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April 08, 2008



That's a great argument - the only problem is that hedge funds are not the ones going under. Instead, it is investment banks or mortgage banks that are going bust. Admittedly, high leverage also seems to be one of the main drivers for those institutions but they are probably still less leveraged than many hedge funds. Thus, it’s not just leverage per-se but also other variables that determine access to liquidity during a crisis. The most interesting part is that ex-ante most observers probably would have argued that hedge funds pose a much greater risk (as Danny Leipziger seems to imply) than the Bear Stearns or Citibanks of this world. Is it thus wrong to bail out these institutions? Maybe, but it’s hard to argue that the failure of these institutions won't pose any systemic risk to the financial system. Hence, it’s not surprising that both Korea and the Fed decided to bail out their respective institutions. And Danny is right on his main point – at least some observers (but definitely not all) seem to apply a double standard in evaluating those policies.


Does it make any sense to compare the leverage of hedge funds to Chaebol without discussing what assets are held on their respective balance sheets? Hedge funds hold liquid assets, and are often, uh, hedged, so the volatility of their assets may not be all that great.

This is just a cheap shot at hedge funds.


Conundrum is right - it is not hedge funds that are the problem but the banks.

But banks are more leveraged than most hedge funds. Even ignoring its off-balance sheet exposures, Bear Stearns was leveraged 33:1 at the end of 2007.

Another example, Citigroup, at the end of 2007 was 19x leveraged (again only accounting for on-balance sheet items).

As for whether to "bail out" these institutions, Bear Stearns was bankrupt. Is it not better to ringfence the problem than risk a "chaotic unwinding of positions"? After all, Bear had exposure to a notional $13.4 trillion of derivatives contracts. Under the original $2 offer the equity left in Bear was essentially worthless.


Ken Houghton

Actually, hedge funds have been going under, but since they aren't required to be registered (forget regulation; I want a database of who ran which hedge fund and what before-fees performance they claimed), they just quietly go out of business.

(Quietly is a relative term. For instance, I can tell you that George Handjinicolaou used to run a hedge fund because I like keeping track of my former bosses, and I see that he's now the EMEA Regional Director of ISDA--but I can't tell you if he left the firm, or sold it, or it folded. Otoh, the people in Derivatives and Fixed Income IT at Bear Stearns have a fate being discussed 24/7 by Bess Levin at Dealbreaker, among other.)

To borrow from Bruce Cockburn: "If a hedge fund falls in the forest, is anybody out there? Does anybody care?" Besides some HNW investors who aren't exactly going to go on CNBC and rend their clothing, generally no.

Btw, Dr. Rodrik, is there a link to the full statement?


To follow up on Ken Houghton, hedge funds going under is no big deal, mainly because they have few employees, and their employees will in general find new jobs. Industrial complexes on the other hand have enormous amounts of employees, and if these lose their jobs, it can cripple entire regions.

So, hedge funds go under all the time. A bit more at the moment. But people who work for hedge funds, and people who invest in them know this risk, and it is part of the game.

Are they good for the economy? Who knows. Are industrial complexes good? Apparently people pay them for their services, so they must be doing something right.

Per Kurowski

Exactly the point I have been trying to argue for more than a decade now, with little luck, being no credible PhD against so many credible PhDs.

There is nothing wrong with a hangover... if the party was worth it.

But the banking regulators, trying to avoid hangovers at any costs, through their minimum capital requirements for banks that are based exclusively on the risk of default as assessed by the credit rating agencies, introduced an artificial risk adverseness into the financial sector and which now has it financing public sector, consumers and whatever else could be construed as safe and AAA.

We just measure the pain when there is a financial crisis, but we never measure the results of the full boom bust cycle. Clearly the full Korean cycle seems a lot better for the long term sustainable growth than the current US boom bust cycle.

If we are going to use risks to direct capital flows then we are much better of with a system that does not stay with the simplicity of a risk of default but introduces, as an example, units of risks of default per decent long term job created.

