More Money than God: Hedge Funds and the Making of a New Elite

Wednesday, June 16, 2010

Sebastian Mallaby, director of the Maurice R. Greenberg Center for Geoeconomic Studies at the Council on Foreign Relations and the author of More Money than God, discusses his book and the role of hedge funds in the financial system.

JESSICA EINHORN: Okay. We're on. And anyone who wants to move up, please do. And there will be more people coming in.

Mr. Lodal, good evening. Come join us. And -- (inaudible).

Good evening. I'm Jessica Einhorn, and it's a pleasure to welcome everyone to this introduction and celebration of Sebastian Mallaby's new book "More Money Than God: Hedge Funds and the Making of a New Elite."

As we begin, let me ask that you all please turn off -- Nancy and Sam, come sit down in the front -- that you all turn off your wireless devices. Please turn them fully off, not just on vibrate, because it interferes apparently with our sound system. And also, please note that unlike the usual convention, this meeting is on the record. So if you stand up or ask a question, it will be on the record.

With the book just being released, I imagine that very few of you had the opportunity to read it already, although some may have enjoyed the terrific article in the Weekend Journal of The Wall Street Journal.

I had the pleasure of an advanced copy. And my aim tonight is to give Sebastian an opportunity to offer an author's perspective on the overall work as well as to engage with all of you in a discussion of the hedge fund phenomenon in the context of this supposedly final round on financial reform legislation.

I think Sebastian is well-known to most of you here at the council. He's the Paul A. Volcker senior fellow for international economics, and he directs the Maurice R. Greenberg Center for Geoeconomic Studies.

Many of us know his writings from the many columns in The Washington Post or as his contributions to numerous other publications.

I've been really fortunate in having chaired the study group at the Council on Foreign Relations that preceded his bestseller book, "The World's Bank: The History of the World Bank Under Jim Wolfensohn." And then I participated in the lively and very interesting group chaired by Peter Ackerman, who's here tonight, to discuss this book as it came about.

It all reminds me of a story that some of you may know about the fly that sat on the ox's nose as the ox went off in the morning for his day of field work. As he went off, the fly would wave at all the passers-by, and they went to till the fields. And at the end of that long day of work, they came back, and the fly would wave again and say, we've been plowing.

So Sebastian, without further ado, let's get to our plowing and turn to the questions.

Thank you for joining us. So you started this book three years ago. And I know that you had it in mind for somewhat longer. It's not a quick-fire response to the financial crisis that you set off to do. You clearly found something fundamental of both interest and importance. Tell us how you made that decision to commit to this big project, hold hundreds of interviews, go through boatloads or maybe I should say yacht loads -- (laughter) -- of material. What fired your interest in the project?

SEBASTIAN MALLABY: What caused me to inflict such an obvious injury on myself? Well, there are two things. The first was that, you know, much of the world economy and much of the financial sector is pretty open, and you can find out about on the Web and so forth. And hedge funds felt like a kind of uncharted frontier, the remaining bastion of secrecy.

And that mystery element was one thing that was irresistible from a reporting perspective.

And the other thing was, it felt as if there was a sort of intellectual arbitrage to be done, where most people, I think, who knew a lot about finance could see the virtue of hedge funds and that, you know, these were small-enough-to-fail institutions that could go down without damaging the system, that they were often contrarian, which was healthy for reducing the size of governments, and that they were probably on balance a good thing.

I think that was a not terribly controversial view among specialists. But it was a massively provocative and controversial view in the general public. And so even reading the newspapers, like The Financial Times, if there was any hedge fund in any scandal story at all, even if the hedge fund had played a subsidiary role to the three investment banks that were also in the same article, the headline would be, hedge fund messes up the world, or some variant on that.

So I felt as though there was a double standard. That, you know, if four quantitative people on the West Coast started out a boutique company, everyone loved it because it was doing software. If four quantitative people started out the boutique company on the East Cost, it was a hedge fund, everybody hated it. And I thought that pushing back against that double standard would be a worthwhile project.

EINHORN: Had you been a customer? Did you know what a hedge fund was? Can you tell us now what a hedge fund is?

