People have found ways to lever themselves rather through derivatives, rather than simple borrowing of cash... e.g. if you want levered exposure to a portfolio of high-grade corporate bonds, you don't borrow money and invest in cash bonds. You get an investment bank to structure a bespoke synthetic CDO tranche which, according to your single-factor Gaussian copula model, gives you exactly the risk and return that you want. If you want levered exposure to interest rates, you don't borrow money and speculate on Treasury notes; you pay (or receive) on an interest rate swap whose notional amount is far greater than the amount of cash you have. With the current state of derivatives regulation, people will be playing these games whether Fed funds is at 0% or 10%.
I will grant you that giving fund managers a call option on their returns isn't a great idea. It has the advantage of being cheap, since the value of a call option is less than the underlying. But at the same time, the value of a call option increases in value as the volatility of the underlying increases. So not only do hedge fund managers have incentive to get good returns, they have an incentive to get volatile returns as well -- this leads to perhaps more risk-taking than is necessary.
Edit: and the funny thing is that JWM Partners, Meriwether's post-LTCM fund, is supposedly down 20% this year. To be fair, they apparently did a pretty good job from 2000-2008 or so.
Yet, banks have freely lent to them, because they could, in turn, borrow from the Fed. The Fed (i.e us taxpayers) have operated as the ultimate patsy in the system, providing a one way bet to the speculating class. The evidence of it is the relentless expansion of the total credit in the system (as a percentage of GDP). Literally, the Fed has allowed the creation of total system-wide credit at 2-3 times faster rate than GDP growth, for many, many years running.
No matter what happens now, most hedge fund managers got theirs. As has already been observed, 8 years of feverish levered returns followed by one year of total wipe-out of capital still makes the managers ahead!
Regardless, it still makes plenty of economic sense for a bank to lend to a hedge fund, whether or not the Fed is involved. This type of lending is typically short term and rolled over as loans expire. If a bank lends to another bank, it only receives LIBOR, but if it lends to a hedge fund, it can charge slightly higher, say LIBOR + 40bps. Given that the bank itself can borrow at LIBOR, this is a decent way to make money. It's really no different than short-term lending to any other kind of corporation.
I won't deny that credit has greatly expanded lately. I just don't think the expansion of credit to hedge funds has much to do with the Fed.
Here is why finance has changed so much and become such a big deal since the early 90s: http://www.mises.org/content/nofed/makegraph.php?tms=true...
http://www.mises.org/content/nofed/chart.aspx?series=TMS
The TMS is heterodox measure, but it has been in use for years.
That kind of leverage is the direct outcome of the 1% interest rates the Fed ran for a while (banks borrowed at 1%, lent to the hedgies at 4-5%, pocketing a nice spread, and the hedgies used that cheap money to run their own leveraged speculation ...) They get 20% of the upside if they win, and get to walk away if they lose.
The net result is a transfer of wealth from productive classes of society towards speculative classes. This is what primarily caused the heightened inequality we witnessed in the last several years. I say all this as an entrepreneur with a libertarian bent.
From an individual point of view, it is perfectly rational to speculate this way. It is the Fed policy that created the incentives to speculate.
My point is that Wall Street riches have not been fairly earned in a capitalistic marketplace, but in an artificial environment fostered by the Fed.