If we just go down the current regulatory route, the only one left standing will be the last bank in town, which is the same as the last bank in the world; and we will all have to work for it as economic efficient alternatives to automated bank teller machines.

And, to top it up, not only do our current bank regulations lack sense and purpose but they are also extremely dangerous… as they do only guarantee that we will follow the credit rating agencies over some precipice, like we for instance did in the case of the subprime mortgages.

Naz Onuzo

The double standards argument is not new, and it comes up every time there is a crisis in the "developed" world. Looking at a standard IMF SAP package, it is impossible to see any "developed country" applying it in time of a crisis. Yet time and again developing countries were made to do so. However I would argue that the double standard exists because the developing countries needed the money the IMF provided. This is increasingly no longer true, so there will be less arguments about double standards going forward.


Echoing what other people have said: the hedge funds actually haven't been blowing up that much more than usual up till now (yes, blowing up more than usual, but not much much more than usual). The banks were leveraged more (sometimes 10 times more) than most hedge funds.

And, while we might not know about smaller hedge funds going under, the collapse (collapse, not winding down due to mediocre performance) of any 1 billion+ hedge fund is fairly widely reported in the business press. It's unlikely that there were big ones that quietly exploded.

Further, if I was a provider of credit, liquid collateral (securities) are generally far better than an industrial asset. You can (at least in typical times, sometimes markets seize up) price a portfolio in seconds.

What's the price of a Korean shipyard that's been operating as a division of a massive and sometimes Byzantine conglomerate? It has some value, maybe even a high value, but not a value that's obvious or simple. And, of course, the market in Korean shipyards may just as equally seize up as any other market.


I wonder your opinion about how the IMF and the world’s central banks should have coped with the economic crisis in the United States. Are there other alternatives to cope with the problem? I agree that their solution for the economic crisis in the United States is less fair than one for the Korea financial crisis. But, when I consider the negative social effects such as bankruptcy of domestic economy, their double standards might be better choice than committing similar errors.


Of course hedge funds have been going out of business, but we have not seen them "blow up". By blow up, I mean that they lose more money than they have in capital. I don't care if a bunch of rich people lose a lot of money. I care if they lose so much money that they go bankrupt and post a threat to the financial system. That's what happened to Bear Stearns.

So, this time at least, hedge funds appear to have been adequately capitalized. Investment banks and banks seem to have been inadequately capitalized. Boos to the banks and (muted) cheers for the hedge funds.

Chui Tey

I don't think we really should be comparing the merits of investment in productive capacity vs investment in housing. The former makes goods cheaper, the latter makes housing more expensive.

Nicholas Shaxson

Martin Wolf had a good comment about all this, here:
This section is fun:
Imagine that we set up a hedge fund with $100m from investors on the normal terms of 2 per cent management fees and 20 per cent of the return above a benchmark. We put our $100m in Treasury bills yielding 4 per cent. We also sell 100m covered options on the event, which nets us $10m. We put this $10m, too, in Treasury bills, which allows us to sell another 10m options. This nets another $1m. Then we go on holiday.

There is a 90 per cent chance that this bet will pay off in the first year. The fund then grosses $11m on the sale of the options, plus 4 per cent interest on the $110m in Treasury bills, for a handsome 15.4 per cent return. Our investors are delighted. Assume our benchmark was 4 per cent. We then earn $2m in management fees, plus 20 per cent of $11.4m, which amounts to over $4m gross. Whatever subsequently happens, we need never give this money back.

The chances are nearly 60 per cent that the bad event will not occur over five years. Since the fund is compounding at a rate of 11.4 per cent a year after fees, we will make well over $20m even if no new money is attracted into this apparently stellar enterprise. In the long run, however, the bad event is highly likely to occur. Since we have made huge profits, our investors have paid us handsomely for the near certainty of losing them money.

