It may be easy to locate the origins of this autumn’s full blown financial crisis in the excesses of a cyclical credit market boom and its early seizure in August 2007. But it took the interplay of many random events and decisions to usher in the cataclysm that has unfolded since mid-September.

Everyone is looking to be wise after the fact. Union Bancaire Privée, the big Swiss fund of funds operator, said recently that it has been reducing exposure to hedge funds from 30% at the end of 2007 to nearer 20%. It and other forecasters say that the number of hedge funds will fall by 25% or more in coming quarters. What would have been an apocalyptic forecast only several weeks ago is suddenly conventional wisdom.

All this followed the gut wrenching volatility of recent weeks, in part fuelled by the wrong-headed ban on short selling financial stocks. Hedge Fund Research’s HFRI index fell 4.68% in September making it the second worst month ever after the LTCM inspired 8.7% drop in August 1998. That took year-to-date losses to 9.41%. Never mind that the long only industry flagship, Fidelity Magellan Fund, is down 50% and the S&P 500 is off over 30% this year.

The catalyst for the latest plunge was the implosion of Lehman Brothers. Unlike Bear Stearns there was no plan. It was as if U.S. Treasury Secretary Paulson wanted to send a message to risk takers and those that price risk. The message got through. Proposals and deals to keep Lehman afloat moved on and off the table with dizzying speed that fateful late September weekend. As Lehman sank, Merrill Lynch hopped ship to Bank of America. But the misguided brinksmanship and Paulson’s lesson on moral hazard could only be taken so far. Just days later American International Group, it turned out, really was too big to fail.

What amounted to the first phase of saving AIG was a US$85 billion cash injection from Uncle Sam for a majority interest. But the knock-on effect of the failure of Lehman, and the attendant administrative freezing of untold hundreds of billions of dollars in assets and transactions, gummed up an already plugged financial system.

Sandwiching these events was the Paulson flip flop. In early October the sonorous Treasury Secretary ruled out any Japan-style capital injections into bank balance sheets. For two long weeks, banking froze and global investors parked cash in T-bills as Paulson proposed a US$700 billion loan package that was stunning in its political naivety. As the plan grew from several bullet points to 400 pages, the world bore witness to the farce of the Congressional legislative process as the House of Representatives played chicken ahead of the Nov 4th election.

The TARP finally passed with the aid of high profile lobbying from Warren Buffet and others even though he cautioned that US$700 billion might not be enough. Days later, financial institutions began to fail or were taken over on paltry terms for shareholders. Washington Mutual, the biggest U.S. thrift, was shunted into JP Morgan Chase. Preceding all of it was the U.S. authorities gobbling up of serial sub-prime mortgage securitisation goliaths, Fannie Mae and Freddie Mac. And with hardly a whimper, Bradford & Bingley, like Northern Rock in February, succumbed to government control in Britain.

Then calamity spread. Across the hedge fund industry selling intensified to raise cash to cope with the de-leveraging sweeping the financial system and hitting their investors. Cash really was king and nobody was safe. Goldman Sachs and Morgan Stanley, the pillars of prime services, saw warp speed changes in their businesses as hedge funds engaged multiple prime brokers and moved cash out. Morgan Stanley’s stock slid to US$7, while Goldman sought out Buffet with a US$5 billion preference stock issue that included a 10% coupon. Suddenly, Paulson knew the game was up. A US$250 billion injection to bank balance sheets followed on the heels of Britain’s part nationalisation of RBS and Lloyds-TSB-HBOS and similar action plans in France and Germany.

The aftermath is sobering. Several prominent hedge funds closed either just before or amid the extreme chaos. But they have done so without high drama and returned money to investors in an orderly manner. Among the survivors, many of the industry’s marque names have suffered year-to-date losses of 15-20%. Now, many are cautious and have amassed enormous cash piles. Safety is the watchword.

Many changes will happen. The rules of counterparty management and of prime services relationships are being rewritten. Leverage is still falling. Among the big funds, more are looking to disintermediate prime brokers by obtaining access to exchanges and trading directly. Quant risk models, too, face many changes. But the premium placed on manager knowledge and experience can be expected to grow even if the industry shrinks in the immediate term.

As the white heat of the crisis intensified, calls for some new uber regulator came from the usual quarters in Brussels, London and Washington. The proposal of George Soros, earlier this year, for some kind of centralised CDS exchange may have merit. For change there will certainly be. But what is vital is that the main focus of scrutiny be directed on shoddy investment bank practices, unprecedented executive incompetence in some quarters and the connivance of the ratings agencies led by Standard and Poor’s and
Moody’s.

To be blunt, the hedge fund industry will have to fight together in the regulatory reviews to come. For now, the star turns in the media of Jim Chanos and Colin McClean of SVM Asset Management, among others, are instructive. Another reason for optimism is the plainly prescient efforts that began in 2006 to develop hedge fund standards. The hedge fund leaders working on the President’s Working Group in the U.S. and the Hedge Fund Standards Board in London have delivered much. When politicians and regulators eventually focus on reform to boost transparency and accountability, the work already accomplished on standards will help the absolute return industry punch above its weight. Success in that future debate is of critical importance. THFJ