to reschedule the debts of a giant hedge fund called Long-Term Capital Management, for fear that if the hedge fund went belly up, it would cause a crisis in credit markets.

In other words, ordinary rules don't apply in extraordinary circumstances. That the inability of several thousand lower-income Americans to meet their mortgage payments set off a chain reaction leading to a worldwide credit crunch is another such extraordinary circumstance. This one may require even more intervention by the Fed and other central banks around the world than we've witnessed already.

But what exactly happened to set this off? In recent years, with so much money sloshing around the global economy, American banks and other mortgage lenders found themselves with lots of cash. They thought they could make a tidy profit by pushing home loans -- not only on average Americans but also on poorer Americans who wanted to own a house but normally couldn't afford the interest on the loans. Oddly, private credit-rating agencies judged these "sub-prime" loans to be relatively good risks. The loans were sliced up and sold to other financial institutions where they were repackaged with other loans.

Meanwhile, hedge funds created what can only be described as giant betting pools -- huge amalgamations of money from pension funds, university endowments, rich individuals, and corporations -- whose assumptions about risk were derived from the assumed low risks of the home loans (hence the term "derivatives"). Investors in these hedge funds had little or no understanding of what they were buying, because hedge funds don't have to disclose much of anything.

It was not just a housing bubble but a financial house of cards that would tumble when central bankers tightened up on the global money supply in order to fight inflation, as they inevitably would, and when the home loans were thereby revealed to be far riskier than thought. Because the bad loans are so widely dispersed and because so much additional credit is connected to them through derivatives, a contagion of fear has spread through financial markets. The credibility of the whole financial system has become shaky.

Americans are understandably nervous. Most American households have invested their savings in stocks and bonds. Most have also relied on the rising values of their homes as "nest eggs" when they retire. The fact that the housing bubble has burst while stocks and bonds have lost ground is likely to cause American consumers to cut their spending. Given that consumers comprise 70 percent of the economy, this could push America into a recession.

Europe and Asia are feeling the effects. The global financial market is now one big pool of money with spigots and drains all over the world. A loss of confidence on Wall Street is felt almost instantly in other financial capitals. Moreover, American consumers have maintained global demand even when other economies have sagged. The possibility that they can't or won't continue to buy is rocking all global corporations that sell them goods or services.

In other words, the Fed has to bail out the speculators, because we'll all suffer if it doesn't.

That doesn't mean, though, that the irresponsibilities now so clearly revealed in American financial markets should be excused or forgotten.

Hedge funds have been operating huge financial casinos without having to disclose what they're betting on, or why. Credit-rating agencies have cut corners or averted their eyes, unwilling to require the proof they need. They've been too eager to make money off underwriting the new loans and other financial gimmicks on which they're supposed to be objective judges. Banks and other mortgage lenders have been allowed to strong-arm people into taking on financial obligations they have no business taking on.

For the financial market to work well -- to ensure fair dealing and to prevent speculative excess -- government must oversee it. This mess occurred because nobody was watching. The Fed and other central banks now have to clean it up. But regulators in America, Europe and Asia have to make sure it stays clean. Hedge funds have to be more transparent. Credit-rating agencies must not have any relationship with underwriters. Banks and mortgage lenders should be better supervised. Finance is too important to be left to the speculators.

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