I don't think you can argue that excessive leverage is the result of low interest rates. LTCM, which was levered around 30 to 1, operated in an environment where the Fed funds rate was around 6%, not 1%. Likewise, Japan has had extremely low (even 0%) overnight interest rates since the 90s, but there hasn't been an explosion of Japanese hedge funds to the extent that there's been an explosion of American ones.
People have found ways to lever themselves rather through derivatives, rather than simple borrowing of cash... e.g. if you want levered exposure to a portfolio of high-grade corporate bonds, you don't borrow money and invest in cash bonds. You get an investment bank to structure a bespoke synthetic CDO tranche which, according to your single-factor Gaussian copula model, gives you exactly the risk and return that you want. If you want levered exposure to interest rates, you don't borrow money and speculate on Treasury notes; you pay (or receive) on an interest rate swap whose notional amount is far greater than the amount of cash you have. With the current state of derivatives regulation, people will be playing these games whether Fed funds is at 0% or 10%.
I will grant you that giving fund managers a call option on their returns isn't a great idea. It has the advantage of being cheap, since the value of a call option is less than the underlying. But at the same time, the value of a call option increases in value as the volatility of the underlying increases. So not only do hedge fund managers have incentive to get good returns, they have an incentive to get volatile returns as well -- this leads to perhaps more risk-taking than is necessary.
Edit: and the funny thing is that JWM Partners, Meriwether's post-LTCM fund, is supposedly down 20% this year. To be fair, they apparently did a pretty good job from 2000-2008 or so.
My point is that real owners of capital (i.e people who saved the capital) will not lend to create the kind of leverage these hedgies have employed. Imagine you are a billionaire. Will you lend to (which is different from having an equity stake in) Meriwether so he can lever up his fund 14x with your borrowed money?
Yet, banks have freely lent to them, because they could, in turn, borrow from the Fed. The Fed (i.e us taxpayers) have operated as the ultimate patsy in the system, providing a one way bet to the speculating class. The evidence of it is the relentless expansion of the total credit in the system (as a percentage of GDP). Literally, the Fed has allowed the creation of total system-wide credit at 2-3 times faster rate than GDP growth, for many, many years running.
No matter what happens now, most hedge fund managers got theirs. As has already been observed, 8 years of feverish levered returns followed by one year of total wipe-out of capital still makes the managers ahead!
Not quite true. The banks which lent directly to hedge funds -- prime brokers -- were not depository institutions and, until last week, they couldn't borrow from the Fed. These were institutions like Bear Stearns or Morgan Stanley. Besides, even depository institutions are reluctant to borrow at the Fed's discount window. Pretty much all bank borrowing is either through short term loans at LIBOR or overnight loans via the Fed funds system. (Note that the Fed funds rate is the rate at which banks borrow from each other using the Fed's system, it is NOT the rate at which banks borrow from the Fed. That's the discount rate.)
Regardless, it still makes plenty of economic sense for a bank to lend to a hedge fund, whether or not the Fed is involved. This type of lending is typically short term and rolled over as loans expire. If a bank lends to another bank, it only receives LIBOR, but if it lends to a hedge fund, it can charge slightly higher, say LIBOR + 40bps. Given that the bank itself can borrow at LIBOR, this is a decent way to make money. It's really no different than short-term lending to any other kind of corporation.
I won't deny that credit has greatly expanded lately. I just don't think the expansion of credit to hedge funds has much to do with the Fed.
Speculative bubbles have always and everywhere been about inflation of the money supply. Dutch tulips, south sea bubble, mississippi company, 20s stocks, nikkei, dot coms -- it's ALWAYS been about the money supply.
What change does the graph illustrate? Each 10 year period is double what it was before. It's not a linear function but it wasn't in the first place. Thanks.
What's the methodology and data behind that graph? The fact that it refers to "True Money Supply" rather than established measures like M1, M2, M3 has me rather skeptical.
People have found ways to lever themselves rather through derivatives, rather than simple borrowing of cash... e.g. if you want levered exposure to a portfolio of high-grade corporate bonds, you don't borrow money and invest in cash bonds. You get an investment bank to structure a bespoke synthetic CDO tranche which, according to your single-factor Gaussian copula model, gives you exactly the risk and return that you want. If you want levered exposure to interest rates, you don't borrow money and speculate on Treasury notes; you pay (or receive) on an interest rate swap whose notional amount is far greater than the amount of cash you have. With the current state of derivatives regulation, people will be playing these games whether Fed funds is at 0% or 10%.
I will grant you that giving fund managers a call option on their returns isn't a great idea. It has the advantage of being cheap, since the value of a call option is less than the underlying. But at the same time, the value of a call option increases in value as the volatility of the underlying increases. So not only do hedge fund managers have incentive to get good returns, they have an incentive to get volatile returns as well -- this leads to perhaps more risk-taking than is necessary.
Edit: and the funny thing is that JWM Partners, Meriwether's post-LTCM fund, is supposedly down 20% this year. To be fair, they apparently did a pretty good job from 2000-2008 or so.