Hedge funds 101

Hedge funds and tax haven from 2000 to 2007

Image via Wikipedia

This is an introductory course in hedge funds. Some or most hedge funds serve a useful purpose by allowing individuals and businesses to protect themselves from some risks, in effect by insuring against adverse events. A hedge is not an insurance policy, but it allows the bearer of risks to decrease a risk by sharing it with someone else for a fee. A hedge fund is a collection of hedges that third parties can invest in.

For example, a farmer could sell his crop for delivery at a future date at a price set in the present. If crops are abundant and prices drop, the farmer is guaranteed that he will receive the agreed higher price. If crops are in short supply and prices rise, the farmer must sell at the lower price agreed upon earlier. Much of what hedge funds deal with are currencies and other financial products.

If hedge funds perform services that is useful to society, they should receive reasonable fees for the services. My gripe is with the large hedge funds that act as giant casinos with our money. Let us use Las Vegas as an example of what I mean. If you or I were to gamble in a casino, we might win or lose with our own money. If we borrowed to gamble, we would be required to repay the loan. If we won, we would be required to pay income taxes at ordinary rates on our winning.

It is different for some large hedge fund. First, they gamble mostly with borrowed money. If they win, they too must pay income taxes, but they do so at specially low rates. If they are too big to fail, you and I as taxpayers will lend or give them money so that they can continue to gamble. The effect is that they keep their winnings, not sharing them with us, and we taxpayers reimburse their losses.

Adding insult to injury, these hedge fund managers pay themselves huge salaries and tremendous bonuses. They claim that the compensation is justified by the service they perform. My reaction to that argument is that I neither want nor am  I willing to pay such enormous fees for a service that society really does not require. Any short-lived mis-pricings in markets will correct themselves eventually, without delivering enormous leveraged profits to a few hedge funds.

Please see Globalization 101

Efficiency

the Great Hedge Fund Hei$t

Image by eyewash via Flickr

What price efficiency? How much is efficiency in financial markets worth? How much is it worth to you or to me? The hedge fund owner/manager who clears $billion in a single year, $500,000 per hour, thinks he/she is worth the price. If we put the job out for bids, I am sure that someone would volunteer to do it for $500,000 per day and then someone else would offer to do it for $500,000 per week and then another for $500,000 per month and finally $500,000 per year. I don’t care if the financial markets are super efficient or not. I might be willing to pay $500,000 per year or I might not.

The standard argument heard from Wall Street is that huge salaries and bonuses are necessary to keep the talented from joining competitive firms. So what? If the talented were not profitable to an individual firm, it would not matter who they worked for.

Then there is the other false argument thrown out by those who support the present tax structure, that the US has a high rate of taxation. That may be true on paper but it does not reflect the real world of tax loopholes and tax havens. If the hedge fund owner/manager really believes this, let him/her take his firm elsewhere and start paying taxes in a foreign country with a lower tax rate that lacks the tax loopholes that exist here in the US.

The numbers describing the US economy are huge, in the $trillions, but that is not an infinite number. If some pay themselves and friends in the $billions, that leaves less to be divided among the rest of us. How much is enough and how much is too much? We can read about how much is more than enough when we read about Wall Street’s greed.

Please see Griftopia

Fairness

Stephen a scharzman blackstone equity group he...

Image via Wikipedia

Some hedge fund owners/managers make as much as a billion dollars per year which is $500,000 per hour while the janitor who cleans their offices at night might make $10 per hour. The person who makes $500,000 per hour would not miss $10 per hour to double the janitor’s wage to $20 per hour. After all, that would leave the hedge fund owner/manager with $499,990 per hour. Surely enough.

The hedge fund billionaire could surely spare $1000 per hour to give 50 breadwinners an additional $20 per hour and thus provide a more decent life for them and their families. If each family consisted of 3 people, 150 people would benefit from the hedge fund owner’s generosity. As Barack told Joe the plumber, he wanted to spread the wealth around. The hedge fund billionaire would still be making $499,000 per hour. The question before us is, how many of us need to suffer to allow a few to live lavishly?

No One Would Listen

Charles Ponzi (March 3, 1882–January 18, 1949)...

Image via Wikipedia

No One Would Listen, A True Financial Thriller by Harry Markopolos. The Bernie Madoff story written by the whistle blower who brought him down and sent him to prison. Seldom do I read a true life tale as good as this one is, that I hated to see it end because I learned so much.

Harry Markopolos worked for a firm on Wall Street that competed with Bernie Madoff in the hedge fund business. His co-workers and superiors asked him to design a product that they could sell to compete with Madoff. After months and years of trying, he decided that he could not design a legal product that would show the consistency and the high returns that Madoff claimed. Markopolos and a small team worked on their own time for no compensation to discover how Madoff operated. They concluded either that he was violating the law by front-running, which is insider trading, or more likely that he was operating a Ponzi scheme.

Markopolos approached the SEC repeatedly over the years and was ignored. It took the Great Recession to bring down Madoff when redemptions outran new deposits in his scheme. The total losses will never be known because some of the victims don’t want their losses know. It is estimated that the losses exceeded $65 billion dollars. Markopolos lists in great detail the flaws in the SEC with suggestions for improvement. Mary Schapiro, the current head of the SEC, is trying to improve the performance of the agency. It would informative to get Markopolos’s opinion on how she is progressing.

Harry caught the fraud investigating bug and has devoted himself to it full time since the Madoff case. He devotes his time to discovering fraud in the financial world and in health care, by which I think he is referring to the pharmaceutical industry. Here is a paragraph from the book.

“…from the pharmaceutical world, which I had discovered was ripe with fraud. As I had learned in my investigations, the health care industry makes Wall Street look honest. It’s a $2-trillion-a-year business with no controls and with limited auditing. On Wall Street the crooks at least have the decency to try to hide their frauds, but those people cheating Medicare don’t even bother doing that. Wall Street is only taking your life savings, but in health care they may be stealing your life. I was surprised to discover how little ‘care’ there is in health care. It’s obviously no surprise that the pharmaceutical industry is a completely profit-driven business, but the methods companies devised to earn some of the profits were surprising—and in the case I discovered, illegal.”