The Times – Why aren’t hedge funds failing as fast as banks?<br/> Because they have different types of ownership,says. And that shows that the markets are not to blame for the financial crisis, by Chris Dillow

Before the credit crunch started, countless experts warned us that hedge funds were a source of “systemic risk”. They were wrong.

Instead, the big dangers to the financial system have come from elsewhere. Fannie Mae and Freddie Mac – the guarantors of US mortgages – had to be nationalised. Three of Wall Street’s big five investment banks have ceased to exist as independent entities. And the future of AIG, which helps to insure investors against defaults on bonds, is in doubt.

There’s a pattern here. The biggest shocks to the financial system have all come from stock market-quoted companies. By contrast, hedge funds, which many expected to cause trouble, have been innocent bystanders. These are, generally, owned as private partnerships.

So, one form of ownership has caused a crisis, and another hasn’t. The reason for this lies in what economists call the principal-agent problem, and what everyone else calls the difficulty of getting your employees to act in your interests rather than their own.

Big, quoted companies have been unable to solve this problem. Shareholders – often, ordinary people with pensions – have little control over fund managers. Fund managers have little control over chief executives. And chief executives have had little control over trading desks, partly because they just didn’t understand the complexities of mortgage derivatives.

So traders were free to gamble with other people’s money. They got multimillion bonuses if they did well, but faced almost no meaningful sanction if they failed: John Thain, Merrill Lynch’s chief executive, is rumoured to be in line for an $11 million payout. The result was excessive risk taking.

In hedge funds, things have been different. Very often hedge fund managers invest their own money and take key decisions themselves, or at least closely watch those who do. Their incentives to take huge risks have been smaller. So these have at least survived.

What we’re seeing, then, is the cost of separating ownership and control. In private firms, or partnerships – even limited liability ones – the two are closely aligned. In stock market-quoted firms, they are not.


And that’s probably all you’ll hear from me on the subject. (At least anything approaching an educated and facts-based approach. I don’t promise not to link to the subject if some politician or other is saying something silly about it but that’s hardly the same thing, I think.)