Hands Off My Hedge Fund!
President Obama's proposal to overhaul and increase regulation of the financial markets has some populist support, but he's punishing many of the companies that have acted most responsibly, says hedge-fund manager Jonathan Hoenig, while giving more power to the bureaucrats who helped cause the crisis in the first place.
As a hedge-fund manager myself, I’m a member of one of those few financial industries that has not asked for and will not receive a bailout. That's ironic, considering that President Obama’s announcement Wednesday of new financial-industry oversights and agencies puts us on the cusp a regulatory beatdown for supposedly fueling a crisis in which we’ve played no role whatsoever.
As much as the president and his minions would love to suggest otherwise, hedge funds and other speculators are simply investors. We buy and sell stocks, bonds, commodities, currencies, debt, and the like, aiming to make a profit. If we make good investments, our clients make money; if we make bad investments, our investors, of which we are almost always one of the largest, lose money.
While the failure of Enron or Amaranth didn’t cost taxpayers a dime, AIG, Citigroup and GM have cost billions of dollars, precisely because of Uncle Sam.
But when regulators get it wrong, which, as Treasury Secretary Timothy Geithner repeatedly admitted during Thursday’s testimony defending the proposal, they often do, they put every American on the hook for their poor judgment, as they already are for AIG, General Motors, Citibank and scores of responsible homeowners. (With all respect for the president, it takes some mad chutzpah to suggest that someone who took out a loan, lied on the application, didn't read the documents, and doesn't make the payments is somehow a "responsible homeowner".)
The gist of the president’s 88-page document is a dramatic expansion of Washington’s control over the financial sector. So how effective are regulators as it is? Consider for a moment that Treasury Secretary Geithner himself couldn’t foresee the collapse even as he was in the catbird seat as head of the Federal Reserve Bank of New York, or that the Securities & Exchange Commission, now seeking even more authority over hedge funds, failed to catch the biggest Ponzi scheme in history when it was literally dropped on their doorstep numerous times.
And while greedy speculators are a populist scapegoat for the downturn, there’s ample evidence that it was regulation, specifically, the Greenspan Fed’s expansion of the money supply, which created the asset bubble that perpetuated the collapse. Now, in response to that mismanagement, even by a “maestro” like Greenspan, we poised to put even more arbitrary power into the Fed’s hands with no assurance that some future Greenspan, with similar delusions of genius, won’t make even more disastrous mistakes.
Central to Obama’s plan is the establishment of a “Financial Services Oversight Council,” charged with stamping out systemic risk. Of course, like “predatory loan” or “toxic asset,” there is no objective definition of what a systemic risk actually is. If a large pension fund is holding “risky” stocks, or if a private-equity firm takes on an inordinate amount of estate-related debt, the Federal Reserve would theoretically be able to take over the firm or demand positions be wound down—all in the name of the “public good.”
In reality, simply empowering a “systemic-risk regulator” is what creates the systemic risk that bureaucrats claim to want to avoid. A free market quickly disciplines poor judgment, unlike arbitrary regulations that end up masking problems rather than correcting them, as was the case with Freddie Mac and Fannie Mae. Shockingly, the quasi-government agencies that literally fueled the boom by leveraging their implied triple-A rating are not mentioned in the president’s reforms at all.
While the failure of Enron or Amaranth didn’t cost taxpayers a dime, AIG, Citigroup and GM have cost billions of dollars, precisely because of Uncle Sam. As the government gets involved, the liability of failure is spread to the public at large instead of being confined to those who willingly accepted the risk.
The element of the plan that hits home for me is the plans to (further) regulate hedge funds. You’d think the interest would come after massive investor losses or widespread fraud among hedge funds, yet in the aggregate, they far outperformed SEC-regulated mutual funds, separately managed accounts, and the stock market in general in 2008.
I have to laugh whenever I hear the suggestion that hedge funds are unregulated bandits wreaking havoc at every turn. The reality is that, even before the president’s new proposals, hedge funds are already heavily regulated, limited to whom they may invest for and how money can be raised. You’ve never seen a billboard for a hedge fund, because solicitation like that is illegal. What’s most ironic about calls for further regulating hedge funds is that king of all fraudsters Bernie Madoff was, in fact, registered with and regulated by the SEC.
The vast majority of money lost in the financial markets, it turns out, has been lost in fully regulated entities. Regulation doesn’t eliminate fraud—it just makes it more difficult to detect. A company that meets government regulation is granted an implicit guarantee of safety. An unregulated enterprise has to be more transparent to attract and build public trust. Regulation often allows a company to meet very low minimums and be immediately considered reputable. With few exceptions, the significant legal costs produces no discernable value for anybody but the regulators themselves.
The justification used in rolling out the new regulatory plan has been the president’s warning that “reckless speculation puts us all at risk”. Yet all investment—all wealth creation—involves speculation, which is nothing more than a derogatory term for forecasting or judgment. When speculators fail in a free economy, they alone bear the losses, even as society at large often benefits in the process. Apple’s Newton was a speculator’s flop, but paved the way for subsequent advancements in handheld technology of which we’ve all benefited… with not a tax dollar sacrificed in the process.
Those who made investments that went sour or borrowed money they couldn’t pay don’t epitomize a broken system, simply poor judgment. In those cases where fraud was committed, there is a robust judiciary to address grievances.
The real tragedy of the proposal is how effectively the president has fanned consensus opinion that free markets are inherently destructive, immoral, and criminal. The belief is that without “public servants” like Geithner or FDIC Chairwoman Sheila Bair, nefarious businessmen would run wild with fraud, looting America down to its last penny. And because the crisis is being blamed on greedy businessmen rather than on the selfless politicians and altruistic regulations that actually caused it, many people are now more hostile toward capitalism than ever. Obama seems to suggest that Big Business is the enemy of liberty, but Big Government is somehow its friend.
It has been estimated that over the past 12 years there have been more than 51,000 new federal regulations put in place, an average of 11 a day, every day, day after day. Does that sound like an unregulated economy to you? Just as Sarbanes-Oxley didn’t eliminate financial crime after Enron, or the creation of the SEC didn’t stop malfeasance after the ’29 crash, the president’s reregulation of the financial markets will not thwart the Bernie Madoffs or prevent future economic declines, only stifle the productivity and wealth creating potential of the honest businessman just trying to make a buck.
Jonathan Hoenig is managing member at Capitalistpig Hedge Fund LLC. He is also the author of Greed Is Good , and has written for The Wall Street Journal Europe, Wired, and Trader Monthly.