To the Editor:
In "The Color of Hot Money," the authors argue that bank debt, not hedge funds, represents the destabilizing "hot money" in global capital markets and conclude that "markets will stabilize as more financial instruments begin to adjust through price rather than quantity." Unfortunately, they mischaracterize the behavior of bonds, stock, and bank debt, along with various market participants, including hedge funds.
When loans are due, banks can "adjust" their price by increasing interest rates to reflect changing market conditions. They are not limited to adjusting the quantity of lending -- contrary to what Baily, Farrell, and Lund argue. The new interest rate may be high, but the borrower has the option to pay it, thereby extending the loan and keeping liquidity in the system. Although banks can and do refuse to roll over loans, their refusal to relend does not make them "irresponsible." They are reacting to deteriorating market fundamentals and have a responsibility to protect shareholder capital.
Second, banks cannot avoid default by declining to roll over loans. Banks can avoid default only by getting paid. Third, loans can be sold by banks, thereby allowing those instruments to adjust through price, not quantity.
With respect to the behavior of bonds and equities, it is unclear what the authors mean by "because prices fall immediately, an investor has no time to sell without incurring a loss." Investors frequently take a small loss hoping to avoid a more significant one.
Equity and bond managers do not always have an incentive to ride out market corrections. Many find better uses for their capital. Furthermore, their own liquidity needs -- often driven by investor withdrawals -- may require them to sell. One cannot, therefore, treat equity and debt capital as inherently stable due to the price adjustment mechanism. Portfolio managers are not necessarily more flexible in reacting to risks than banks are, since they are subject to investor withdrawals if performance suffers. They, too, have their "hot money" fears.
The authors also mischaracterize hedge funds. Most hedge funds, although technically unregulated, provide substantial disclosure, having discarded their penchant for secrecy in order to attract institutional capital. Furthermore, most hedge funds, although admittedly not all, are relatively conservative investment vehicles that use relative-value, event-driven, or hedged-equity strategies. Their true absolution from the "hot money" label comes from the fact that the overwhelming number of hedge funds do not use the aggressive, macro-oriented trading strategies that have often been blamed inaccurately for global market instability.
MARTIN J. GROSS
President, Sandalwood Securities, Inc.