Subprime Mortgage Crisis Sealed Off

Bloomberg has a good "Special Report" on the Subprime Mortgage Crisis here. The first of its five reports details something that is not getting talked about enough - how hedge funds and newer features of the capital markets are inoculating the risk of a systemic financial crisis emanting from an isolated crisis in a troubled sector. In fact, the MSM is all over the theme of increased risk in the financial system due to the proliferation of hedge funds, those nasty secretive partnerships for the rich only. The conventional wisdom is that because many of these hedge funds are large, trade rather aggressively, and nobody knows quite what they are doing, they pose a risk to the financial system. Nobody ever says how they pose a risk, just that those salient characteristics - big, aggressive, opaque - simply have to be bad. Those adjectives are good enough for the media and for our politicians to mount the stump in opposition.

Truth is that, in at least two instances now, these large pools of capital have acted as buffers keeping specific financial crises contained within their own worlds. As the Bloomberg Special Reports chronicles, numerous large hedge funds have swooped in to take busted subprime assets off of the troubled lenders, acting as a valuable extra source of liquidity and providing a price floor for the assets, which in the past might not have found a buyer at any price making the crisis much worse. Something similar happened when Amaranth Advisors blew up over its natural gas trades. Plentiful capital was available and willing to take the busted trades, preventing a liquidity crisis that could hopscotch around to other sectors. In both these instances both the strategies and the structure that hedge funds represent are innovations to the markets that have added degrees of flexibility and layers of depth to the markets that previously weren't there. There is a strong case to be made that the proliferation of hedge funds, or hedge fund-like operators, makes the capital markets less prone to systemic risk than in the past. If indeed the case, this is a development that the media and the political establishment should welcome, as it means all those cuddly goods of American life - the "little guy" and "nest eggs" and "hard-working Americans" - are better insulated from financial catastrophe. At least of the variety that is no fault of his or her own, as opposed to that which is brought upon themselves through their own greed and imprudence.

UPDATE: Apparently, though, it's been sealed off in Califiornia.