MALLABY: I wasn't a customer, I'm not a customer, I won't be a customer. You have to have $5 million in liquid assets to be a customer. I don't have more money than God. So I didn't know really a lot about it. But what I discovered pretty quickly is that hedge funds, if you put sort of five experts in a room, you'll get six definitions of hedge funds. So I had to sort of adopt a working definition.

And the one I took goes back to Alfred Winslow Jones, the first hedge fund manager who set up his fund in 1949, long before most people realized there were hedge funds. And he was an interesting character. He had operated undercover anti-Nazi missions in the 1930s in Germany.

And when he set up his fund, he had four working, sort of distinguishing characteristics. The first thing was a performance fee, 20 percent of the upside was kept for him and his team. And he had this sort of grand, eloquent justification, which was that Phoenician merchants, sea captains, had kept 20 percent of the profits from a successful voyage. And so he said, I'll do like the Phoenicians. And the point was that he gave this money to his managers when they did well. So he gave them an incentive to really hustle hard for good ideas.

The second thing was, he was undercover. You know, he had been undercover against the Nazis. His wife at the time had operated anti-Nazi missions out of the maternity wing of a hospital. And he just maintained that method when he went into finance, didn't tell anybody, raised money privately by word-of-mouth. Often that meant between mouthfuls at his dinner table. And that's how he raised money.

The third thing was that he went short as well as long. He bet against stocks as well as in favor of their going up. And that allowed him to hedge out some of the market risk. Because if he was long and short, it didn't matter much what happened to the broad index.

And because he had reduced that kind of risk, the fourth thing was that he could leverage. He could borrow money and take extra stock-specific risk because he had taken away this other risk that he didn't have a view on.

So those four things are my working definition of hedge funds.

EINHORN: And you have to remember them. (Laughter.) Now, let me say that what Sebastian also tells us in the book in the chapter on Jones is that in fact the idea of the 20 percent carry was thought up by a very crafty accountant who worked for him and was in fact trying to come up with a tax dodge. And because Alfred Winslow Jones felt that the IRS in those days was actually very attentive to those sorts of things, he was afraid that if he divulged it, the IRS would close him immediately.

And so instead, he made up this grand plan of the Phoenicians. And I don't know how the legislation is progressing through Congress. But in any event, for that, your book was instructive.

So your book is really illuminating in many ways, how innovation spurred success in each new generation of funds. One manager discovers returns to volatility, another one finds out that money is not institutional and so there's bloc trading. And the innovations come from an enormously colorful cast of characters.

I wonder if you could give this audience, before they read your book, some sense of the ingredients of success for the hedge fund managers and some of the characteristics you maybe find they have in common.

MALLABY: Okay. So, well, I mean, you know, hedge funds do attract contrarians, mavericks, larger-than-life people, people who wouldn't necessarily fit into a normal Wall Street institution. And one could start with the person who emerged in the 2000s as the highest earner of them all, and that's Jim Simons, who set out Renaissance Technologies, which was a sort of -- (inaudible) -- quant, Ph.D.-intensive mathematics fund, which wouldn't hire any economists or MBAs or anything like that. They wanted -- basically, it started with code-cracking people who came out of the Institute of Defense Analysis which had done code-cracking for the Pentagon. And then supplemented that with some translation specialists.

And what these two groups of people had in common was that they were used to looking at traces of code in a sea of data where you had no clue where to start. So when you get the enemy's code, you have nothing to start on. And in the same way, when the computer is looking at a foreign language, it gets, you know, reams of foreign words and doesn't know where to start. So they are algorithm-specific to try to comb through data and find patterns. And that is what Jim Simons did. That is what his team did. And that is what generated the kind of model that made Jim Simons, you know, annual earnings sort of in the 1.5 (billion dollars) to $2 billion a year kind of zone.

But Jim Simons is not the kind of character who would, as I say, fit into a normal Wall Street house. He's the sort of person who, you know, doesn't wear socks. He seldom goes in his car without speeding. You know, he goes from Boston to Bogotá on a Lambretta motor scooter. He hires a guy who, you know, goes around the office on a unicycle.

