Washington Post Sebastian Mallaby

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Washington Post columnist breaks down hedge funds – the subject of his new book, More Money Than God.

Sebastian Mallaby is the Paul Volcker Senior Fellow for International Economics at the Council on Foreign Relations. He's also a columnist for The Washington Post, where he spent eight years on the editorial board. His books include The World's Banker, a New York Times Editor's Choice, and, his latest, More Money than God—described as the first authoritative history of hedge funds. Mallaby previously covered international finance in London and served as bureau chief in southern Africa, Japan and Washington for The Economist.


Tavis: Sebastian Mallaby is a senior fellow in international economics at the Council in Foreign Relations and a columnist for “The Washington Post.” His new book is called, “More Money than God: Hedge Funds and the Making of a New Elite.” He joins us tonight from Washington. Sebastian, good to have you on the program, sir.
Sebastian Mallaby: Great to be with you.
Tavis: Let me start with a simple and basic question, because we read these stories every day and we try to follow this as best we can, but for those who don’t know what a hedge fund is, describe for me what these hedge funds are.
Mallaby: Okay, well, if you put five financial experts in a room and you ask them that very question, you’d probably get six different answers. But the answer I go with goes back to the first hedge fund manager, Alfred Winslow Jones, who in the 1950s originated this style, and the first thing he did was to keep it secret, to be under the radar, to avoid regulation.
This came to him naturally because he’d been a secret anti-Nazi activist in the 1930s, so he didn’t register with the SEC. He basically stayed out of the view of the regulators.
Second thing he did was a performance fee. He paid his guys one-fifth of the profits that they made from the fund, so that gave him an incentive to hustle pretty hard and think up new ways of making money. Then he combined two other things, quickly. One is he bet not only that stocks would go up, he would bet that some would go down. So he was betting both ways. And he borrowed money, so he leveraged, expanded his bets, with that borrowed money.
Tavis: For a guy who was the first hedge fund manager to come along, as you mentioned, back in 1949, why is it that it’s only been in recent times that hedge funds have become, on the one hand, all the rage, and on the other hand the case of our downfall? What happened between ’49 and recently that made hedge funds all that, so to speak?
Mallaby: Well, I think it all comes down to this idea that they were secretive. They wanted to be under the radar. They didn’t want you or I or anyone to notice them, and in fact that’s why when I began doing this book three years ago that’s what was so attractive. It was the last frontier of mystery and secrecy in a world which is mainly all on the Internet and wired and you can find out all about it.
These guys are secret, and because they are secret they won’t notice for a long time, and because they are secret they are resented and misunderstood. It’s sort of all the same thing.
Tavis: Should they be resented?
Mallaby: I don’t think so. Clearly, sometimes hedge funds go wrong. They can blow up. In fact, between 2000 and 2009, 5,000 hedge funds did blow up, they did go under. But the good thing about it is that whereas a lot of financial companies, the big Wall Street houses, they are too big to fail, so when they blow up they cost the taxpayers a lot of money.
These guys at hedge funds, they’re small enough to fail, so when they blow up they don’t cost the normal people anything, and I think that’s a lot better.
Tavis: When you say they don’t cost normal people anything, help me understand that, because you can’t read about the Wall Street fiasco without hedge funds being at the center of that conversation. So if nobody got hurt by it, when you say nobody is impacted or hurt by it, what do you mean by that?
Mallaby: Well, what I mean is that when Lehman Brothers goes down it causes a sort of global panic because it’s so big and it’s so interconnected with everything else that when Neiman went down the whole economy went into a tailspin.
When Bear Stearns went down, the other big investment bank, the Federal Reserve had to come in with public money to help to prop it up. When AIG, the big insurance company, got into trouble, again, the taxpayers put money into that company to try to prop it up.
Same thing with Citigroup, a big bank – they got government money; in other words, money from you and me, from taxpayers. The money market funds, they also got a government guarantee.
So a lot of these financial institutions, what’s really bad about them is that when they make a lot of money and things go well, guess what? The bankers keep the money. When it all goes wrong, the risk is shared by Joe Taxpayer. The thing I like about hedge funds is when it goes wrong, they go out of business. So it’s skin in the game – it’s fairer.
Tavis: How can anything, to your earlier point, though – your point now notwithstanding; back to your earlier point – how anything done in secret where that kind of money is being played with, how can that be good, period?
Mallaby: Well, I don’t think that everything has to be totally transparent for it to be virtuous or good. The thing is, when you invent a new kind of pharmaceutical product, a new kind of technology product, you have intellectual property laws that protect your invention.
In finance, there’s no intellectual property laws to protect what you’ve invented, so when the hedge fund guys come up with a new way of trading that’s going to make them some money, the way they protect it is by secrecy.
Now, if that secrecy was doing damage to somebody, then I would be against it. But no one has ever been able to argue what the damage is.
Tavis: The damage is that the greed gets to be so bad that the wealth becomes obscene, that everybody’s in it for the wrong reason. That’s the damage.
Mallaby: Well, I think if the wealth is obscene – and I agree with you, it can be – then you need taxation. You need progressive taxation to redistribute the proceeds of the money from –
Tavis: But you can’t do that if it’s secret, Sebastian. That’s the point.
Mallaby: Oh, no, but the profits aren’t secret. These guys have to report their earnings, right? They fill in tax forms. That’s no secret. So they can be taxed. I called the book “More Money than God” because they do make a crazy amount of money. Some of these guys make $2 billion a year. So of course that should be taxed, and it should be taxed more than it’s being taxed.
But at the same time, we’ve got to recognize that there is financial risk out there in the economy. Currencies will go up and down, interest rates will go up and down, stuff will go wrong. Finance has been blowing up ever since the 17th century, with the tulip crisis.
