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 Journalknows, 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 risk.
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 knees.
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 cronyism.
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.
