It's odd that the biggest hedge fund cheerleader in the press, Sebastian Mallaby, knows so little about hedge funds (and financial markets in general, for that matter). Honestly, the thing that bothers me most about Mallaby's cheerleading isn't his painfully obvious ignorance of financial markets, it's that he accuses anyone who criticizes hedge funds of not understanding how international financial markets work! Unlike noted financial economist Sebastian Mallaby, of course. Last year he defended hedge funds in a Foreign Affairs article that read more like a hedge fund prospectus than a scholarly article. Mallaby started the article with some of his trademark condescension, assuring all those pathetic souls who don't understand hedge funds that "the fear of hedge funds is overblown, [and is] based on a misunderstanding of their role in the international financial system." Oh Sebastian, won't you please explain it to us? In the entire 12-page article, the word "leverage" appears a total of one time, and the word "liquidity" doesn't appear at all. This from an article allegedly about hedge funds. In one of his Washington Post columns, Mallaby had the gall to write, "the critics of the funds should at least understand their contribution." Then in a later column, he called hedge funds "the purest apostles of market forces." I kid you not. This man still has a job. Now Mallaby has another article in Foreign Affairs defending hedge funds, and it's even more detached from reality than his previous article, if that's even possible. He writes:

"Hedge funds, for the most part, have weathered the storm remarkably well. Their occasional failures have stemmed mainly from errors that were not of their own making. Because banks have mismanaged themselves so thoroughly, they have had to mobilize capital by calling in loans to hedge funds, forcing the funds to sell off positions precipitously."
If only those unscrupulous banks hadn't made such bad investments in subprime-backed assets, hedge funds would still be riding high! This is false on so many levels that I don't even know where to start. The most obvious thing that Mallaby fails to get his mind around is that the margin calls were the result of hedge funds' diminished creditworthiness. Also, if the hedge funds hadn't been so highly leveraged in the first place, then they wouldn't have needed to dump assets into illiquid markets to meet the margin calls. If most hedge funds aren't dangerously levereaged, as Mallaby claims, then why did they need to dump assets to meet margin calls? Mallaby's next fantasy borders on efficient-markets lunacy:
"When the subprime bubble was inflating, several hedge funds, notably an outfit called Paulson and Co., bet that it would pop. These funds not only made astronomical profits, they also prevented the bubble from growing even bigger than it did. Now that the bubble has burst, hedge funds will likely serve as opportunistic buyers of distressed assets, putting a floor under their value."
First of all, hedge funds are not even close to big enough to put a floor under the value of subprime-backed assets. This is reminiscent of Ben Stein's bizarre claim that hedge funds can manipulate stock prices for fun. Second, Goldman also bet that the subprime bubble would pop when it was inflating, and Goldman is much bigger than any hedge fund, so his claim that it was hedge funds that "prevented the bubble from growing even bigger" just doesn't make sense. Finally, Mallaby displays a shocking naïveté about the broader role of hedge funds:
"[S]tarving well-managed hedge funds of credit is likely to reduce the efficiency of markets; most funds earn their keep by moving prices quickly to the level that reflects the underlying value of assets, ensuring that the world's stock of savings is allocated productively."
Obviously, Mallaby has never met a trader in his life. But aside from his faith in the inner goodness of hedge fund managers, does Mallaby get all his economic knowledge from a Principles of Economics textbook? Does he really believe that stock prices aggregate information, and represent the true value of a company? Sebastian, here's a term you might want to look up: liquidity. It's liquidity that drives both the equity and bond markets, especially during credit contractions. To think that hedge funds are buying assets based on their underlying value right now, you'd have to be mindblowingly naïve. Sebastian: Please stop holding yourself out as an authority on anything remotely related to finance; you're embarrassing yourself.


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