According to Bloomberg.com, hedge funds lost an average of 2.7 percent in May according to the HFRX Global Hedge Fund Index, as the sovereign debt crisis in Europe prompted declines in stocks, the euro and commodities, and the gap between the yields in U.S. short-term and long-term debt narrowed. This was the biggest decline in the industry since November of 2008, when hedge funds lost 3 percent in the wake of Lehman Brothers’ collapse two months earlier.
On Tuesday, E.U. finance ministers approved plans to reign in hedge funds with tough new oversight rules, overriding the objections of the UK (and, more specifically, the City of London), where some 80 percent of European hedge funds are estimated to be based. The proposed legislation aims to subject so-called “alternative investment funds” to greater scrutiny in the interest of avoiding future financial crisis like the credit crunch and the recent run on Greece’s debt, both of which many critics have claimed the hedge fund industry’s excessive risk taking has had a substantial role in instigating.
On April 20, after having been incarcerated beginning in mid-January on charges of running a multi-million dollar Ponzi scheme, Weizhen Tang won his freedom (temporarily) by posting $150,000 bail. According to the Toronto Sun, Tang said, “I want a chance to prove my innocence— that’s why I came back from China.”
The SEC is really on it’s game so far this year. I mean, granted, catching the idiots in the case I’m about to write about wasn’t exactly rocket science, but still… mad props (yes, I’m stuck in the early 1990s. It’s cool).
Last year was a very good year for hedge funds. According to the New York Times Dealbook, BarclayHedge, which tracks the flow through hedge funds, reported that 2009 was the best year in the industry’s history (since BarclayHedge began tracking the data in 2000) in terms of performance when compared to the S&P 500. The industry’s resurgence has been nothing short of a Lazurus-like resurrection from the 2008 financial crisis that followed Lehman’s collapse. On the whole, hedge funds were down 18 to 19 percent at the end of 2008. In contrast, the average hedge fund returned 19 percent in 2009. It’s been a pretty miraculous turnaround. No one can deny that. And investors are responding by pouring money back into the industry, particularly into those funds “focused on distressed debt, fixed-income and so-called event-driven strategies where a manager takes a position in a company because he believes its situation is about to change,” according to the New York Times.
BarclayHedge reported that investors invested some $16.6 billion in hedge funds in February alone, with industry assets totaling an all-time high of $1.5 trillion, putting it within range of the projected $2 trillion mark before the year is out.
The New York Times reports that Deutsche Bank’s Alternative Investment Survey projected that a total of $222 billion would be invested in hedge funds this year. It’s an ambitious number, especially in light of the negative light cast upon the industry by Paulson and Co. and Magnetar’s recently disclosed involvement in betting against the housing market. Public sentiment will almost certainly be turned against all hedge funds, who the average American may inaccurately equate with the people who brought down the housing market– but, then again, the average American is not your typical hedge fund investor. Hell hath no fury like a foreclosed home owner… or something like that. Well, except for this guy.
Despite the return of investors to the hedge fund industry, there’s been a drought of seeding capital, according to the Financial Times (subscription required). One reason for the continuing lack of capital is the decline in seeding activity from investment banks in the wake of the Lehman Brothers collapse as banks have focused their attention on larger issues. Furthermore, amid the uncertainty of the new financial regulation, which may eliminate their ability to participate in proprietary trading and hedge fund activity, many banks may be hesitant to provide seeding capital. Fund of funds are currently the main seeding investors, followed by followed by asset management companies and family offices, according to a survey by Deutsche Bank. And with due diligence becoming a more pressing issue for investors, money is being handed out less liberally and in smaller amounts.
One consequence of the financial mess that ensued in 2008 is that investors are demanding more liquidity and greater transparency. Of course, just because investors want these things doesn’t mean they will necessarily get them, but there is a collective demand being voiced. And some funds are obliging. Another trend is that investors are doing significantly more due diligence before investing with a strategy. Regardless of the fact that investors are taking a couple extra months to do due diligence and demanding shorter lockups, more liquidity and greater transparency, they’re pouring money into hedge funds at a record-setting pace.
It’s brilliant. A hedge fund for men who love sports. Better yet, a hedge fund for men who have a gambling addiction (yes, it is a real diagnosis– pathological gambling is now defined separately from manic episodes in the DSM IV-TR, many well respected addiction centers across the country offer treatment for it, and Gambler’s Anonymous (GA) has existed for years). But you don’t have to be an gambling addict to take an interest in this new hedge fund venture– because everyone knows gambling is just plain fun! And it’s not gambling if you KNOW you’re going to win! Besides, what’s more genteel and respectable than a hedge fund? It’s not like going to the racetrack and paying your bookie… I’m guessing that was the thinking behind the Galileo fund.