When I visited the campus, you know, it's this kind of Swedish style sort of philosophy kind of center. It was almost too antiseptically clean. But the one piece of mess is that, you know, on the corners there are these special mirrors so that if the guy on the unicycle is coming around the corner, you can see him coming and you won't crash into him.

So it's that kind of figure who kind of, you know, made the book fun.

EINHORN: And I say the Simons chapter, in particular, he's unique in his secretiveness. And I couldn't help -- in the back of my mind, I kept thinking Madoff. He's so secretive, does he clear his trades through somebody? And does he return investment income on a regular basis? Or is this --

MALLABY: Yeah. It's actually a question which I believe the SEC might have asked of that company.

EINHORN: Well, better late than never. (Laughter.)

MALLABY: Right, exactly, yeah. (Laughs.) The Madoff thing is funny because, you know, as one fund manager said to me, before Madoff, you know, I always used to show my returns, you know, to people and I would try and accentuate the positive. Since Bernie Madoff, you know, I go to my investors, and I say, it's okay, we have down months. (Laughter.)

I think, you know, Jim Simons has had, his fund has had unbelievable returns since 1990 when they put in place a particular kind of short-term pattern-recognition model. I don't think there's been a single down year, and most of the years have been up on the order of 80 percent.

Yeah, but he does clear the trades through an outside broker.


MALLABY: And also, the other really important point is that nearly all of the money in this fund that is doing this incredible stuff belongs to Jim Simons and his employees and a few of his ex-employees, he's trying to keep them loyal, you see. And so the notion that this is some kind of con doesn't work, because this is their money.

EINHORN: Okay. That's true, and that's probably actually another one of those characteristics of hedge funds, which ends up much more important later when you're public.

I read this book cover-to-cover over Memorial Day weekend, and I can say that it is a great read. And it's actually two books. This book will be a legend for its narrative, I think, for years, decades to come. But I think it's also fair to say that, in addition to this history of the hedge fund industry, it's also a policy piece.

And the relevant part of the policy seeks to explain hedge funds so well that you'll understand, that the reader will understand why you think very little regulation should come to this industry. And I wanted to ask you if you started with that hypothesis or whether that's a conclusion that you drew as you went through your work.

MALLABY: I did start with that hypothesis, because I felt as though, you know, more hedge funds is -- if there is a problem with hedge funds, it is that they could, you know, drive the price of a particular market in one direction too much. And the best antidote to that is to have more hedge funds so you have more diversity of views within hedge funds and there's a sort of you know -- so I think my view was, to get more hedge funds, you basically want to have less regulation. You don't want to create barriers to entry.

And particularly if you want small hedge funds, which are not too big to fail, which will go down without causing any systemic difficulties, the last thing you want to do is create barriers to entry.

And often when I go around talking to the more established hedge fund managers, they say, oh, I'm fine with regulation. You know, we should regulate with the SEC. Absolutely, that's fine.

Well, sure. When you're managing more than $10 billion, you know, you've got plenty of scale. You can hire umpteen lawyers and registering with the SEC is fine.

But what it's not so fine for is the startup company. And I was always struck by a manager I met very early on in my research, who was a young Yale Law School graduate. And she figured out a way of doing some distressed debt investing in China. And she wanted to raise money from her Yale Law School friends who kind of knew her personally and believed that she -- (inaudible) -- what she was up to. But they were working for public prosecutors or something, they didn't necessarily make a lot of money, they had a few thousand dollars that they could invest with her, but they didn't have lots of money. And they were not allowed to invest with their friend because of the rule that says you've got to have $5 million in liquid assets to go invest.

So that's an example of the way that regulation, albeit well-intentioned, creates a barrier to entry, which discourages smaller funds. And I think smaller funds, the boutique funds, that's exactly what we want because it's healthy for the system.

EINHORN: And I imagine we'll come back to some of that. Sebastian, you sit in the Paul Volcker chair, so the next question is going to be sort of close to home. But I'm wondering whether your book might well be read as testament in favor of the Volcker rule, which is, you say the future of finance lies in the history of hedge funds. Do you think that it is in the public interest to move the trading operations, proprietary trading and the investing in private ventures to outside these banks? And again, is the Volcker rule that, or is there more to it that you see?

