The obstinate refusal of a small group of hedge funds to accept the government’s terms for helping Chrysler avoid bankruptcy will probably unleash the legislative equivalent to waterboarding.
Hedge funds have strong legal precedent to argue that under contract law their claims were senior to Chrysler employees. Therefore they deserve more equity in a reorganized Chrysler than the United Auto Workers union. Hedge fund opponents counter that they should have considered the “greater good of the country” and will argue that left unchecked, hedge funds pose a systemic risk to the global economy.
Between 1990 and last year, assets under hedge fund management grew almost fiftyfold, to nearly $2 trillion.
Roughly defined, hedge funds are investment vehicles that use alternative or nontraditional investment strategies to manage investors money. These diverse strategies can include the use of short sales, arbitrage, leverage, or derivatives.
The word “hedge” is a misnomer. In reality most are speculative pools of money. They employ multifaceted business strategies and can take enormous risks. The risk/reward is asymmetrical. In a success mode, hedge funds make billions and payout enormous bonuses. In a failure mode, limited partners and counterparties are left holding a pretty soggy bag.
American International Group illustrates what can go wrong. The world’s largest insurance company effectively allowed its holding company to operate like an unfettered hedge fund. Its mistaken policies forced AIG to incur cash flow liabilities that exceeded $160 billion. As a consequence, the government needed to provide AIG massive bailout funds to prevent a systemic global collapse.
Hedge funds are lightly regulated, unlike mutual funds or investment advisers, because purportedly their investor base consists of “sophisticated investors.” The reality is different. Hedge funds frequently have blindsided their investors because these funds do not provide transparency on essential details such as portfolio transactions and holdings.
Going forward, the government must impose heavy margin requirements on every holding and require some look-back after possibly 60 days on holdings and transactions.
The government must also dramatically overhaul the methodology used by hedge funds to raise money. I would like to share my thoughts about the inherent flaws involved in the marketing hedge funds. This follows some 10 years of hedge fund experience.
Why do I say, “Hedge funds are sold not bought”?
Hedge fund management and performance fees are high (generally a 1 percent management fee plus 20% of the upside). The industry effectively has added steroids to Madison Avenue sales techniques.
The government should no longer grant hedge fund managers a “blank check.” They should no longer be able to bury their mistakes behind legal documents that are self-serving. Limited partners should have legal remedy to recover financial damages, including “clawbacks” of previous years’ bonuses.
Financial liability should be applied to “gatekeepers, rain makers, and other third party finders.” Recently, several states have sued Bernard Madoff’s finders for civil contempt because of their alleged failure to perform the appropriate “due diligence” of Madoff’s alleged Ponzi operation.
There is a growing scandal involving billions of dollars of New York state pension funds. Prosecutors allege that officials pressured money managers to pay some $30 million in finders’ fees to financial consultant Hank Morris in return for managing a portion of the state’s $122 billion pension fund.
After President Franklin Roosevelt appointed Joseph Kennedy to clean up the Securities and Exchange Commission, somebody asked FDR why he had tapped such a “crook. “
“Takes one to catch one,” Roosevelt reportedly replied.
President Barack Obama should be mindful of this precedent given our paramount need to regulate the hedge fund industry.
Originally published in the Sarasota Herald-Tribune
