Hedge funds have received more than their fair share of criticism in the past two years. They've been called too secretive, overpaid, indulgent, bratty and -- most seriously, because of the regulatory implications -- dark pools of potentially overleveraged capital highly correlated in risk with other financial institutions.

I think all these characterizations are distorted, although there's an element of truth in them. Drive around the Hamptons in the summer and you too might roll your eyes at some of the excesses of hedge fund managers.

But when you review 2008, no hedge funds of any consequence were at the center of the meltdown (aside from Bernie Madoff, but he was simply a fraud, not a hedge fund). Some failed, but there was not one government bailout of a hedge fund.

Most regulatory concerns about hedge funds today relate to a hedge fund that has been out of business for more than a decade: Long-Term Capital Management. When it blew up in 1998, its infallible Nobel laureate managers saw their losses get multiplied 40 times because of excessive leverage. Worse, those losses were amplified because LTCM's counterparty banks had mimicked many of the fund's trades. Leverage at many hedge funds appears to be much more in check these days. Funds are also much more secretive about their trades.

One thing that does irk hedge fund investors is when fund managers close up shop after a bad year only to reopen six months later. They typically do this after poor years, so that they won't be required to make up investors losses in the following year before they get paid their incentive fees (a provision called a "high-water mark," which is a standard part of a fund's offering documents).

LTCM co-founder John Meriwether got flak recently after he walked away from his second hedge fund and immediately raised funds for his third. Most managers stick it out however. And many have already reclaimed their high-water marks in 2009.

Because hedge fund managers are required to make up losses before receiving their incentive fees, their compensation is different from that of bankers.

Banks pay out a substantial amount of their revenue in both good years (2009) and bad (2008). Most hedge funds got no incentive compensation last year and this year.

Now that the hedge funds have repaid their losses to investors, they can look forward to a more "normal" 2010, where they'll get a bonus, although they won't get it until 2011 (a full 3 years after their last bonus or the heady days of 2007). Banks, on the other hand, have received compensation throughout.

I thought of this as I read through Bethany McLean's excellent and balanced article on

Goldman Sachs

(GS) - Get Report

in

Vanity Fair

. She chronicles the gap in perceptions between those who work inside and outside of Goldman when it comes to the issue of their compensation and what their people are worth.

There were a couple of insightful comments in the article from Anthony Scaramucci, head of SkyBridge Capital and a former Goldman vice president. It's unusual for a Goldman veteran to go on the record with a truthful critique of the firm. Yet Scaramucci did. It reminded me of

a comment

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I'd heard him make earlier this fall. I didn't pay much attention to it at the time, but it now rings true more than ever before. What if hedge funds caused the crash -- making bankers green with compensation envy?

What screwed up our financial system is that Wall Street's natural hierarchy got torn asunder as hedge funds grew in popularity from 2003 to 2007. Junior bankers left jobs where they were making $3 million a year and started earning $10 million, $20 million or even $50 million a year working at hedge funds. Their former bosses -- 10 years along in seniority -- were back at the banks still pulling in $10 million a year.

The left-behind bankers needed to figure out some way to get their own pay back up to some multiple of their former lackeys. Otherwise, they wouldn't be achieving their full career potential.

So the solution for all these "too-big-to-fail" bankers was to try to morph their organizations into large hedge funds built on top of deposit-taking, federally protected banks.

They levered up mom-and-pop deposits 40 times and built up their in-house trading operations to execute what they thought the bigger hedge funds were doing. These banks never had to go on the road and face skeptical institutional investors in order to raise money (as real hedge funds did). They never had to show they had a unique strategy with effective risk management. They just repurposed their deposits and ran with it.

Of course, Goldman did about as well in its trading as any large hedge fund. As a result, former trading group head Lloyd Blankfein's power base increased. His promotion to CEO only further cemented the dominance of trading in the overall firm, compared with the traditional "white shoe" Goldman bankers who advised clients.

Virtually all of the banks did disastrously when the downturn came. Undeterred, the bankers then used their deposit-taking status to get a bailout from the government. They also continued to pay themselves, year in and year out, while the hedge funds who performed poorly either shut down or didn't give their people bonuses for several years.

Our financial system was done in not by smart people or unethical people but by overly envious bankers who wanted to keep up with the Rajaratnams.

Isn't envy what drives the free market system? Shouldn't we let these bankers go off and do this again? Maybe their desire to buy a bigger yacht will drive them to create some financial innovations that will serve the broader market? Who are we to judge the power of the free market?

But the banks weren't operating in a free market. The bankers used the government -- through FDIC protected deposits -- to shelter their own trading operations from the judgment of true market forces. A real free market would have told many of these guys that they had no business trading -- especially with 40-to-1 leverage.

To truly learn from the lessons of 2008, we don't need the government setting pay scales with the help of Ken Feinberg. We need it to establish limits on leverage. Scaramucci has suggested a limit of 20-to-1 is appropriate. Simply instituting that limit would have an effect on pay. More importantly, it would lower the prospect of a systemic-risk event like LTCM. (It would also have ramifications for the credit default swap market.)

Bringing back Glass-Steagall also makes sense in my view. Why not let the banks bank and traders trade? We shouldn't allow rules designed to protect banks to insulate traders from true market forces.

I believe doing this would force traders to adopt the same compensation system as hedge funds.

Critics complain when hedge fund managers make a lot of money in a good year, but no one covers the story of the guy who gets no bonus for three years. That's a fair system that allows for high pay in the good years.

We will always have envy in our free markets, and that's a good thing. But it's also good to have clear "rules of the game." Let's ensure that bankers bank, traders trade and everyone lives or dies by his or her performance.

At the time of publication, Jackson had no positions in stocks mentioned.

Eric Jackson is founder and president of Ironfire Capital and the general partner and investment manager of Ironfire Capital US Fund LP and Ironfire Capital International Fund, Ltd.