MALLABY: Yeah. I mean, actually, it's ironic, because in the big picture about finance, I don't necessarily agree with Paul Volcker. I mean, he has this view that no financial innovation has been of any value in the last 20 years apart from the ATM machine, which I find so extremist. You know, I'm not there at all.

I'm pretty much a proponent of financial innovation, which is not a fashionable thing to be, but I do believe that there will be risk, currencies will fluctuate, interest rates will fluctuate, there will be difficult decisions about how you allocate scarce capital in a very sophisticated economy. And somebody's going to take that risk if you want capital formation.

And if hedge funds or other investment vehicles don't take it, it will be retained by corporations who will have to hold large stocks of capital. And that means that capital gets tied up unproductively inside the vaults of companies as insurance, and the cost of capital across the economy goes up.

So I believe in the financial sector and its contribution to the economy, which is not where Paul Volcker is, but I agree with him on the Volcker rule, because I think that driving risk capital out of big institutions which have now been exposed as too big to fail is systemically healthy. If we can drive it into freestanding hedge funds, not hedge funds, by the way, which are subsidiaries of JPMorgan -- I don't think that achieves anything -- I want it to be driven out of these big behemoths, which are effectively underwritten by you and me, into freestanding hedge funds, because I think that they are small enough to fail, their incentives are better aligned, they have this peculiar risk management culture, a kind of paranoia about risk, which explains why they went through the crisis in 2007, 2008 far better than any other kind of institution.

I mean, banks had to be bailed out, investment banks failed, money market funds needed a government backstop, big insurance companies failed. But hedge funds took zero cents of government money. And so for this reason, I do support the Volcker rule.

EINHORN: Well, I'll do one more question, I think, before I open it up. As you say in the book, a world in which hedge funds traded, everything is a world of unpredictable connections. And there's a lot of collateral damage to bystanders in some of the chapters of your book. Indeed, given the leverage and the needs for liquidity, when the going gets rough, it seems as if it's the best-managed and most open and liquid markets that really get shaken up and all their investors do when the bloodletting really gets going.

But your test is really, do they take taxpayer's money in failing? And if not, then we ought not to regulate. So my question is, with the sovereign fund crisis and the sovereign debt crisis sort of standing at our doorway, do you see any reason in this fixed-income area for wanting to turn the clock back and for wanting to regulate the activities of hedge funds because of collateral damage, not because of their asset management returns?

MALLABY: Well, look, Jessica, I mean, particularly since there's this, you know, you said this is the last question so I want to not leave people with the impression that I think it's an uncomplicated verdict to say that hedge funds are good. I mean, there is complication in reaching that judgments, and there are qualifications.

And the story I tell as a sort of narrative history, of course, includes episodes like long-term capital management blowing up. It includes Amaranth going spectacularly wrong and being totally mismanaged and blowing up $6 billion of equity in the space of a month or so. So there are clearly things that go wrong.

And there are moments when hedge funds can be a kind of force multiplier of markets that are spinning out of control.

But I think the test is, are they more likely to multiply bad news than other kinds of money managing? Are they more lemming like, you know? Are they more leveraged and, therefore, more accelerated? And the answer is, they're not more lemming like, they're more contrarian, and they're set up to be managing for absolute value.

They're not more leveraged, contrary to myth. In fact, the average hedge fund leverage is two-to-three, whereas investment banks are more like 30, or were at least in 2006.

So I think, you know, as I say, there will be risk, and that includes for hedge funds. But money has to be managed somehow. Risk has to be absorbed somewhere. And I think these are really the least -- (inaudible) -- options.

So when it comes to Europe and I look at these European governments, the Greek government, you know, claims it has a 3 percent of GDP budget deficit, and says, oops, we were lying through our teeth, it's actually 13 percent, and, by the way, it's the fault of the hedge funds that we lied, I'm sorry, I mean, I just think that's scapegoating.