Centaur Group’s Galileo fund makes investments not in traditional stocks, commodities, or derivatives, but rather by betting on the outcomes of actual tennis matches, soccer and cricket games, golf tournaments, and horse races. By all accounts, Galileo is the first hedge fund ever to make bets on sports.
Mark Cuban, owner of the Dallas Mavericks and perhaps more famous for his stint on Dancing with the Stars, caused quite a stir five and a half years ago when he had announced his intentions of starting a similar sports betting hedge fund, but quickly came up against opposition because of U.S. laws. Now Cuban is an outspoken supporter of the Centaur venture– and Tony Woodhams, the managing director at Centaur Group, which operates Gallileo, likewise, has said that Cuban was right on with his instincts that the stock market had more inefficiencies than sports betting. According to CNBC,
Besides emotion, Woodhams said that the sports market has a lot of mispricing, with some bookmakers that don’t often set the best lines for every game. The market isn’t effected by the economy and there’s no intervention from outside parties like a central bank or a government.
Woodhams was quoted in the LA Times as saying,
We put numbers against those things that you and me and everyone in pubs have casual discussions about. That gives us an edge on these markets.
Woodhams claims that Centaur has a proprietary number-crunching system that is data-driven and can make sports bets with far better results than the casual bettor. In fact, the Centaur plans even plans to use fluctuations in odds and point spreads that are affected by amateur bets to its advantage and somehow make money off of it. The exact method is, obviously, proprietary and probably beyond my comprehension anyways because I was never much of a gambler, but we’ll soon see if they can produce results or if they’re just talking a good game.
Though the firm is technically based out of Gibraltar (where the regulatory environment is a little bit more lax), Centaur will have 25 traders working on its London trading floor. According to the LA Times,
The traders will use statistical modeling to place bets on websites such as Betfair, which is popular in Britain but banned in the U.S. The bets will not just be on matches’ final outcomes — Centaur will also wager on items such as the over-under that takes into account the total points scored.
Of course, Galileo is not the kind of “sports bet” you make lightly– and it’s not open to just anyone. The fund requires a minimum investment of 100,000 euros (about $135,000). Not exactly pocket change. But Woodhams has found a few investors (he says there are fewer than twenty), and he has set a goal of growing assets under management to $100 million within the next two years. And Centaur is charging a hefty 3% management fee and 30% performance fee– not the typical “2 and 20″ seen in the industry. Maybe he has a L’Oreal Complex and can justify the exorbinant rates “because he’s worth it”– after all, he is projecting returns of 15-20 percent. For it’s part, the fund promises not to bet more than five percent of assets under management on any one event.
For now, at least, the fund is only open to Europeans– the SEC has yet to confer its blessing. According to the LA Times, Woodhams said Centaur hope to get SEC approval sometime in 2011. In the U.S., online sports betting is generally illegal (as Cuban found out), with horse racing being the major exception. But some gambling experts say Galileo could win approval because Americans who invest in the fund would not be placing bets themselves. So for now, at least, loaded Americans with a gambling penchant are SOL. But there’s always Vegas…
It’s easy to confuse them: John and Hank. They share a surname, both have Harvard MBAs, have connections to Goldman Sachs, and have drawn attention from the SEC. So it’s little wonder that some people get a little mixed up.
Here’s a short guide to telling the difference between two of the biggest names in finance:
* Early Years: Henry (Hank) Paulson was born in Palm Beach, FL, later moved to Barrington, IL, and went to Dartmouth undergrad where he was an ΣΑΕ (ΦΑ, gents) and also graduated Phi Beta Kappa and was All Ivy, All East, and honorable mention All American in Football. He went on to receive a Harvard MBA. John Paulson was born in Queens, NY and went to NYU undergrad where he graduated valedictorian of his class. He went on to receive a Harvard MBA where he was designated a Baker Scholar.
* Career: Hank Paulson was Staff Assistant to the Assistant Secretary of Defense at The Pentagon from 1970 to 1972. He then worked for the administration President Richard Nixon, serving as assistant to John Ehrlichman from 1972 to 1973, during the Watergate scandal for which Ehrlichman was convicted and sentenced to prison. After that, he joined Goldman Sachs and rose through the ranks, eventually becoming CEO from 1999-2006, after which he left to become US Secretary of the Treasury.
