Guest Post: David Brooks' Big Wet Kiss To Hedge Fund Managers
Submitted by David Fiderer
After he read a book that he didn't understand, David Brooks came up
with another crackpot distortion of capitalism. This time, he finds a
sharp contrast between bankers and hedge fund managers, whom he lumps
together all other business entrepreneurs. In his latest column he writes:
The smooth operators at the big banks were playing with
other people's money, so they borrowed up to 30 times their investors'
capital. The hedge fund guys usually had their own money in their fund,
so they typically borrowed only one or two times their capital.
The social butterflies at the banks got swept up in the popular
enthusiasms. The contrarians at the hedge funds made money betting
against them. The well-connected bankers knew they'd get bailed out if
anything went wrong. The solitary hedge fund guys knew they were on
their own and regarded their trades with paranoid anxiety.
Because they weren't playing with other people's money, hedge fund
managers were more careful than the big banks? How fatuous is Brooks'
analysis? Let's count the ways:
1. Hedge fund managers are insulated from investment losses
and from taxes, whereas bankers are not.
As anyone who reads The Wall Street Journal knows, hedge
fund managers get rich because of the "Heads-I-win-tails-I-don't-lose"
fee structure paid by their investors. Typically, they charge a 2%
management fee, plus they take 20% of all profits. The fund manager only shares
in the profits, not the losses. So his primary incentive is to seek a
big short-term upside, rather than to limit downside risk. When a hedge
fund manager puts his own money into a fund, he benefits primarily from
the leverage of other investor contributions, rather than from external
debt. And when a fund manager collects his no-risk fees, he doesn't pay
taxes the way ordinary Americans do. Those fees, which take out 20% of
the fund's profits, are considered capital
gains rather than ordinary income, which is quite a trick, since
the theory behind lower rates on capital gains is that money was put at
A hedge fund manager who takes spectacular losses can start over by
launching a new fund right away, whereas a bank executive who screws up
usually gets fired. At best, Brooks' claim that, "well-connected bankers
knew they'd get bailed out if anything went wrong," is grossly
misleading. Banks that got bailed out also got dismantled. Bear Stearns,
Wachovia, and Washington Mutual no longer exist. AIG is being broken
up and Merrill is a shadow of its former self. The one possible
exception is Citibank, which was forced to sell Salomon Smith Barney.
Moral hazard remains a huge issue, and the senior executives who failed
to properly manage their banks walked away rich. But these guys were
also fiercely driven and committed staying on top, which is why they
never thought, "I'm well-connected so I'll get bailed out." Instead,
their common failure in judgment was to accept bogus triple-A ratings on
mortgage securities at face value
2. Hedge funds made money by exploiting secrecy, whereas
banks were regulated.
The largest hedge fund in the world was run by Bernie Madoff. Many other hedge funds invested
almost exclusively in the Madoff Fund. Clearly, these feeder fund
managers, and other sophisticated investors, were clueless. The Madoff
scam thrived because the entire hedge fund industry, which dominated many credit markets, had operated in
secrecy. The funds that offered the skimpiest financial disclosures were
able to snare investors who treated due diligence as a joke. This
complete lack of transparency gave hedge funds large incentives and
opportunities to manipulate markets and to trade on inside information. Amarenth and Centaurus exploited that secrecy to
manipulate natural gas markets. In a prequel to the financial crisis of
September 2008, a single hedge fund, LTCM, brought Wall Street to its
Commercial banks are subject to a lot of regulatory oversight. Again,
the banks failed, and the regulators failed to provide effective
oversight, primarily for one simple reason: They all relied on bogus
triple-A ratings for toxic mortgage securities. They saw the rating and
disregarded the need for substantive due diligence or analysis on those
investments. John Paulson, and other "contrarian" hedge fund managers
whom Brooks' exalts, had figured out the triple-A scam and got rich by
creating, and then shorting, new toxic assets designed to fail.
3. Because they are black boxes, hedge funds borrow in the
repo market, whereas bank leverage is a consequence of Bush-era
Brooks insinuates that hedge funds had two times leverage because
their managers were cautious. Not true. Banks would only lend to them on
an overnight basis, while they held marketable securities as
collateral, because a hedge fund's financial position can change
instantaneously. Investment grew their leverage, to 30 times equity,
because a Bush-era crony, S.E.C. Chairman Chris Cox, gutted regulatory oversight of investment banks.
Over the objections of a unanimous commission investigating the subject,
Cox decided that investment banks could opt in or out for "voluntary
oversight" whenever they felt like it.
All of this segues into Brooks' real agenda, which is to pervert
history. He wants us to equate the Bush Administration's refusal to
enforce the law, and its wholesale emasculation of regulatory
institutions, with a creeping socialism. He wants to us to believe that
the bank profits are caused by government regulation, which stifles
those engines for growth in the real economy, hedge funds. He calls
bankers "princes" and hedge fund managers "grinders":
The princes can thrive while the government intervenes in
the private sector. They've got the lobbyists and the connections. The
grinds, needless to say, don't. Over the past decade, professionals --
lawyers, regulators and legislators -- have inserted themselves into
more and more economic realms. The princes are perfectly at home amid
these tax breaks, low-interest loans and public-private partnerships.
They went to the same schools as the professionals and speak the same
language. The grinds try to stay far away and regard the interlocking
network of corporate-government schmoozing with undisguised contempt.
For the record, banks are making lots of money because of
low-interest rates and reduced competition, two offshoots of the Bush
financial crisis, and because financial reform has yet to pass. As for
those hedge fund managers who show disdain for Washington lobbyists,
check out this. There's a reason the book touted by Brooks
is titled, More Money Than God.