I think that, you know, I tell the story in my book of 1992 when after the Quantum Fund drove Sterling out of the exchange rate mechanism -- and by the way, did the same for Sweden, it (attacked ?) the Swedish currency, made almost as much money on that, a story that people don't know. You know, there was a lot of scapegoating then of hedge funds, too. And I don't think it made sense then. I don't think it makes sense now.

Markets are markets. You can't suppress risk. The question is, how do you move risk into institutions that will manage it in the most sane and least dangerous way possible?

EINHORN: Yeah. And in a follow up to that, I think what comes through this -- there were some wonderful chapters when you come out of the early hedge funds and you go into the funds, into the world of macro. And there are two chapters, one for Soros and Druckenmiller, and the next one for actually named for Greenspan, in which you go from a completely different world into one-way bets, because governments have to stand on policies.

So just as one last follow up on that, when you move into fixed income and you move into government fixed income, any scope for regulation that's different from what you would do in the equity markets, the commodity markets, anything like that?

MALLABY: I'm not sure the fixed-income markets make the question different. I do think that there is, as you say, and particularly maybe for a policy audience in Washington, there's a fascinating thing about the contrast between the way that hedge fund people see risk, understand risk and the way that policymakers often see it.

And I think there are many illustrations that come up repeatedly in this history, but one kind of very graphic one is how, you know, there are people here from the Treasury, and maybe they'll contradict me, but I think that policymakers going into the weekend of the Lehman Brothers failure were partly hoping that Barclay's would buy it and so forth.

But to the extent that they recognized that Lehman Brothers, if it wasn't bailed out, might actually go down, were thinking to themselves, okay, here's the calculation. We don't like bailing everybody out, so we'd prefer not to bail it out. And we think there's a 50-50 chance that if we don't bailout Lehman Brothers, the markets have adjusted, okay? I mean, people have had time and warning enough that they've adjusted their portfolios to protect themselves against Lehman Brothers, so a 50 percent chance we cannot bailout out Lehman and we'll be okay. Fifty percent chance we might have a bit of a rocky time, but 50 percent chance we'll be okay.

So then I go and talk to Paul Tudor Jones, who's one of these fantastic macro traders, a classic of this sort of way of looking at the world. And Paul Jones says to me, look, you know, 50 percent of the chance is that it's going to be flat, 50 percent of the chance is it's going to go down, so if I'm short and it doesn't go down, I won't lose anything, it's going to be flat. But if it does go down, I'm going to make out like a bandit. I will be so short, you won't see me. I will be, you know -- I mean, to him, it was sort a no-brainer asymmetric trade, because he doesn't think about risk just in terms of two possible outcomes. He thinks about the consequence of each outcome. What is the weight that you put on it? What is the payoff?

And to him, this was like a roulette wheel where there's red and there's black, and it's 50-50, but suddenly the house says, if it's red, we'll pay you 50-to-1. Thank you very much, I'll bet on red. I'll bet it all on red. And because I'm betting it all on red, this is the difference with markets, it will actually make red happen. Because when everybody's betting that way in markets, of course, it's self-fulfilling.

So I think if Hank Paulson, who, of course, came out of an M&A background, not out of a prop trading background or a markets background, if he had seen the world as a trader does, he might have made a different call on what he did with Lehman Brothers.

And the same was true of the Bank of England in 1992 when it was up against Soros. The same is true repeatedly, when policymakers collide with market people.

EINHORN: Thank you. So now you've seen a sense of this book. And especially thank you for that last one.

Let's open now, invite members of this audience to join the discussion. I'm going to ask you to wait. I'll point to you so that they can bring the microphone to you. Please speak directly in it. I think you know the way we do it, so we'd really appreciate it if you'd stand, state your name and your affiliation. And keep questions and comments concise to allow as many possible people to speak.

If you stand up and say, I have two questions, Sebastian will start figuring out which one's the easier one, and then that's the one he'll take.

There's a gentleman right here in the tweed suit.

QUESTIONER: I'll tell you, it's very hard to get people to identify themselves, having run some of these meetings. Roger Kubarych, National Intelligence Council, and colleague of Sebastian's.

In those years when I was working for the German bank and going over once a month --

EINHORN: Bring the mike to your mouth.

