Thursday, April 17, 2008

Ugly hedge fund managers

I’m not an accountant so I don’t know much hedge funds and sub-prime mortgages (except that one has made a lot of people very rich and one has made a lot of people very poor – or at least poorer than they were before) but I was astounded to read on the front page of the International Herald Tribune today that one hedge fund manager in the US, John Paulson, made US$3.7 billion (yes, billion, not million) by betting against mortgages and some of the complex financial products that held them.

Meanwhile, thousands of homeowners in the US (and probably in other parts of the world too) are being evicted from their homes as the banks foreclose on them.

How can someone make US$3.7 billion by betting on mortgages? And the article said that two other fund mangers made almost US$3 billion each by doing the same.

The story went on: “Hedge fund managers have redefined notions of wealth in recent years. And the richest among them are redefining those notions once again. Their unprecedented and growing affluence underscores the gaping inequality between the millions of Americans facing stagnating wages and rising home foreclosures and an agile financial elite that seems to thrive in good times and bad.”

If hedge fund managers can make over US$10 billion by ‘betting’ on other people’s mortgages (whatever that means – I really don’t understand how you can ‘bet’ on a mortgage), then doesn’t that suggest something is wrong with the system?

I do know enough about accounting to know that debits must equal credits, so if their funds have been credited to the tune of US$10 billion, then someone else’s (or many someones) must have been debited the same amount.

But they have earned that for doing what? Nothing it seems except placing a bet.

The Chief Investment Officer of the bond fund Pimco, William Gross, was quoted in the story as saying: “There is nothing wrong with it – it’s not illegal.”

He added: “But it’s ugly.”

It’s more than ugly – it’s obscene.

With so many millions of people starving in the world, trying to survive from one day to another on a dollar a day or less, these hedge fund managers are making more money in an hour than most people make in a lifetime.

1 comment:

Ken A said...

Hi David--I found your blog from TE. Nice stuff. I hope more audience finds you.

What Paulson apparently did was to buy Credit Default Swaps (CDS). These are a kind of derivative that's sort of like an insurance policy against default. If you own a lot of bonds of, say, General Motors, you could buy CDS that will pay you if GM defaults. The seller of the CDS is not an insurance company, it is some other investor who is willing to bet that GM will not default, and has to pay off on the "policy" if they do. You can also buy CDS for bonds that are backed by packages of mortgages. And you can do so even if you don't actually own any such bonds. I gather that is what Paulson bought. Sort of like buying a life insurance policy on some total stranger you think is about to die. If you think mortgage bonds are going to "die", you buy "life insurance" on them.

Anyway, I'm not an expert at all so I may not have the details correct.

As a hedge fund manager, Paulson probably takes something like a 2% fee on all the assets he manages, plus 20% of all returns above some standard threshold (like the S&P 500 or whatever.) So it he is good and big-time investors give him, say, 20 billion to manage, and through bets on CDS and other securities he turns that into, say, 40 billion in one year, then maybe that's 18 billion above the threshold for gains, and he pockets 20% of 18 billion, which is a huge wad of money, no question.

So if people think Paulson is good enough that they will give up 20% of their gains in order to invest with him, and he more than meets their expectations, where do we say no, you can't make that much money? Should he have to give it back to the investors? They're rich people too. I'd rather let him make the money, and then pay a relatively high tax rate since he can afford it.