* Career: John Paulson began his career at Boston Consulting Group before leaving to join Odyssey Partners. He later worked in M&A at Bear Stearns, then became a partner at the mergers arbitrage firm Gruss Partners LP. In 1994, he founded his own hedge fund (Paulson & Co.) with $2 million and two employees (himself and an assistant). Paulson & Co. is now the world’s third largest hedge fund, with $32 billion in assets under management, thanks in large part to its successful bet on the housing market crash.
*Run-ins with the SEC: John Paulson’s name popped up in connection with civil fraud charges filed against Goldman Sachs and VP Fabrice Tourre last Friday. According to the charges, Goldman and Tourre allegedly misstated and omitted the fact that the CDOs they were marketing to investors as the housing bubble was bursting were tied to subprime mortgages that Paulson had helped create and recommend to Goldman– mortgages which he later bet against by buying credit default swaps, garnering over $1 billion for himself and $3.7 billion for his firm. Although Paulson was not named in the suit and Goldman denies all wrongdoing, reputations have been dragged through the mud. Hank Paulson, meanwhile, allegedly received a tip from GE in 2008 that it was having trouble selling debt and the SEC has taken an interest in why the company shared this info with the Sect. of the Treasury and no one else, particularly because it has been suggested Paulson profited from this information.
*Wealth: Hank, by no means poor, has amassed a fortune of somewhere in the vicinity of $700 million, according to various web sources. However, John’s hedge fund paydays put his net worth somewhere in the $12 billion range. He is ranked #45 on Forbes list of the World’s Richest People.
*What They’ll Be Remembered For: Hank Paulson is most famous for his service as the US Secretary of the Treasury and his handling of the financial crisis– specifically TARP and bailouts of “too big to fail” firms. John Paulson is most famous for his financial prowess and huge accumulation of wealth through operation of his hedge fund– though, now, he will probably also be remembered for his role in betting against the housing market.
In addition to the charges from the SEC, Goldman is now facing charges in Britain and additional scrutiny in Germany. With all of this going down while we await the passing of new hedge fund legislation in both the E.U. and the U.S., we have to ask ourselves, if the AIFM directive passes and if the Volcker rule goes through will it even make a difference? Would more financial oversight be able to prevent these losses? Will any kind of regulatory structure be able to eliminate this kind of conduct on the part of hedge funds?
I honestly don’t know. These sort of back-room deals done with a handshake and a wink and a smile by the a couple of “old boys club” guys in $5,000 suits are notoriously hard to police. Sure, we can attempt to limit compensation and cut big banks out of hedge fund activity and proprietary trading. We can require hedge funds to register with the SEC or with some regulatory body abroad, monitor their risk exposure and the amount of leverage they can take on, restrict who they can employ in third party roles, try to force them to increase transparency… but, honestly, there are nearly 15,000 single-strategy hedge funds globally… somehow I feel that, even with the most dedicated and brightest of staff (and the SEC is apparently looking to hire experienced hedge funders now so they will have insight into the inner workings of hedge funds in order to properly monitor them), the highly intelligent minds running those hedge funds will be able to find loopholes in whatever laws the government comes up with– or just disregard the laws entirely and conceal whatever devious designs they have to make a fast buck. There will always be loopholes—and sometimes, making money isn’t pretty. In fact, greed can be downright ugly, as we have seen here with the Goldman fraud charges. The only real solution I can see is to minimize the opportunities for such insider deals by pushing as many transactions as possible onto central clearinghouses and exchanges in order to increase transparency– and that’s not really a solution. People will still find ways around it.
Ever since Lehman collapsed in 2008 and America has really been feeling the financial strain (not that our economy was exactly setting records prior to that), there has been public outcry that something be done. Big banks are not making themselves look good. Hedge funds are not helping themselves out here either, despite the fact that official reports looking into the financial crisis — such as the British government-commissioned Turner Review, published in March — assigned such funds only a marginal role in the melee. But most politicians are quick to blame, the public is easily convinced of their guilt, and they’re an easy scapegoat. It looks really bad when America finds out that they’re the ones largely behind all of this mess… nevermind the fact that there were only a select few jackasses behind the plan to create the CDOs that Paulson would later bet against and Goldman would conveniently forget to tell its investors Paulson had a hand in creating and picking… now both industries will be blamed. And the big paydays for bank and hedge fund heads look really bad when 10 percent of the nation is unemployed and close to 17 percent is underemployed thanks to the mess they helped (in part) to create. I mean, the current state of the economy is hardly entirely Goldman’s fault (or Lehman’s or any one other entity’s), but they certainly didn’t help matters.