QUESTIONER: Yeah, how's that? Better?

EINHORN: Better.

QUESTIONER: The one thing that struck me is, those are the days of the German politicians complaining about the Heuschrecke, the locusts. But when you really talk to them and you talk to some of the people around them, they really were confusing hedge funds with private equity funds. Why is that? I mean, they are very, very different in almost every way. And why is it that once you get a few feet away from Wall Street, you have this tremendous misunderstanding of the different both valuable functions, but very different functions of these two parts of the market?

MALLABY: Yeah, it's a good question about why continental European regulators are like that. But I mean, I think it's, you know, it's just part of the context of European economic management where it's a bank-based form of capitalism. Any kind of market, sort of actively traded markets of all kinds were rather late to develop. Open contests for corporate control are very alien to Germany.

And that Heuschrecke comment came off the back of a moment, actually. It was Chris Hohn, who is a hedge fund manager, who was forcing the Deutsche Borse management to do something it didn't want to do. And I forget the details beyond that.

And this young guy from London, running a hedge fund, comes to the head of the German stock exchange and says, you know, I have so much power over you now and so many of your shares that I can force Mickey Mouse onto your board if I want to, so you've got to do what I say. And you know, it's just a kind of visceral reaction.

There's a story in my book about how Julian Robertson of the Tiger Fund, one of the great managers who figures quite a lot, because, a, you know, he wrote monthly detailed letters to his partners over this 20-year period, and he allowed me to read the whole set. There were two massive binders about his travels around the world and so forth.

And then I interviewed -- (inaudible) -- lots of people who worked for him, and was able to reconstruct in great detail how Tiger went about doing business. And one of the things that happened was that when the Berlin Wall came down, one of Julian Robertson's deputies, who was on leave at Stanford Business School, you know, the fax arrives in his room and it says, big fella, big guy -- this was a tall sort of, you know -- everyone at Julian Robertson's company for some reason was a college athlete, that was who he hired. And so this sort of six-foot-four guy, you know, gets this fax, and it says, big guy, the Berlin Wall coming down, this is going to be a big deal, we've got to get over there.

So Julian Robertson starts buying stocks on the theory that, you know, there would be a reunification boom. And he's incredibly bullish on Germany, having never been there in his life. And then after a year or so of sort of buying up German stocks left and right, thinking, and he starts looking at the price-earnings multiples. First, he buys because of unification. Then he actually looks at a couple of numbers, and says, holy cow, the price-earnings multiples on these German companies is ridiculously low. I mean, it's one-quarter of what I could buy the same company for in the U.S. Gee, I'll buy, you know, 10 times more.

And then he thinks, well, maybe I should actually go and look at these companies, you know, having bought them all. So he shows up, and, you know, there's this series of conversations in corporate board rooms in Germany where his eyes opened, and he realizes that, gee, this is a different kind of capitalism. You know, they don't care about shareholders, they don't believe in markets for corporate control. The incumbent managers have low price-earnings ratios because they're not actually trying to, you know, get the earnings up very much.

And there's this moment when he's sitting at a German company, and he looks out of the window from the cafeteria, and he says, first of all, this is a delicious lunch, must be great to be a chief executive when you get served this delicious, opulent lunch, not telling the chief executive that he'd rather they saved money and gave it to the shareholders, i.e., him. And the chief executive says, oh, no, no, this is the lunch we give to all our employees.

So you know, Julian Robertson was thinking, hmm, one reason to sell the stock. (Laughter.) And he looks out of the window, and he says, oh, wow, the planes are flying very close to your building. And the chief executive says, well, that's because we have a flight training school, and all our employees get free flight training at lunchtime, you know, if they want to.

So you know, Julian Robertson walks out of this meeting, and he basically sells his German positions. But that's a roundabout way of saying that, you know, it's just a different view of capitalism in Germany.

EINHORN: Who's next? Here's one right in the front row.

QUESTIONER: Dennis Lamb (ph), OECD.

LTCM, it was too big to fail, but the government didn't bail it. Could you talk a bit about that incident?