So the question is who will absorb that difficult risk, and who will do it without a taxpayer backup? My argument is that these smaller entrepreneurial boutiques – in other words, hedge funds – that’s a better place to put all the risk than putting the risk in some big bank like Citigroup, which if it goes wrong taxpayers will be on the hook.
Tavis: So there’s no blame to be laid at the feet of hedge funds at all for this Wall Street fiasco that we’re all paying the price for now? No blame to be laid at hedge funds’ feet at all?
Mallaby: Well, think about it this way. In 2007, which was the start of the financial crisis, the average hedge fund was up by 10 percent, so they didn’t blow up. In 2008, hedge funds were down but they were down half as much as the broad stock market index, so again, on a relative basis they were doing pretty well, they were pretty stable, okay?
So the question is do we want to blame and penalize the guys who got it roughly right, or should we be saying, “Gee, that’s great they got it right,” because it didn’t cost the taxpayers anything and we ought to shift more of the risk?
I’m personally mad at the financial companies that did mess up, that did go bust, that did need a bailout, that did cause the global economy to crater worse than it’s ever cratered since the 1930s. That’s the problem – it’s when things go wrong that is a problem.
If they go right and people make profits, I think in the United States we should be basically in favor of that. If we don’t like the fact that the rewards are excessive, then sure, have more tax. But don’t close down entrepreneurial boutiques.
Here’s one more thing about this. When four quantitative people set out an entrepreneurial boutique company on the West Coast, people like it because it’s doing software, right? When four quantitative people set up a boutique company on the East Coast, people say, “Oh, it’s a hedge fund. I don’t like that.”
I think that’s a cultural double standard. I think we should just sort of think a bit about what the consequences of this hedge fund trading is. Basically it’s more stable than banks, it’s not underwritten by you and me, there’s a special culture in hedge funds, a kind of paranoia, a focus on risk control, which means that they don’t blow up so often, and that’s good. We should celebrate that. We need financial guys who do not blow up.
Tavis: What’s the value of their blowing up? What’s the value of this obscene wealth? What’s the value of these new elites that these hedge funds have created? What’s the value of that to us, the American people?
Mallaby: Well, look, somebody has to make decisions about how to allocate scarce capital in a modern economy, right? The more sophisticated the economy gets, the more there are complex decisions about do you allocate scarce savings to this company or that company? It’s so specialized and technical.
Big local companies at the same time have to manage a global set of risks, right? They’ve got to think about is the dollar going up or down, is the oil price going up or down, is interest rate going to go up or down?
All these risks are out there in the system, and the point of finance, and hedge funds is part of this, the point of finance when it’s working well is to absorb some of that risk so that your average retail company, your average manufacturing company that’s creating jobs out there in the real economy, so that those companies don’t have to keep the risk on their own shoulders.
So think about an exporter. An American exporter is worried that if the dollar gets too strong he can’t export anymore. Now think about another company – an American importer. It’s worried about the opposite problem, okay? It’s worried that if the dollar gets too weak its imports will be expensive and this import company will be in trouble.
So both the exporter and the importer are worried about this currency fluctuation, and because they’re worried they don’t hire so many people, they don’t create so many jobs.
But along come the financial markets and enable these two equal and offsetting risks of dollar strength and dollar weakness to be traded off together. By putting them both in a hedge fund they cancel each other out. So you’ve got less financial risk left in the economy and as a result those exporters and importers can hire more people, create more jobs, feel safer and grow the economy, and ultimately, that’s why it’s good for ordinary people.
Tavis: We could debate that all day long. I guess where I take exception is there is no opportunity anywhere in America for everyday people who have a little bit of money to take the kind of risk – most Americans, I think, would gladly do it if the rate of return for the risk that they would take with the money they had were anywhere near what these hedge fund managers make.
So when you say there is value to the American people, again, it’d be nice if everyday Americans could take the money they have, play the same kind of game, have the same kind of risk, the same potential for reward. It’s only hedge fund managers that get a chance to do that, creating obscene wealth, growing the gap between the have-gots and the have-nots in America. I think your read, respectfully, is awfully charitable and awfully generous.
Mallaby: (Laughs) Well, I’d like to be a star football player and get paid the kind of money that football stars get paid. I’d like to get paid like the hedge fund guys get paid, but I’m not.
Tavis: The difference, though, is the football player is based upon his talent. It’s a meritocracy. If you can run faster, if you can jump higher, if you can dunk better, that’s how you make money. It’s not based upon some risk that you get a chance to take because you’re operating in secret as a hedge fund manager.
Mallaby: Well, I think you don’t take the risks and actually make the money unless you’ve got the skill too. You need the skill; otherwise you’re just going to blow up. It won’t do you any good. So the guys in hedge funds who make the money know they are the Michael Jordans of their industry, because the guys who aren’t Michael Jordan, they lose, they get out. They get pushed out.
So I think there is skill in the hedge fund business, and I agree with you, look, that the rewards are crazy. They’re disproportionate. But my answer to that is tax these guys.
Tavis: Yeah, okay.
Mallaby: I think there’s one other thing to keep in mind, which is that about half or maybe two-thirds of the money in hedge funds now is coming not from individual investors who are rich individuals. It’s coming from institutions, and that includes retirement plans which are investing on behalf of ordinary Americans.
So to some extent, hedge funds are making profits which are shared with lots of people through their retirement plans. So that’s one more thing to keep in mind.
Tavis: I take it. The book is called “More Money than God,” and that’s exactly what it is, “Hedge Funds and the Making of a New Elite” that you and I are not a part of, but I digress. Sebastian, good to have you on this program.
Mallaby: Great to be with you. Thank you.

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Last modified: April 26, 2011 at 12:28 pm