More Money Than God_Hedge Funds and the Making of a New Elite
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Almost half a century later, hedge funds were still getting privileged information and still getting into trouble. This time the center of the scandal was Raj Rajaratnam, a voluble Sri Lankan-born investor with a Bob Brimberg physique, who ran a hedge-fund company called the Galleon Group. He was less a master of the universe than a master of the Rolodex, as the SEC’s enforcement chief remarked; he had no amazing special sauce, but he had a lot of special sources. According to a criminal complaint brought by the Manhattan district attorney’s office in 2009, Rajaratnam’s contacts gave him advance warning that a technology manufacturer called Polycom would announce unexpectedly good earnings; Galleon allegedly turned that tip into a quick half-million-dollar profit. The contacts whispered that the private-equity group Blackstone was about to bid for Hilton Hotels; Galleon allegedly pocketed $4 million. The contacts knew for certain that Google’s earnings would disappoint; this time the supposed windfall weighed in at $9 million. Rajaratnam’s Rolodex extended to a senior executive at Intel and a director at McKinsey, both of whom were apparently prepared to leak secrets in return for a share of the takings. According to the prosecutors, the conspirators sought to cover up their trail by frequently discarding mobile phones, a technique reminiscent of drug gangs. After an illegal trade, one of the accused allegedly destroyed his phone by tearing the SIM card in half with his teeth. In the face of all these allegations, Rajaratnam pleaded innocent.
Clearly, hedge-fund managers are not angels. Their history is full of blemishes, from Michael Steinhardt’s collusive block trading to David Askin’s nonexistent mortgage-prepayment model. The very structure of a hedge fund has worried regulators since the early days. At the time of the Douglas Aircraft case, regulators fretted that hedge-fund patrons included rainmakers and senior executives at public firms—what if these well-placed folk leaked privileged facts to the men who looked after their money? Two generations later, these suspicions seem to have been vindicated in the Galleon affair, and it would be naive to suppose that other 1960s misgivings have lost their relevance. The Douglas case showed that the enormous commissions that hedge funds generate for brokers create a potential for abuse, and it’s a pretty fair bet that such abuses continue. There are criminals and charlatans in every industry. Hedge funds are no different.
And yet, equally clearly, hedge funds should not be judged against some benchmark of perfection. The case for believing in the industry is not that it is populated with saints but that its incentives and culture are ultimately less flawed than those of other financial companies. There is no evidence, for example, that hedge funds engage in fraud or other abuses more often than rivals. In 2003 an SEC inquiry looked for such evidence and found none; and indeed a freestanding hedge fund is arguably less likely to receive illegal tips than an asset manager housed within a major bank, which is privy to all manner of profitable information flows from corporate clients and trading partners. For sensitive news to reach the wrong ears inside a modern financial conglomerate, it merely has to pierce the Chinese walls dividing equity underwriters or merger advisers from proprietary traders. For the news to reach a hedge fund, it has to take the additional step of exiting the building.
What is true for fraud and insider trading is also true for most other accusations leveled at hedge funds: The charges might be better directed against other financial players, as we shall see presently. But the heart of the case for hedge funds can be summed up in a single phrase. Whereas large parts of the financial system have proved too big to fail, hedge funds are generally small enough to fail. When they blow up, they cost taxpayers nothing.
AFTER THE BUST OF 2007–2009—AND AFTER THE CIRCUITOUS regulatory debate that has followed—it is hard to overstate this small-enough-to-fail advantage. The implosion of behemoths such as Lehman Brothers and AIG caused a freeze-up in the global credit system, creating the steepest recession since the 1930s. The cost of the bailouts compounded the crisis of public finances in the rich world, accelerating the shift of economic power to the emerging economies. The U.S. national debt jumped from 43 percent of GDP before the crisis to a projected 70 percent in 2010, while public debt in China, India, Russia, and Brazil remained roughly constant; meanwhile in Europe, countries such as Greece and Ireland teetered on the brink of bankruptcy. According to the International Monetary Fund, the cash infusions, debt guarantees, and other assistance provided to too-big-to-fail institutions in the big advanced economies came to a staggering $10 trillion, or $13,000 per citizen of those countries.3 The sums spent on rescuing well-heeled financiers damaged the legitimacy of the capitalist system. In December 2009, President Barack Obama said plaintively that he “did not run for office to be helping out a bunch of fat cat bankers.”4 But help them out is what he did, and populist anger at his openhanded policies is hardly surprising. Even more worryingly, neither Obama nor any other leader knows how to prevent too-big-to-fail institutions from fleecing the public all over again. The worst thing about the crisis is that it is likely to be repeated.