MALLABY: Right, sure. You're exactly right. LTCM was not huge in terms of its equity, but was so massively leveraged, and it was an exception, that it was almost to the point where the government, you know, lost its nerve and put money into it.

The government didn't do that. The government, the New York Fed convened the bankers who had lent money to LTCM, put them all in a room, and said, it's all in your interest to cough up hundreds, you know, I think ended up being 250 million (dollars) each, and the total bailout was 3.6 billion (dollars).

So the Fed convened the bailout, it didn't do the bailout. And that's an important distinction. And in fact, you know, they would not have done the bailout. They wouldn't have put public money in.

But I do take that as, although afterwards, I don't think any other hedge fund has come close to being 25-to-1 levered, which is what LTCM was. And LTCM has become kind of the false poster child for the hedge fund industry, where people think, you know, oh, they're all very levered because LTCM was. In fact, the truth is that LTCM is an order of magnitude higher levered than the average.

But I do take in my conclusion the LTCM episode as an indicative to a point which I didn't make and I should have in response to Jessica's question about regulation. Because I do think that when the gross assets, the leveraged balance sheet of a hedge fund reaches a certain size, maybe it's not small enough to fail, perhaps it can be systemic.

And what's the threshold of where it becomes systemic? There's no clear rule about that, and you can read the history carefully, and you can look at different episodes. Amaranth had 9 billion (dollars) in equity, and it failed, and it was totally unsystemic.

When the quant quake happened, which was a time when lots of quantitative funds got into trouble in the same week in 2007, there was probably 800 billion (dollars) of money in that trade. It went wrong simultaneously. It was not systemic. It didn't have to be bailed out. So that's an example of where, if you're in highly liquid equity markets, 800 billion (dollars) is small enough to be okay.

But I think that nonetheless, the 120 billion (dollars) portfolio that LTCM had is a reasonable benchmark for where the authorities should ask questions, where if we get a systemic regulator as a regulator as a result of the reform, you know, it's fair for the systemic regulators to say, okay, do you have a decent match between the structure of your liability and the structure of your assets? Are you borrowing short and lending long, effectively? You know, are you in very illiquid over-the-counter instruments, in which case we're a bit nervous about you?

So I think the LTCM thing is a benchmark. And by the way, if you apply that benchmark of the 9,050 funds I identify when I did the test, roughly 9,005 or something were totally nonsystemic, much smaller than LTCM. So in my view, the 9,010 or whatever it is, you know, should be affirmatively not regulated, because why erect any barriers to their setting up? The argument I made earlier.

So I'm against this rule that says, which is in the bill, once you've got $100 million in assets, in equity, you have to register with the SEC. I think 100 million (dollars) is a stupidly small threshold.

You know, what LTCM teaches is that, you know, you've got to be up a lot bigger than that.

EINHORN: And one other criteria that Sebastian has in that policy conclusion is, if you're not privately owned. As soon as you become publicly owned, you're under Sebastian's suspicion.


EINHORN: So let's see some hands. I'd love -- yes, please. One here, and is this side quiet, or are there some hands over on this side as well? Oh, I'm sorry.

Okay, you go ahead, and then right behind you.

QUESTIONER: Aaron Goldzimer, under recently with Environmental Defense Fund.

My understanding of at least some of the activity of hedge funds in the recent financial crisis runs a little counter to your story, so I'd like you to tell me where I'm wrong. The way I understand a lot of the hedge fund activity was not in being contrarian to the housing bubble and therefore helping prick it early and reduce it, but rather kind of creating additional synthetic non-real ways in which it could bet against it that kind of further inflated the bubble.

I mean, you see John Paulson creating instruments that he could then bet against. And you see all the credit-default swaps. And so you then begin to get an understanding where there's lots of dumb money running around, writing credit-default swaps and betting on all these instruments, and the smart money betting against it all. And that doesn't prick the bubble, but rather helps inflate it. So tell me how I'm misunderstanding that.

MALLABY: You put the question with marvelous tact, so thank you for that. (Laughter.)

So look, no, this is, again, an area where, you know, I have a conclusion I've stated, and I'm going to end up restating it. But I want to confess that along the way there are some tough issues you've got to reckon with, and you've raised them very eloquently.