The immediate response may be that so naked a scam is inconceivable. Well, imagine a fund that leverages investors’ money by borrowing massively in short-term money markets in order to purchase higher-yielding paper. Assume, again, that the premium gives a correct estimate of the risk. With sufficient leverage, this fund, too, is likely to make profits for years. But it is also very likely to be wiped out, at some point. Does this strategy sound familiar? It certainly should by now. . .

The more one believes this is how an unregulated financial system operates, the more worried one has to become.


The crucial difference is that Korean chaebol executives are not Republican party donors, but Wall Street and Greenwich types are indeed. There is no double standard because there are two completely different situations. There is one standard for USA players who understand how the world works, and another for stupid foreign people who create value added even if with a little bit of financial trickery. «The more one believes this is how an unregulated financial system operates, the more worried one has to become.» It is not finance, it is insurance. Every time insurance is unregulated, players take the premiums and run without providing sufficient reserves, as the FT article you quote says.

David Johnston

Economic crisis is one of the major problem that a country is doing or making a resolution. Because of the economic crisis the price of the products in the market is also increasing. So, we as a consumer is affected by this.


Hadn't hear this argument brought up before and I track hedge funds daily for my own site - thanks for the story and commentary.

- Richard
Richard Wilson

Obama IS America!

So I am a blogger too. I am an academic, but no economist. I took some courses on the political economy of Latin America and of Southeast Asia (read some of your works Dr. Rodrik!), so of course I understand the history and the underpinnings of the Asian Financial Crisis.

As I mentioned above, however, I am no economist, and am shaky on some of the details about the role played by the chaebol in the financial crisis of Korea. So with this disclaimer, I would like to throw out an idea.

It seems to me that the US's desire to bailout GM is akin to the subsidization of the chaebol in Korea. The connection I see is that the chaebol were huge, unwieldy, heavily indebted companies protected from external competition, which were subsidized by the government because of their huge role in the Korean economy.

Similarly, instead of letting a large, unproductive, unwieldy, uncompetitive and bankrupt company (GM) submit to the rigors of the market and therefore go bankrupt, we want to bail it out, i.e., subsidize it with public funds. It seems that the rationale behind the GM bailout is that it will prevent us from feeling the burn of this major company dying, and more jobs won't be lost.

However, I see the bailout of GM as being nothing more than a short term solution and generally a terrible investment by the US, because it will not change any of the problems we are facing in the long run, especially considering that the conditions for the bailout do not seem to be nearly as rigorous as they should be. It seems to me that a bailout will likely rule out the likelihood of any sweeping company-wide structural reforms from occur for GM. Additionally, this giant, unwieldy conglomerate will continue to be unwieldy and therefore inefficient.

Here are a couple of articles that have had some influence on my thought on these matters:



As I mentioned before, I don't know enough about these issues, and would love if someone could provide more insights about whether or not there is a comparison to be made here, and a lesson to be learned.

I will likely post this comment on the blog and throw it out as a question to the public, but if anyone here has any thoughts on these matters, I would love to see what you have to say.

If anyone wants to check out the blog, the link is: obamaisamerica.blogspot.com.

If you want to email your thoughts or suggestions, the email is [email protected]


Obama IS America!

Changes to this paragraph:

However, I see the bailout of GM as being nothing more than a short term solution and generally a terrible investment by the US. I cannot foresee the bailout of GM having any major impact in the long run, especially considering that the conditions for the bailout do not seem to be nearly as rigorous as they should be. It seems to me that the way that the conditions for the bailout are being structured will likely rule out any sweeping company-wide structural reforms from occurring within GM as a company. If this is the case, then it seems that this giant, unwieldy conglomerate will mostly likely continue to be unwieldy and not as efficient, creative, and productive as it could/SHOULD be.

Erectile Dysfunction

There are several dozen large Korean family-controlled corporate groups which fall under this definition. Through aggressive governmental support and finance, some have become well-known international brand names, such as Samsung, Hyundai and LG.

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