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.
Throwing Goldman Sachs’ execs own words back at them, Senators repeatedly perked up everyone’s ears Tuesday as they pointedly tossed around the obscenity the execs had so liberally used to describe one of their failing investment deals, known as Timberland. Funnily enough, it was Sen. Carl Levin (D-MI), chair of the Senate investigative panel looking into Goldman, who was getting the most mileage out of the epithet as he blasted the execs being questioned for their “unbridled greed” and repeatedly accused them of peddling a “shitty deal” to investors. In the process, he described not only how his committee’s 18 month investigation into Goldman had revealed documents that prove the firm not only bet against the U.S. housing market, but also how it earned huge profits doing so while taking advantage of many of its own clients.
Paolo Pellegrini, a former Paulson executive who worked on the Abacus deal, has come forward with information contradicting the government’s contention that Goldman misled investors by marketing complex synthetic financial securities to them that were tied to subprime mortgages chosen by John Paulson and which Paulson later bet against. According to the LA Times, Pellegrini reportedly told the government under oath that he advised ACA Management, the firm Goldman hired to build the portfolio, that the Paulson & Co. would be shorting the bonds placed in it.
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.
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.
In the words of the infamous, fictional Gordon Gekko, “Greed is good.” But in this economic climate, the kind of money that hedge fund managers are raking in seems almost… wrong. Especially since many of the top-earning hedge funders pay day has hinged on what the New York Times has quite accurately called a “Lazarus-like recovery of the nation’s big banks”.
We’re not talking millions or even tens of millions or hundreds of millions. We’re talking billions. With a B. In fact, the highest earning 25 hedge funders earned a collective $25.3 billion, according to the survey, beating the old 2007 high by a wide margin. According to the New York Times,
The minimum individual payout on the list was $350 million in 2009, a sign of how richly compensated top hedge fund managers have remained despite public outrage over the pay packages at big banks and brokerage firms.
And when 20% of the population doesn’t have decent paying work, somehow that just seems a little… unseemly. I’m not saying these guys aren’t ridiculously smart and hard working and don’t deserve compensation. But the sheer greed… well. It’s a little much to take.
This year’s top earner (as ranked by AR: Absolute Return+Alpha magazine) was David Tepper, who raked in $4 billion in 2009 by betting big that the government wouldn’t let the big banks fail. His investors didn’t do too shabby either, gaining 130 percent last year. Tepper was quoted in the New York Times as saying, “We bet on the country’s revival. Those who keep their heads while others are panicking usually do well.”
George Soros came in second in terms of earnings with $3.3 billion in fees and investment gains. His fund grew 29 percent in 2009.
Still, the success of these few hedge fund managers is not representative of the entire industry. Big gains were not a constant last year. In fact, industry experts say there is a widening gap between winning and losing funds.
According to the New York Times,
For many of the top 25, the big personal gains in 2009 came after steep losses in 2008. Half of the top 10 managers in 2009 lost money the year before, including Mr. Tepper, whose flagship fund, Appaloosa Investment Fund I, dropped 27 percent in 2008….
Three managers among the top 10 — Mr. Soros (No. 2), James Simons (No. 3) and John Paulson (No. 4) — were back-to-back winners, having profited during the lean times of 2008 as well as in the booming market of 2009.
It remains to be seen if Washington (or any external influences, such as the E.U.’s proposed AIFM directive or this summer’s G20 summit) will seek to limit hedge fund pay days. According to a Washington Post article,
When the Obama administration imposed restrictions on executive pay last year at some of the largest companies the government had bailed out, officials said they were aiming to set a new standard for compensation across corporate America that would discourage risky business practices.
But as firms begin to disclose last year’s bonuses ahead of annual shareholder meetings, it is becoming clear that companies across a wide range of industries are paying executives in ways that officials worry will not discourage the kind of excessive short-term risk-taking that led to the financial crisis.
The Treasury Department said it is not looking to limit the total pay executives receive. Kenneth R. Feinberg, President Obama’s special master for compensation, wants to change pay incentives, giving executives a greater stake in the long-term performance of their firms. That would mean, for example, smaller up-front cash salaries and fewer perks, more compensation in the form of company stock and a longer wait to receive it.
My guess is that little will be done to limit compensation because the rich are powerful. My hope is that those who have more money than god feel a pang of conscience and give some of the money to charity (or just do it for the tax write off at the very least).
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