The primacy of hedge funds in the subprime crisis

Abstract

When the subprime crisis broke out in the summer of 2007, the hedge funds avoided blame by disassociating from those that supplied the subprime-backed products and by disappearing among those that bought these products. This twofold defense strategy has worked to perfection because almost everyone who has studied the crisis is convinced that it is the banks and not the hedge funds that were chiefly responsible for causing it. This article puts forward a different interpretation of events. Its central argument is that had it not been for the hedge funds' intermediary position between the investors seeking yield on the one hand and the banks that created the high yield bearing securities on the other, the supply of these securities would never have reached the proportions that were critical in precipitating the near collapse of the whole financial system. Take away hedge funds and a general financial crisis could still have occurred in 2007-8, but it is only because of the hedge funds that the crisis that actually occurred initially took on the form of a subprime crisis. The policy implication of this analysis is that regulatory controls on hedge fund activities must be far tighter than those currently proposed.

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