How Hedge Fund Compensation Envy Caused the Financial Meltdown

By Eric Jackson, Senior Contributor

12/08/09 - 12:27 PM EST

Hedge funds have received more than their fair share of criticism in the past two years. They've been called too secretive, overpaid, indulgent, bratty and -- most seriously, because of the regulatory implications -- dark pools of potentially overleveraged capital highly correlated in risk with other financial institutions.

I think all these characterizations are distorted, although there's an element of truth in them. Drive around the Hamptons in the summer and you too might roll your eyes at some of the excesses of hedge fund managers.

But when you review 2008, no hedge funds of any consequence were at the center of the meltdown (aside from Bernie Madoff, but he was simply a fraud, not a hedge fund). Some failed, but there was not one government bailout of a hedge fund.

Most regulatory concerns about hedge funds today relate to a hedge fund that has been out of business for more than a decade: Long-Term Capital Management. When it blew up in 1998, its infallible Nobel laureate managers saw their losses get multiplied 40 times because of excessive leverage. Worse, those losses were amplified because LTCM's counterparty banks had mimicked many of the fund's trades. Leverage at many hedge funds appears to be much more in check these days. Funds are also much more secretive about their trades.

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