Thursday, November 25, 2010

Book Review: More Money Than God

Today I finished More Money Than God. A book written by Sebastian Mallaby.

A lot of book reviews are already written about More Money than God.

The book is a well written piece of art about hedge funds, their business and the managers who run them. Sebastian Mallaby did a great job with a good categorical and chronological approach to the subject.

The most interesting part I found his standpoint on the issue of hedge funds regulation. Mallaby doesn't think it is wise.

Hedge funds are defined by four characteristics: they stay under the radar screen of regulatory authorities; they charge a performance fee; they are partially isolated from general market swings; and they use leverage to take short and long positions on markets. Most importantly, in a financial system riddled with conflicts of interests and skewed incentives, hedge funds get their incentives right. As a result, according to Mallaby, they do not wage any systemic threat to the financial system, and they may even provide part of the solution to our post-crisis predicament.

The first set of well-aligned incentives deals with the issue of ownership. Hedge fund managers mostly have their own money in their funds, so they are speculating with capital that is at least partly their own--a powerful incentive to avoid losses. By contrast, bank traders generally face fewer such restraints: they are simply risking other people's money.

Partly as a consequence, the typical hedge fund is far more cautious in its use of leverage than the typical bank. The average hedge fund borrows only one or two times its investors' capital, and even those that are considered highly leveraged borrow less than ten times. Meanwhile, investment banks such as Goldman Sachs or Lehman Brothers were leveraged thirty to one before the crisis, and commercial banks like Citi were even higher by some measures.

As Mallaby notes, hedge funds are paranoid outfits, constantly in fear that margin calls from brokers or redemptions from clients could put them out of business. They live and die by their investment returns, so they focus on them obsessively.

The second set of incentives deals with how hedge funds operate. They are usually better managed than investment banks. Their management culture tends to encourage team spirit and collaborative work as much as individual performance. Alfred Winslow Jones, the originator of the first hedge fund and the "big daddy" of the whole industry, invented a set of management tools and compensation practices to get the most from his brokers and managers.

According to Mallaby, some of the perverse incentives that banks face come from regulation. Rather than running their books in a way that rigorous analysis suggests will be safe, banks sometimes run their books in a way that the capital requirements deem to be safe, even when it isn't. By contrast, hedge funds are in the habit of making their own risk decisions, undistracted by regulations and the false security provided by credit ratings. As a result, the hedge fund sector as a whole survived the subprime crisis extraordinarily well. By and large, it avoided buying toxic mortgage securities and often made money by shorting them.

The discussion whether hedge funds should be regulated or not will be an interesting one and this book really makes a good contribution for governments to encourage hedge funds.Hedge funds are clearly not the answer to all of the financial system’s problems. They will not collect deposits, underwrite securities, or make loans to small companies. But when it comes to managing money without jeopardizing the financial system, hedge funds have proven their mettle.

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