So it’s little wonder that Obama and et al., along with most of Europe (with the notable exception of Britain, which is trying to push for softer hedge fund regulation) are clamoring for financial reform, with the U.S. trying to corral the commercial banks and the E.U. seeking to reign in hedge funds. Right now, big banks are a frickin’ jack of all trades. In this case, Goldman was creator, trader, hedger and seller of the CDOs. It reminds me of a Homer Simpson quote: “Television: teacher, mother, secret lover.” Not quite the same, but my brain is wired a little funny, and I have loose associations, so indulge me. My point is, maybe banks have their fingers in too many pies and their sticky fingers are creating quite a mess… at least such is the thinking behind the proposed legislation. If we were to restrict the number of functions they could perform, we could also eliminate some of the conflicts of interest. Maybe.
But the banks are fighting hard against the legislation designed to weaken their market power, despite the fact that their actions continue to erode public trust in the markets. It’s a real blow to the financial system as it struggles to rebuild public confidence. And as long as this lack of trust and uncertainty persists, markets might charge a higher systematic risk premium. A new breakdown in trust could also undermine efforts to revitalize the battered financial industry, possibly increasing concerns about transparency, due diligence and complexity.
It’s unlikely that the timing of the charge brought against Goldman is coincidental: Obama is probably going to use it politically to bolster his argument that America seriously needs the financial reform he is proposing– most likely, as the Washington Post put it, “as a cudgel to persuade Republicans to line up behind the bill.” I already thought that the odds of the legislation being passed were high, but now I’m all but certain of it. The public wants greater oversight. They want the big banks to stop screwing them over and taking them under when they bet big and lose.
The SEC’s allegations against Goldman are hardly shocking, and I expect that in the coming weeks/months we will see more charges against other firms involved in similar investment schemes. A headhunt was all but inevitable—it’s just took a little longer than I personally thought it would. But, again, maybe Obama was biding his time, waiting to announce it so that it coincided with the near-passage of his proposed financial reform legislation. Just a pet theory.
The sad truth is that there is a solid chance that Goldman may get away with this, despite the public desire to see heads roll. The reality of the situation is that there has been a lot of deregulation in recent years (see the Commodities Futures Modernization Act of 2000, for example)—maybe too much deregulation for Goldman to be found guilty, and maybe too much for these charges to even stick. You’ve got to know Goldman has it’s legal team working overtime to find a way out of this, and fast– before its stock sinks any lower. It’s entirely possible that Goldman’s conduct may be ruled distasteful and unethical, but technically legal… Unbelievable as that may seem, it’s entirely possible. Only time will tell.
So April 16, the SEC charged Goldman Sachs and VP Fabrice Tourre with civil fraud charges stemming from 2007 CDO deals with John Paulson’s hedge fund (the eponymous Paulson & Co.)– and since Goldman and Paulson are huge names and the prospect of scandal makes us all salivate, everyone has their panties in a twist. The basic gist of the whole thing is that Paulson, who was notably bearish on subprime mortgages, was involved in having Goldman creating the crappiest, most toxic part of CDOs (known as “equity”) he packaged into the “Abacus” investments he recommended to Goldman and which he later bet against by buying credit default swaps– but Goldman never disclosed this information to investors. Paulson saw that the housing market was going to collapse and he saw an opportunity– so he picked out the people most likely to default (people with crappy credit scores) and bet that they weren’t going to pay off their mortgages. Pretty safe bet. Moody’s had apparently placed their once revered AAA rating on the Abacus deal, so investors thought it was a good thing– only it wasn’t, and it was quickly downgraded when Moody’s realized it was crap. The deal could never have been done without the stellar initial rating.
Apparently the SEC doesn’t have enough to go to trial against Paulson… because technically there is nothing illegal (though the words “douche-y” and “unethical” come to mind) about going to Deutsch and Credit Suisse Bear Stearns and Goldman and asking them to create a toxic mortgage product just so he could bet against it. And a statement from Paulson & Co. quoted in the New York Times has emphasized that the firm was “not involved in the marketing of any ABACUS products to any third parties,” and that the deal’s CDO manager and not Paulson “had sole authority over the selection of all collateral in the CDO, securities of which were subsequently rated AAA by both S&P and Moody’s.” But the SEC is pursuing the case against Goldman and Tourre– because the the public bloodlust demands that someone pay. Goldman is saying the charges are unfounded and vowing to fight them and defend its reputation. Right.
