Hedge Fund Transparency?

Mike's alerting me to a huge expansion of the federal bail-out into hedge funds - yes, hedge funds - made me think (for some reason) of Sebastian Mallaby. Although he wrote this a couple of weeks ago, I think it deserves a bit of attention:

Madoff illustrates a problem with investment outfits that claim to have some special sauce that is too valuable to discuss. People who entrusted their money to Madoff thought he had a clever options trading strategy; they were wrong. Worse, people who entrusted their money to respected banks and investment advisers had no idea that their savings were being passed out the back door to Madoff. On Monday, I happened to be visiting one of the most famous traders in Manhattan. He had invested with a hedge fund that had in turn invested with Madoff, hot-potato style.

The good news is that Madoff's fraud was so brazen that any future imitators may be spotted. A newly chastened wealth management industry will be warier of people who hire bucket-shop auditors; the "fund of funds" industry, which gets paid to do due diligence on hedge funds, will feel appropriate pressure to redouble its efforts. Even though hedge fund managers may legitimately refuse to disclose their trading strategies, there are some things they can be open about. Do they trade through a respected external broker? (Madoff apparently didn't.) If their returns clock in at 1 percent per month with eerie consistency, can they explain why? (Madoff could not have.)

I can think of three reasons why hedge fund managers might refuse to disclose their trading strategies:

1. They're "secret sauce" isn't anything special - it would be easily replicated by their competitors;
2. They're engaged in trading strategies that skirt the boundaries of the law, and people would be appalled that their actions are legal (or might conclude, even under present law, that they're not); or
3. Like Madoff, they're criminals and disclosure would reveal their crimes.

Now sure, some hedge fund managers may truly have developed secret trading methods and sophisticated models of predicting markets, that would lose their power if their competitors had even a hint of how they worked. But why am I thinking that the principal reason for the secrecy lies behind door #2, and that the net result is that the industry demands a freedom from regulation and oversight that protects those who, like Madoff, lurk behind door #3?

Although Mallaby is not skeptical of hedge funds - quite the opposite - he is concerned about door #3: As a result of the way the system is structure, he tells us, "the bad news is that less-brazen fraudsters may be impossible to detect" and "this Achilles' heel could eventually kill hedge funds". Nonetheless, "Responding to this scandal with more regulation would be like thrusting more pills on a patient who refuses medication." (Why do I suspect that Mallaby has no problem drowning hedge funds in taxpayer money, even to the likely benefit of hedge fund managers who are continuing to perpetrate their hard-to-detect frauds?) Wouldn't Madoff's fraud have been discovered even with a modestly thorough audit? "No.... Regulation bad...."

This is curious:

Perhaps half of all funds use strategies about which there is no great secret, so disclosure is possible...

If that's truly the case, how do we justify the astronomical compensation taken by hedge fund managers? How can anyone defend taxing their income at the capital gains rate, instead of as... income?

Moving to more current news:

Last month, five hedge-fund managers who each made more than $1 billion a year were called before Congress to discuss the industry's role in the crisis and the case for regulation. Four of the five said they thought that hedge funds could pose a systemic risk to the economy. "Any institution that has a pool of capital at its availability and uses reckless leverage indeed poses a potential systemic risk to the marketplace," said Philip A. Falcone, manager of Harbinger Capital Partners.

When pressed, the hedge-fund gurus agreed that they could probably live with some form of disclosure to a federal banking regulator, as long as the data are not shared with the public.

How... special.

If Kristol, Reich, Mallaby and Krugman Are All Skeptical....

Although you may not get a sense of it from reading this blog, as I focus on the 10% at issue, I don't much care for the brand of debate where people focus exclusively on the 10% of issues that give rise to contentious political debate, rather than the remaining, soft 90% of issues where people are mostly indifferent or are largely in agreement. Despite occasional controversy, it's hard to find someone who gets hot under the collar because our nation "doesn't have the sense" to eliminate the Electoral College. You would have to work pretty darn hard to find somebody who is incensed that we don't have a unicameral legislature, or that Presidents are elected every four years. You may find people who scoff in one direction or the other at notions of an "ownership society", but general concepts of capitalism and private property are uncontroversial.