To see why this is so, start with the catch-22 that bedevils government support for the financial sector. On the one hand, many financial institutions are indeed too big to fail; if governments refuse to rescue them, seeking to protect taxpayers’ money, they open the door to a meltdown that will cost taxpayers even more—as the post-Lehman crisis demonstrated. On the other hand, each time the government pays the bills for the risk taken by financiers, it reduces the cost of that risk to market players, dampening their incentive to reduce it. If there were no deposit insurance, for example, depositors would face losses when banks went under; they might refuse to entrust their savings to risk-hungry banks, or might demand higher interest rates as compensation. Equally, if governments did not backstop banks (and now investment banks) by acting as lenders-of-last-resort, investors who buy bonds issued by banks might do more to monitor their soundness. The point is not that there should be no deposit insurance or lender-of-last-resort liquidity insurance, since letting big institutions fail is simply too costly. But the unpleasant truth is that government insurance encourages financiers to take larger risks; and larger risks force governments to increase the insurance. It is a vicious cycle.
You can observe this cycle at work in the history of banking. Over the past century, governments have repeatedly broadened the scope of last-resort lending, loosened its terms, and extended deposit insurance to a larger share of banks’ customers. As governments have underwritten more risks, risk taking has grown. Since 1900, U.S. banks have tripled their leverage from around four to twelve; they have taken more liquidity risk by using short-term borrowing to purchase long-term assets; and they have focused more of their resources on high-risk proprietary trading.5 The 2007–2009 crisis, in which governments extended the reach of deposit insurance, guaranteed savings held in supposedly uninsured money-market funds, and bent over backward to pump emergency liquidity into all corners of the markets, is likely to induce even more recklessness in the future. Put simply, government actions have decreased the cost of risk for too-big-to-fail players; the result will be more risk taking. The vicious cycle will go on until governments are bankrupt.
There are two standard responses to this scary prospect. The first is to argue that governments should not bail out insurers, investment banks, money-market funds, and all the rest: If financiers were made to pay for their own risks, they would behave more prudently. For example, if investors had been forced to absorb the cost of the Bear Stearns bankruptcy in early 2008, rather than having the blow softened by a Fed-subsidized rescue, they might have prepared themselves better to absorb the costs of Lehman’s failure some months later. But this purported solution to the too-big-to-fail problem denies its existence: Precisely because some institutions are indeed too big to fail, they cannot be left to go under. What’s more, the behemoths and those who lend to them understand their inviolability all too well; the government may claim that it won’t rescue them, but everybody understands that it will have no choice when the ti
me comes. Even the soft version of this laissez-faire prescription is unconvincing. One can speculate about a world in which regulators save really large institutions but allow medium-sized ones such as Bear to go under. But this is not the world we inhabit. Regulators will usually lean toward intervention because they don’t want a disaster on their watch. That is human nature, and there is no way to change it.
The second standard response to the vicious cycle is to devise regulations that break it. Safety nets for banks may encourage risk taking, and risk taking may force the growth of safety nets; but this arms race can be stopped by imposing capital requirements on banks, monitoring their liquidity, restricting their proprietary trading—and generally by curbing their risk appetites. Up to a point, tougher regulation holds out hope; as I finished writing this book, governments across the rich economies were getting ready to try it. But the world has experimented with multiple regulatory efforts by multiple agencies in multiple countries, and it has learned to its cost that no regulatory system is foolproof. The firms that went wrong in 2008, for example, were overseen by a broad array of agencies applying a broad array of rules. American deposit-taking banks were overseen by the Federal Reserve, the Federal Deposit Insurance Corporation, and two smaller bodies, and they were required to abide by the Basel I capital-adequacy standards: They did miserably. American investment banks were overseen by the Securities and Exchange Commission and required to abide by a different set of risk limits: Two failed, one sold itself to avoid failure, and two were rescued by the government. The government-chartered housing finance companies, Fannie Mae and Freddie Mac, had a special government department devoted to their oversight: They had to be nationalized. The giant insurer AIG crashed through the regulatory net; money-market funds, supposedly overseen by the Securities and Exchange Commission, required an emergency guarantee from the government. Meanwhile in Europe, the chaos was equally awful. London’s Financial Services Authority was thought to be a model regulator; Britain was nonetheless beset by a string of costly disasters. In continental Europe, banks were subject to an updated version of the Basel capital requirements. It did not make any difference.
When so many regulators fail at once, it is hard to be confident that regulation will work if only some key agency is differently managed, better staffed, or cleansed of alleged laissez-faire ideology. Rather, the record suggests that financial regulation is genuinely difficult, and success cannot always be expected. Again, there are reasons why this should not come as a surprise. Determining what it takes to make a financial institution robust involves a series of slippery judgments. The amount of capital needed should not be measured relative to assets, since assets could mean anything from a scary portfolio of mortgage bonds to a safely hedged book of government bonds. Instead, capital should be measured against risk-weighted assets, but then you have to define risk—and be prepared to argue about the definition. Further, it is not just the amount of capital that determines how resilient an institution is. Borrowing short-term makes you more vulnerable to a sudden loss of confidence than borrowing long-term, so the structure of an institution’s funding must be reckoned with. Trading illiquid instruments that cannot be sold quickly, whether they are complex mortgage securities or loans to Kazakh banks, is riskier than trading on a well-organized exchange, creating another dimension on which regulators are obliged to make a judgment. Competent officials can navigate such tricky challenges and sometimes do—regulators are like air-traffic controllers, who are ignored when things go well and excoriated after a disaster. But at each step of the way, the regulators’ desire for safety will bump up against financial institutions’ appetite for risk. Given the brainpower and political influence of large financial firms, they are bound to win some of the arguments over judgment calls. Regulation will be softer than it should be.
