Felix Salmon thinks that the fact that Goldman Sachs is bailing out one of their own hedge funds to the tune of 3 billion dollars (admittedly, only about 2 billion of that was their own money) is a sign that smart money smells an opportunity. Is he right?

I will grant you that Goldman Sachs fits the definition of smart money. But I have to wonder if it is wise to take their pronouncement that “We are investing not because we have to, but because we want to” at face value. As this article in the Economist points out…

This makes sense. After all, prime brokers provide the finance that allows hedge funds to gear up their returns and lend them the stocks so they can sell individual shares short (ie, gamble that their prices will fall). And monitoring is made all the easier because three investment banks—Goldman Sachs, Morgan Stanley and Bear Stearns—dominate prime brokerage. The trio act as brokers for about 60% of hedge-fund assets.

But this is where the paradox appears. Hedge funds are supposed to be dispersing risk. But if their chief financiers are just three Wall Street banks, is this dispersion more apparent than real? Could banks have shown risk out of the front door by selling loans, only to let it return through the back door of prime broking? Take credit insurance. Banks that own corporate bonds may use the swaps market to hedge against a company defaulting. But if the other side of the swap is taken by a hedge fund whose finances are dependent on loans from that same bank, has risk really been transferred?

Maybe I am being too cynical, but it seems to me that Goldman Sachs has every incentive to make sure this system keeps working. Goldman could easily survive the fallout if its alpha fund went down. But could they survive the fallout of all the quant funds going down? At the rate losses were occurring (Alpha fund was down 13 percent in one week) they might have figured that they had to do whatever it took to stop the rot.