As usual James Surowiecki has an excellent piece. Excerpt:
Fund managers get bonuses at the end of each year, and they keep those performance fees even if the fund eventually goes south. So if a billion-dollar hedge fund rises twenty per cent in its first year and falls twenty per cent in its second, its investors will have lost money, while the fund’s manager might earn forty million dollars in performance fees. Hedge funds do have a rule that’s meant to deal with this problem: when a fund loses money, it yields no performance bonus until investors get back to even. The catch is that nothing prevents a hedge-fund manager from simply shutting down after a bad year and walking away with the fees he’s already accrued…Because fund managers reap large rewards on the upside without a correspondingly punitive downside, they have a much greater incentive to take big risks than ordinary investors do.
Managers, or for that matter ordinary investors, may not under normal conditions have enough incentives to take risk. Remember the Kenneth Arrow argument that not all private financial risks amount to equivalent social risks? Who cares if you lose money, provided that no real resources have been destroyed? Yet a risk that pays off, say with a new product, does not in general return the entire social value of that product to the entrepreneur.
With hedge funds, are we now above or below the optimal amount of risk? The answer of course is "we are taking the wrong kinds of risk." We are finding more and more ways to (implicitly) write naked puts in highly leveraged forms. Yes this has brought us new products but it all seems to be new mortgage products. Could those products possibly justify the financial carnage we have seen? That is the critical question but I suspect the answer is "no," that in this sphere we stepped beyond the bound of optimal risk-taking.
The junk bond revolution of the 1980s involved some "excess" risk-taking, but I believe those risks were more closely connected to the real economy, and more likely to bring real economy benefits, than the recent spate of mortgage-related risks.