The Real Way to Prevent Systemic Hedge Fund Risk

When the TARP funds ended up being used to bail out Wall Street firms of systemic importance, while contentious, the funds were being used to prevent failure of significant firms. When Fannie Mae and Freddie Mac were instructed to buy up toxic assets from the market at large with no caps on their exposure, regional and retail banks of no systemic importance whatsoever were saved as well, and the federal government ended up backing over $8.1 trillion of debt on top of the $7.8 trillion US government debt.

 

As Greece tried to refinance its short-term debt into long-term bonds and could find no buyers to take on the risk, the eurozone counties stepped in with a multibillion bailout package of loans for Greece. Now, Greece had long flouted the EU’s standards for fiscal prudence, but it was thought that a Greek default would imperil the euro. In fact, quite the opposite was true; had Greece been allowed to default, then the eurozone would have demonstrated its strong commitment to principles of fiscal balance and prudence. Instead, it saddled itself with debt, diluted the currency, and showed that the actions of a single member nation can bring down the whole. Hence, the euro has dropped precipitously to a new low of $1.22.

 

Now, both the EU and the U.S. have taken up reform of hedge funds, and Germany just announced an immediate ban on short selling of certain financial products in an effort to slow the slide of the euro. In so doing, all have cited the desire to curb the incentives of speculators to take big risks. In this vein, the Dodd so-called reform bill could include the “Volcker Rule,” which would require most banks to spin off their proprietary trading divisions in an effort to decrease risky speculation.

 

Yet politicians have forgotten the most crucial root cause of such speculation: the knowledge that, if bets go bad, the government will be there with golden parachutes in hand. So, speculators have every reason to structure a high-risk / high-reward quick payout portfolio because if things go poorly, they will not suffer the losses, but taxpayers will pick up the toxic tab.

 

If governments actually wish to discourage aggressive risk-taking in financial markets, then they must convince the banking community that the state will not step in as an insurance policy. Investors only assume risks reluctantly, so governments should allow the risk of the products to stand and speak for itself.

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