Hedge Funds, Lending, and Basic Finance

I’ve spent most of my professional life working on Wall Street, and a fair amount of that time working with hedge funds. Over the past few years, I’ve moved over to spend more of my time working with politics and non-profits. Now, the mainstream media is starting to look at hedge funds and lending and how this relates to the political process.

John Edwards worked for a hedge fund. Barack Obama is having a major fundraising event in Greenwich CT at the house of one of the top names in hedge funds. Chris Dodd received over $380,000 in donations from a single hedge that has become a big player in funding campaigns.

A lot of people are attacking these candidates, yet these attacks seem to reflect a basic lack of understanding about hedge funds, lending or finance. More details below the fold.

First off, let’s talk about hedge funds. Prior to 1933, the regulation of security trading was largely regulated by state laws. There were plenty of abuses and after the 1929 stock market crash and the ensuing depression, Congress passed laws to protect investors. There was an exception made for ‘sophisticated investors’. Sophisticated investors, it was argued, didn’t need the protection that regular people needed. It would simply get in the way of their investments.

The simplest definition of a sophisticated investor, was someone who had sufficient income or capital to be able to safely risk large amounts of capital. Hedge funds were set up as an investment tool for such sophisticated investors.

Yet this does not mean that hedge funds are completely uncontrolled. First off, any trading that a hedge fund does on behalf of a sophisticated investor on public exchanges are regulated by the exchanges, and authorities that regulate the exchanges, such as the SEC, NASD, CFTC, and other organizations. Hedge funds are typically set up as limited liability corporations, that investors buy a limited partnership in. As such, they are regulated by the rules which apply to all corporations. Various legislation, like provisions in the Patriot Act to prevent money laundering also apply to hedge funds.

That said, hedge funds attempt to be as secretive as possible. People must sign non-disclosure agreements with the funds. When people leave hedge funds, they often need to sign agreements not to disclose any of the secrets of the hedge fund. So, don’t expect anyone who has worked for a hedge fund to disclose a lot of information about what they did there. They may be contractually obligated not to.

There is actually a good reason for this. Trading strategies typically aren’t protected by intellectual property laws. Even if they were, it would be nearly impossible to enforce. So, the only way to protect the competitive edge that one hedge fund has over another is secrecy.

Now, lets move on to the lending industry. Lending has been getting a bad name recently. Predatory lending is taking advantage of people in financial difficulties. Student loans are being issued in misleading and predatory ways. Mortgages are in trouble as our economy struggles along. In particular, subprime lending, loans to people with poor credit is particularly affected. All of this is compounded by changes to bankruptcy laws which are much more advantageous to lenders than debtors.

Yet this does not mean all lending is bad. Many of us wouldn’t have been able to get through college if it weren’t for student loans. Most of us probably couldn’t own houses if it weren’t for loans. Businesses and even governments rely on loans to get by.

The problem isn’t loans. The problem isn’t even subprime lending. The problem is when the lending becomes predatory, when the lending takes unfair advantage of other’s financial distress. Unfortunately, many journalists seem to miss this point.

If you want an example of lending to people with poor credit that isn’t predatory, take a look at the work of Muhammad Yunus, who won the 2006 Nobel Peace Prize for his work in extending loans to people too poor to qualify for loans from traditional banks.

So, the next time you hear someone attack a candidate for accepting donations from employees of a hedge fund or for having worked for a hedge fund, stop and think for a moment. The next time you hear someone confusing predatory lending with lending that helps people who otherwise couldn’t get loans, stop and think for a moment.

The attack dogs of the mainstream media may be ignorant of basic finance, or they may simply choose to ignore basic facts of finance to facilitate their attacks, but those of us who try to ferret out what is really best for our country through our participation in blogs online communities and online information gathering surely can do better than that.

(Cross posted at DailyKos)

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