Alphaville has published a very good article in FT.com titled "In Defence of Hedge Funds". A brief summary of the article is shown below.

The article quotes Dick Fuld recounting the position of the US Treasury towards hedge funds, "…kill the bad HFnds + heavily regulate the rest" that came from an email between Fuld and Lehman’s general counsel, Thomas Russo, recently made public by US Congress.

The banks were clearly successful in convincing the US Treasury that the banks were not to blame and that more liquidity and more confidence was needed, not more capital. While Paulson eventually came around to the view that the banks needed recapitalising, hedge funds are still in the target sights of regulators.

The BBC’s business editor Robert Peston is quoted as saying:

"…the (hedge fund) industry as a whole hasn’t even begun to address the central charges against it: namely, that it helped to stoke up the credit bubble by providing a market for toxic investments; and that it has brought disorder to the puncturing of that bubble, through the poisonous combination of deliberate strategies to destroy the credibility of weaker financial firms, and through massive automatic sales of assets in a falling market.

Really?

The article explains:

Firstly - on “providing a market for toxic instruments”.

It’s right to say, as Peston does, that hedge funds were often the happy buyers of the lowest tranches of mortgage backed CDO's: the mezz and equity pieces that support above them a far greater number of AAA-rated senior tranches. In fact, the “toxicity” of CDOs relates to the AAA tranches which holders thought had little or no chance of default.

Smart money stopped buying the senior pieces a long time ago. Banks still wanted to issue CDOs though and needed AAA tranche buyers and built securities to carry these risks, some of which were held on their own balance sheets and have since taken large writedowns and suffered capital impairment charges. Greedy banks were the cause of their own demise.

Secondly - on “the poisonous combination of deliberate strategies to destroy the credibility of weaker financial firms”.

The article points out that you don’t need shorting to make people panic about banking confidence. It shows how the FTSE fared after the FSA banned shorting financials (indicated below by the vertical blue line):

Volatility increased and, after an initial rally, the market simply continued on its secular trend. This was the case in Australia also, as shown in my earlier post titled "Australia's Short Selling Ban - One Day Wonder?"

Thirdly - on “massive automatic sales of assets in a falling market”.

The article makes the point that sales by hedge funds have been driven by redemptions that in turn have been adversley impacted by falling confidence. Another cause of the fall has been margin calls made by the banks themselves.

The article concludes that the investment banks are the arhitects of this crisis, not hedge funds.