The whole thing is pretty simple: Goldman (like other firms who will probably emerge as part of a similar investment scheme betting on the housing downturn and be charged later– Soros Asset Mgmt. and Magnetar profited from similar deals, but don’t appear to have had any special relationships with investment banks that have been discovered thus far) teamed up with one of its most valued hedge fund clients to create subprime mortgage products the hedge fund would later bet against. And the SEC, like many others, feels that Goldman and Tourre owe investors more than just a “my bad”.
The SEC maintains that Goldman should have told investors that the product they were being sold was linked to the performance of certain mortgages and that the hedge fund betting on the mortgages’ demise helped design the product. In fact, Goldman brought in a third party, ACA Capital, to manage the deal named Abacus 2007-AC1. So Goldman told investors that ACA was responsible for picking the bonds– not Paulson. The SEC says this is enough to support civil fraud charges. When this was announced on Friday, Goldman’s stock dropped some 13 percent, while the stock of several of the underwriters of those mortgages, such as Deutsch, Morgan Stanley, and Bank of America, which owns Merrill Lynch, and Citigroup, dropped 9 percent, 6 percent, 5 percent and 5 percent, respectively.
Deutsche Bank AG, UBS AG and Merrill Lynch & Co. are among those firms that created mortgage deals that went sour. It is not yet known who the SEC is investigating. Traders say that the deals generated about $1 billion in total fees for the firms. Investors in the CDOs Paulson helped create/Goldman sold ended up losing $1 billion in what was one of the worst-performing deals of the housing-crisis. Paulson & Co. walked away with something like $3.7 billion in 2007 by betting against the housing market, according to the LA Times. Turns out Paulson really knows how to pick ‘em. According to the Wall Street Journal, future cases may hinge not just on questions such as whether a deal favored one client or another, but whether there was misrepresentation.
A critical part of the SEC’s case against Goldman is that the firm allegedly misled investors by not notifying them of the role of hedge-fund investor John Paulson—who was dubious of the housing boom—in selecting what went into the mortgage deal Goldman sold. Goldman said it fully disclosed the investments and didn’t need to reveal the Paulson connection.
According to a different New York Times article, Goldman’s mortgage group consisted of several hundred people split up into several subgroups, each with a specialty, which took different positions on the mortgage market. Fabrice Tourre’s mortgage group’s position clashed with many of the others by betting against the housing market, most of which took positive positions. “[Golman employee Jonathan] Egol and Fabrice were way ahead of their time,” said a former Goldman worker. “They saw the writing on the wall in this market as early as 2005.” Although an unpopular position within the company at the time, it turned out to be incredibly prescient. Unfortunately for Goldman, it just might turn out to have been a little illegal.
If you want insight into the whole CDO thing and don’t want to spend money on Michael Lewis’s The Big Short, you can read AK Barnett-Hart’s Harvard Thesis, which Lewis mentions in the acknowledgments section of his book here for free. It’s a lot drier and more academic than Lewis’s book, but it’s still insightful– and it’s well written and, most importantly, it’s free.
Billionaire investor George Soros says maybe there might be something to the notion that the banking “oligopoly” formed by the four largest banks in the U.S. needs to be broken up. The so-called Volcker rule, named after Obama adviser and former Chairman of the Federal Reserve Paul Volcker, proposes, among other things, to limit the growth of commercial banks through merger and acquisition, in addition to banning banks from owning and investing in hedge funds and forbidding them from engaging in proprietary trading. The aim of these restrictions is to limit the financial system’s exposure to what many view as excessive risk taking by big commercial banks.
According to a BusinessWeek.com report, Soros said earlier this week at a London event that he was in favor of the Volcker rule.
The article went on to say that financials accounted for 6.6 percent of Soros Fund Management LLC’s stock holdings during the fourth quarter, according to a regulatory filing. Citigroup Inc., one of the large banks likely to be affected if the Volcker rule is passed, was the hedge fund’s fifth-largest stake as of Dec. 31, with 94.7 million shares. Currently, Soros Fund Management has about $25 billion in assets.
Although the Volcker rule is not written into the House bill that was passed, the Senate’s banking panel approved Sen. Christopher Dodd’s financial-rules overhaul, furthering the Obama administration’s efforts to accomplish the largest restructuring of Wall Street in nearly seven decades, according to BusinessWeek. The bill itself would create a consumer protection bureau at the Federal Reserve, if passed, in addition implementing the Volcker rule and establishing a mechanism that enables the government to dismantle failed firms that threaten the financial system.
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