Two And Twenty And The Hedge From Hell

mike_ryan There are many culprits in the current banking crisis. First there were the mortgage companies who pushed the sub-prime loans. There were hefty fees and increased earnings lifting the price of their stock. There were the homebuyers who were caught up in the frenzy of real estate speculation and were only too happy to borrow money they could not repay except from the ever-increasing home equity they believed they would receive. There were the hedge funds that bought the sub-prime mortgages and packaged them into derivative securities they then sold to other investors. There were the investment banks that loaned the money to the hedge funds allowing them to leverage their investment up to 100 to 1. Finally there were the rating services who provided bogus investment grade ratings (AAA) to very poor credit securities and the bond insurers who normally insure municipal bonds but were enticed into this very risky market.

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What a band of rogues. Each was culpable but I think the ones that really fueled the fire were the hedge funds. Hedge funds are private partnerships that are not registered securities. They operate under the exception under securities law that says if you are a wealthy sophisticated investor you should be allowed to invest wherever and with whomever you want. Remember the tax shelter scams of the eighties.

Hedge funds gather the money of wealthy investors and then invest in just about whatever they can dream up. They can buy with the hopes of higher prices (go long) or sell with the hope of lower prices (go short). They may do both at the same time in order to “hedge” their position. They attract managers because the supposedly sophisticated investors are willing to pay the managers of the funds a fee of 2% of the value of the fund plus 20% of all profit.

The fees are enormous. Assume you are a hotshot young trader who builds a reputation on Wall Street. You take those ‘creds” and raise a billion dollars in a hedge fund. In year one you earn a twenty percent return and double that in year two. In year one you make a minimum of twenty million on the two percent fee alone plus an additional forty million on the twenty percent share profit you take. Your investors earn 16% so they don’t complain. The second year you really rake it in. You will have minimum fees of $24 million and an incentive fee of $96 million for a yearly haul of $120 million. Gains of this magnitude are not uncommon in the hedge fund world. Some managers would consider these earnings as paltry.

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So what is the problem? Yes the hedge fund managers raked it in but the investors did have a two-year return of close to fifty percent. What’s wrong with that? Well to start with the investors returns were taxed as ordinary income. For those living in high income tax states this means a combined rate of well over 40% so the after tax return is really more like 28%. Congress likes hedge fund managers so they were allowed to have their income taxed at the capital gains rate of 15%.

So far it sounds great for the hedge fund manager, so- so for the investor. Year three is not so good as markets cool. The fund looses 10%. The manager is sorry but his feelings are certainly assuaged by the $30 million base fee. Unfortunately the investors are now earning municipal bond after tax rates of return for all their efforts as sophisticated investors. Are you getting the picture?

It is now 2007. The hedge fund manager knows he won’t get back to the incentive fee level unless he makes up for last years loss. These are called hurdle rates that are meant to protect the investors from excessive fees. They actually create incentives for the manager to take even greater risks to achieve high returns. The manager loads up on sub prime mortgages and increases the leverage by borrowing even more money from his prime broker and investment banker, Bear, Stearns.

The credit market collapses early in 2008. The fund cannot meet the margin calls and most of the investor’s equity goes to hedge fund heaven. Bear Stearns, whose stock had been at $158 per share in April of last year, sells out to JP Morgan Chase for two dollars a share.

Who are the winners? JP Morgan gets a deal. The real estate of Bear Stearns is probably worth much more than two dollars a share. The hedge fund manager heads for his yacht with over $200 million in the bank from bilking the investors in his now defunct hedge fund. Believe me we will hear from him again in a few years when he starts his next hedge fund in more conducive economic conditions.

The losers are a long list. The homeowners who were sold the sub prime loans loose their home. The mortgage brokers are probably out of business or have seen their profits plummet with their stock price. The investment bankers who funded the hedge funds are gasping for survival and begging for bailouts. The sophisticated investors who lost all their investment in the hedge fund, although I would not feel too sorry for anyone who had several million to invest in a highly leveraged speculative investment.

In the end the big losers will be the American taxpayers who will be asked to bail out a corrupt system that is structured to provide immense rewards for making highly leveraged bets on investments that have no transparency or oversight. There is little I am sure of but I can say with complete confidence that until we change the incentives which allow huge upside profits with little or no consequences for failure we will see this sad history repeated again and again.

Mike Ryan CFP®

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