But sometimes the stars align in funny ways, and a consensus forms among people on an issue that is controversial despite their political differences, or get incensed on a topic where the mainstream media seems to be largely reacting with a shrug. Perhaps it isn't too surprising that Paul Krugman, economist, and Sebastian Mallaby, defender of the financial industry, both question the Bush Administration's proposed $700 billion financial industry bailout. Given what's known of the plan, I would be surprised to see any economist not demand additional details or question the viability of the plan as proposed. And Mallaby's defense of the financial industry necessarily involves making the industry responsible for its own failings. When you advocate leaving the industry largely unregulated such that financial geniuses can find clever ways to make money without the interference of government, you can't credibly argue that when those geniuses mess up - big time - that the government should bail them out with a blank check.

Krugman's instinct may be toward more regulation and Mallaby's toward less, but their common ground is to try to hold financial institutions responsible. Putting things in very simple terms, with regulation you risk stifling innovation, and you may still the source of an eventual financial crisis. With less regulation (and I'm not aware of anybody who is seriously involved with these issues who advocates none) you risk what we're seeing right now, but you enjoy the fruits of the innovation that might otherwise occur. Under the Mallaby approach, holding financial institutions responsible for their own failures is even more critical, as that's the check that is supposed to keep them responsible in their experimentation and innovation.

Robert Reich is a very smart man, but he also has a clear political affiliation, as does Bill Kristol. Reich offers some proposals that, apparently, would make this bailout acceptable to him. (Contrast that with Mallaby, who proposed alternate plans that might achieve the desired effect without a taxpayer subsidy.) Reich's credulity - this is a plan he seems to believe we can fix - lends credence to Kristol's worry, which is sufficient in magnitude to overwhelm his more typical deference to the latest party memo:

[The plan] would enable the Treasury, without Congressionally approved guidelines as to pricing or procedure, to purchase hundreds of billions of dollars of financial assets, and hire private firms to manage and sell them, presumably at their discretion There are no provisions for - or even promises of - disclosure, accountability or transparency. Surely Congress can at least ask some hard questions about such an open-ended commitment.

And I’ve been shocked by the number of (mostly conservative) experts I’ve spoken with who aren’t at all confident that the Bush administration has even the basics right — or who think that the plan, though it looks simple on paper, will prove to be a nightmare in practice.

But will political leaders dare oppose it?

It depends upon how much cover they get. And despite Kristol's skepticism of the plan as a whole, his proposed fixes for the plan are far less significant than Reich's.

Comments by McCain on Sunday suggest he might propose an amendment along the lines of one I received in an e-mail message from a fellow semi-populist conservative: “Any institution selling securities under this legislation to the Treasury Department shall not be allowed to compensate any officer or employee with a higher salary next year than that paid the president of the United States.” This would punish overpaid Wall Streeters and, more important, limit participation in the bailout to institutions really in trouble.

Reduced salaries for one year? You could drive a semi through the loopholes that idea creates. But to his credit, Kristol ends up more in Mallaby's and Krugman's territory than in Reich's:

While assuring the public and the financial markets that his administration will act forcefully and swiftly to deal with the crisis, [McCain] could decide that he must oppose the bailout as the panicked product of a discredited administration, an irresponsible Congress, and a feckless financial establishment, all of which got us into this fine mess.

Many have observed our society's tendency to cheer on capitalism and private profits, but to socialize losses. This appears to be a grotesque example of the Bush Administration doing exactly that - with the financial industry eagerly demanding an even larger bailout of all of its junk assets. I'll credit Reich, Mallaby and Krugman with far more knowledge of economics and market theory than I, so (dare I say, like Kristol - I guess we're in that area of overlap that's so often hidden in plain sight) I'm operating more on instinct. But my instincts are screaming, "This is an incredibly bad deal for everybody but Bush, Paulson and a handful of financial elites."
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Update: Dean Baker observes,

If the bailout were properly structured, firms would not be lining up to get in. It should be a last resort that involves selling most of the firm to the government, as happened with AIG. If banks are lining up to get in, then the people who designed the bailout should be chased out of town.