Many of the investors driving the extraordinary rally in GameStop (GME) and a handful of other shares cite the 2008 financial crash as motivation. But by going after hedge funds and short-sellers, they’ve fingered the wrong villains.
The GameStop phenomenon involves packs of day traders targeting “meme stocks” that have unusually high “short interest,” with institutional investors betting the stock prices will go down rather than up. As a surge of buying in these shares pushes prices up, it causes a brutal “short squeeze” that forces short sellers to rapidly unwind their trades. Hedge funds have lost at least $12 billion so far.
Many of these day traders feel deep hostility toward hedge funds and short sellers dating to the 2008 financial crash, which vaporized trillions of dollars of household wealth. “The ’08 recession collapsed my family,” one investor wrote on Reddit’s WallStreetBets forum. Another Reddit investor told Yahoo Finance’s Ines Ferre, “you have people who were aggravated at the bailouts that occurred 13 years ago, people … playing their own game and beating them at it.”
But hedge funds and short sellers weren’t the bad guys back in 2008—and they didn’t get any taxpayer bailouts. The financial crash was complex, and it formed over many years. Wall Street banks certainly played a role, but there are important differences among the institutional investors collectively known as “Wall Street.”
In a 662-page report analyzing the ’08 crash, the Financial Crisis Inquiry Commission identified a broad cast of villains that caused or contributed to the crisis. They include 5 investment banks that at the time fueled a surge of trading in “toxic” mortgage-backed securities, and derivatives of those securities: Bear Stearns, Citigroup, Goldman Sachs, Lehman Brothers and Merrill Lynch. AIG insured billions of dollars of overvalued securities without the reserves to cover losses. Horrible underwriting standards at mortgage underwriters such as Countrywide and Wachovia produced millions of mortgages borrowers were destined to default on.
Bond-rating agencies such as Moody’s and Standard & Poor’s failed to identify the risk and rated mortgage-backed securities destined to blow up as safe as US Treasuries. Fannie Mae and Freddie Mac, the government agencies that securitize mortgages, became insanely overleveraged and collapsed. Regulators such as the Federal Reserve and the Securities and Exchange Commission did nothing to intervene until it was far too late. Years of federal policy meant to encourage homeownership allowed some buyers to borrow far more than they could afford. And a 1999 law that eased bank regulations allowed banks to take risks that ultimately threatened the entire financial system.
Hedge funds had little to do with this. There were two hedge funds run inside investment bank Bear Stearns that bet heavily on mortgage-backed securities and collapsed in 2007. But those weren’t the types of hedge funds run by independent operators mostly working with wealthy individuals’ money. A 2012 Rand report found that hedge funds played little role in the housing bubble that caused the crash.
Hedge funds did contribute to instability in 2008, as the system began to quake, by withdrawing funds from banks and brokerages that looked shaky. The funds did that to protect their own money in case the banks went bust, which Lehman Brothers did and several others nearly did. But you can’t really argue hedge funds should have kept their money in failing banks to help the banks survive their own bad decisions.
The Rand report also found that short sellers didn’t contribute to the financial crisis. Some hedge funds used short selling to make money at the time, such as John Paulson, who began to sense in 2006 that mortgage-backed securities were wildly overvalued. He made billions of dollars betting against the securities, correctly foreseeing the housing-market collapse. But that didn’t hasten the collapse or make it worse, and Paulson himself, a Wall Street backbencher up till then, was taking on financial titans such as Citi, Merrill and Lehman.
Taxpayers hated the bailouts that stabilized Wall Street, but that intervention helped save the financial system, and all the big banks that survived paid the money back, with interest. Overall, the government made a profit of $110 billion on the bailouts, with no net cost to taxpayers.
No hedge fund got a direct bailout. Hedge funds benefited from the bailouts, which kept many of their trading partners in business and saved many deals. But mostly everybody benefited from the bailouts, which prevented a recession from becoming a depression.
The government’s biggest “loss” wasn’t on a bank, but on General Motors. The government chose to exit its ownership stake in GM, for a loss of $11 billion, in 2013. Even so, that bailout preserved hundreds of thousands of auto industry jobs, including those at suppliers that would have closed if GM went down.
None of this means hedge funds and short-sellers are altruistic angels on a mission to improve humanity. They’re not. They’re on a mission to make money any legal way, often without regard for the consequences.
Short sellers help identify mismanagement and fraud, but they also irk some people because they appear to be angling for businesses to fail. Hedge funds can be an important investing alternative for pensions, but they also tend to specialize in financial engineering that makes gargantuan profits for a few with no benefit for most. The animosity some folks feel toward these Wall Street insiders may be warranted, but all fat cats are not the same.
Rick Newman is the author of four books, including “Rebounders: How Winners Pivot from Setback to Success.” Follow him on Twitter: @rickjnewman. Confidential tip line: [email protected]. Click here to get Rick’s stories by email.
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