What is a Hedge Fund?

The Washington Post article discusses hedge funds and their purpose. Below are parts of the article, but the entire article is worth a read.

Wall Street chroniclers one day could look back at the early 21st century and easily dub it the Era of the Hedge Fund. The question is whether it will be remembered as an age of reason or irrational exuberance.

Hedge funds hold unparalleled sway over the financial markets, . . . . hedge-fund managers are responsible for more than a third of stock trades and control more than $2 trillion worth of assets, according to industry researchers. Each of the top hedge-fund managers earned more than $1 billion in 2006 alone.

But like the Wizard of Oz, these funds hide behind a cloak of mystery as they pull the levers that make Wall Street go. "To a great degree they're unregulated and hardly understood or not understood at all," said James Grant, publisher of Grant's Interest Rate Observer. . . .

The Bear Stearns funds were on the cutting edge of the hedge-fund world that reaps billions of dollars from slicing up corporate loans, mortgages and other kinds of debt into pieces that can be traded like shares on the stock market. This process is considered by many bankers and regulators to be one of the great advances in finance over the past five years. With hedge funds acting like shock absorbers, investment banks and lenders have been able to make massive loans to freewheeling borrowers and feel less impact from the risk.

. . . . Some analysts say hedge funds have become more important financiers than the long-established investment firms of Wall Street. Greenwich, Conn., where more than half of the biggest hedge funds are based, has earned nicknames such as "The New Wall Street" and "Hedgistan." It also has become one of the most important stops along the presidential campaign fundraising trail.

Yet the trouble at Bear Stearns is revealing that the system may not be as crash-proof as once thought. And it has left Washington regulators and Wall Street analysts with questions: How dependent has the new financial system become on hedge funds? Are their trades getting more risky? If one of them unravels, who absorbs those losses?

The answers are unclear, even to top economists. Part of the problem is that most hedge funds do not reveal much about their trading activities. Many operate offshore. Even for the ones that are based in the United States, no federal agency is empowered to regulate or watch their activities.
The SEC in 2004 passed a rule requiring hedge-fund managers to register with the agency and submit to some oversight. But a U.S. Court of Appeals struck down that rule in June 2006. Later that summer, SEC Chairman Christopher Cox testified to the Senate Banking Committee that hedge funds were operating in a "gap" in the SEC's authority, but he fell short of asking Congress to address the issue through legislation.

The President's Working Group on Financial Markets, which was founded after the collapse of hedge fund Long Term Capital Management in 1998, said in February that hedge funds needed no regulation.

Yet many market watchers worry that, shielded from regulators and operating in the dark, the biggest and most influential hedge funds might be making bets that put the entire financial system at risk.

"There's been a fundamental change in the debt markets that I don't think people appreciate yet," said Richard Bookstaber, who has managed hedge funds and recently wrote a book on the topic, "A Demon of Our Own Design."

"I don't think anybody knows how much leverage a particular [group] of hedge funds is using or how much leverage has grown. . . . We are running the risk of making the markets more levered and more complex so that something can go wrong all of a sudden," Bookstaber said.
So what is a hedge fund?

For starters, hedge funds take money only from those with deep pockets. They pool huge amounts of money mainly from super-wealthy investors, Wall Street banks and other hedge funds. About 25 percent of their money comes from pension funds and endowments, according to data from Greenwich Associates.

In the late 1940s, managers of the first hedge funds invented ways to make money no matter which way the stock market was moving. They used terms like "short the market" -- a technique for profiting when stocks go down -- and "going long" -- which means selling stocks after their prices have gone up. The trick was figuring out how many "short" and "long" positions a manager should have in a portfolio.

. . . . Former Federal Reserve Chairman Alan Greenspan was an advocate for how hedge funds help spread investment risk across many partners. The concept of "risk dispersion" has been described by Federal Reserve Governor Donald L. Kohn as a pillar of the "Greenspan doctrine."

Over the past five years, advocates say, it has created a more stable financial system.
In 1998, just when hedge funds were starting to become big, Long Term Capital Management collapsed, nearly paralyzing the U.S. bond market. The disruption was so severe that the Fed had to organize a temporary rescue. The fund lost about $3.6 billion before closing in 2000.
But when the Amaranth hedge fund imploded in September 2006, losing about $6.4 billion on bad bets in natural-gas commodities, federal regulators stayed on the sidelines. Returns plummeted for a few hedge-fund managers and a pension fund in San Diego, but the markets generally shrugged off the news.

The problem is similar to what happens in the housing market. Because houses are "traded" infrequently, homeowners often struggle to figure out the right price to attract interest. An appraisal can help, but a house's actual value is established only when a buyer and seller agree on a price.