NYU economist Thomas Cooley explains complicated derivative securities.
Question: Are hedge funds good for the American economy?
Thomas Cooley: Well, I don't think that-- I don’t see hedge funds as being particularly detrimental, you know, they're just-- hedge funds is a very broad category that represents different investment strategies. Now, one of the things that is true is that hedge funds rely on complicated securities, trading complicated derivative securities, which people don't understand very well. And they rely on high degrees of leverage. So if they have, you know, a billion dollars in their hedge fund, they might borrow as much as $30 billion to trade with. And so, their strategies are backed by high amounts of leverage. And that creates some problems. But what we've learned is that the investment banks were very highly leverages as well, some by 35 or 36 to 1. And that means that if you're leveraged that heavily when the market's head down, you can be brought to your knees very quickly. It's like having only three percent equity in your home. So if home prices fall by three percent, you might as well walk away. So that was the status of Bear Stearns, that's what brought Bear Stearns down.