If financial behemoths cannot be left to go under, and if regulation is both essential and fallible, policy makers should pay more attention to a third option. They should make a concerted effort to drive financial risk into institutions that impose fewer costs on taxpayers. That means encouraging the proliferation of firms that are not too big to fail, so reducing the share of risk taking in the financial system that must be backstopped by the government. It also means favoring institutions where the incentives to control risk are relatively strong and therefore where regulatory scrutiny assumes less of the burden. How can governments promote small-enough-to-fail institutions that manage risk well? This is the key question about the future of finance; and one part of the answer is hiding in plain sight. Governments must encourage hedge funds.
Hedge funds are clearly not the answer to all of the financial system’s problems. They will not collect deposits, underwrite securities, or make loans to small companies. But when it comes to managing money without jeopardizing the financial system, hedge funds have proved their mettle. They are nearly always small enough to fail: Between 2000 and 2009, a total of about five thousand hedge funds went out of business, and not a single one required a taxpayer bailout. Because they mark all their assets to market and live in constant fear of margin calls from their brokers, hedge funds generally monitor risk better and recognize setbacks faster than rivals: If they take a severe hit, they tend to liquidate and close shop before there are secondary effects for the financial system. So rather than reining in risk taking by hedge funds, governments should encourage them to thrive and multiply and absorb more risk, shifting the job of high-stakes asset management from too-big-to-fail rivals. And since the goal is to have more hedge funds, burdening them with oversight is counterproductive. The chief policy prescription suggested by the history of the industry can be boiled down to two words: Don’t regulate.
THIS VERDICT IS OPEN TO SEVERAL OBJECTIONS, AND THE first concerns the way that hedge funds treat their customers. Ever since the 1960s, the 20 percent performance fee has excited envy and alarm—surely this heads-I-win-tails-you-lose format promotes wild punts with clients’ capital? More recently, academics have advanced a subtle version of this criticism: The incentive fee may induce hedge funds to generate pleasingly smooth returns that conceal a risk of blowup. A fund can take in $100, stick it in the S&P 500 index, then earn, say, $5 by selling options to people who want to insure themselves against a market collapse. If the collapse occurs, the hedge fund gets wiped out. But, over a five-or even ten-year time frame, the odds are good that a collapse won’t happen, so each year the fund manager will beat the S&P 500 index by 5 percentage points—and be hailed as a genius. When this sort of trickery is rewarded with hedge-fund performance fees, the argument continues, rogues are bound to try it out.6 The upshot is that investors who ought to have the benefit of consumer-protection regulation will be left to get hurt. And when options-selling hedge funds blow up, markets will be destabilized.
These complaints about hedge-fund incentives seem plausible—until you take a look at the alternatives. Investing in a hedge fund is safer than other behaviors that do not excite controversy—buying stock in an investment bank, for example. Hedge funds have a powerful reason to control risk better than banks, as we have seen: The majority of them have the managers’ own wealth in the fund, alongside that of their clients. Moreover, if hedge funds’ 20 percent performance fees seem to invite excessive risk taking, bank performance fees are far larger. In recent years, investment banks have distributed fully 50 percent of their net revenues as salary and bonuses; even though this comparison is not perfect, it puts the criticism of hedge-fund fees in perspective. Investment-bank compensation creates a larger incentive for managers to shoot for the moon, damaging financial stability when they miss it. And whereas the formula for fees at hedge funds is fixed ahead of time, banks reserve the right to decree the appropriate level each year. The payout can change on the managers’ say-so, and rank-and-file shareholders have no right to be consulted.
How do hedge funds compare with mutual funds? On the face of it, hedge funds are scandalously expensive: Whereas mutual funds tend to charge a
management fee of about 1 percent, hedge funds tend to demand a management fee of 1 percent to 2 percent plus the performance fee of around 20 percent. But to understand which vehicle is the rip-off, you have to distinguish between alpha (returns due to the fund manager’s skill) and beta (returns due to exposure to a market index). An investor can buy exposure to a simple index such as the S&P 500 for a mere ten basis points (tenths of a percent), so the actively managed mutual fund with a 1 percent fee is effectively charging ninety basis points for delivering alpha. Unfortunately, study after study has found that active mutual-fund managers, as a group, do not beat the market.7 They are charging ninety basis points and delivering nothing. Their fee per unit of alpha turns out to be infinite.