I think that, first of all, you know, it is a fact that, you know, going on the data that we have, which is not perfect, hedge funds leading up the subprime bubble were not inflating it, which marks them off from almost all other money managers in the universe.

So in 2007, not only was the average hedge fund up 10 percent -- that's the year, of course, subprime blew up -- but the subcategory of hedge funds that were supposed to specialize in asset-backed securities, including subprime securities, these guys were at 1 percent, so they were flat. So in other words, they hadn't exposed themselves, and they hadn't jumped on this crazy bandwagon, which is different to the insurance guy, is different to the, you know, the investment banks, different to the deposit-taking banks, different to the long-earning pension, I mean, everybody else was caught up in this bizarre think. The regulators were, by the way, caught up in it.

The one people who were not -- the credit-rating people were totally caught up in it. So it is, I think, incontrovertible, that the only species of money manager that got it roughly right was hedge funds.

Now, it's also true, as you rightly say, that they were buying synthetic shorts. Okay, so when you do that, you're creating more paper out there. But you're not creating that paper by yourself. That's the important thing.

In this famous transaction which the SEC has brought to the front pages of he newspapers, where John Paulson gets into bed with Goldman Sachs and they create these synthetic instruments, Paulson shorts them and ACA, this other company, is long, and then a lot of it is passed out the back to the Germans, you know, you couldn't do that transaction unless the dumb money wanted to be dumb.

So the question is, who do we blame in the financial system? The dumb money or the smart money? The guys who got it right, the guys who got it wrong? The guys who understood what was happening, or the guys who were just completely betting without thinking about it?

My inclination is to put more of the blame on people are supposedly managing money on behalf of pensioners and everybody else, who are simply not exercising any due diligence whatsoever. Those are the guys I blame. I don't blame the guys who got it right. It's a matter of taste, perhaps. But I'd rather have finance run by people who understand it. I'd rather have risk taken by people who understand the risks.

EINHORN: Well said.

All right, you're up. And so, can we have the microphone right there please?

QUESTIONER: Thank you. Barbara Matthews with BCM International Regulatory Analytics.

And thank you, Sebastian. Actually, I think the buy side has been completely ignored in a lot of the debate, but that's not my question.

I'm wondering how much time you spend in the book talking about the investor side. And the reason why I ask is, you've made a lot about the barriers to entry, but the policy underlying the reason for having, you know, 5 million (dollars) in liquid assets is because presumably these are investors who are, a, sophisticated and so therefore can understand the risks that they're taking when they employ the money manager of the hedge fund. And b, if they lose it, they can afford to lose it.

If you eliminate the barrier to entry, then you expose a lot of people to a very different type of risk, and this gets me to the buy-side point. There were a lot of people that weren't understanding it, that were sophisticated already.

So I'm wondering, do you address the buy-side component at all in the book? Or is that a separate book in the writing?

MALLABY: I do talk about, you know, the investors who put money into hedge funds, a bit about who they are. It's not the main focus, but, I mean, there is a chapter where one of the central characters is David Swensen who is the manager of the Yale Endowment, who arrived in the mid-late 1980s, and in 1990 became the first endowment manager to put money in a hedge fund, which was (Ferrell ?) on the West Coast. And so the chapter is about (Ferrell ?) and David Swensen. (Ferrell's ?) chief went to Yale and so it's called the Yale Men and it's about this.

And you know, if you ask, you know, was that good for Yale? I mean, the answer is resoundingly, screamingly yes. I mean, there was a study in 2005 where Yale figured out they had by then a $14 billion endowment. They figured out that 8.6 billion (dollars) of that 14 billion (dollars) came from David Swensen's high performance relative to other endowments. So by putting money into an alternative, which included hedge funds, you know, Swensen had generated $8.6 billion. He was a bigger contributor to Yale, effectively, than Harkness or Melon or any other of the storied philanthropists that had ever donated to education -- $8.6 billion generate for Yale for merit scholarships, science facilities and so forth.

So you know, when I went on a TV show today, Tavis Smiley, where it emerged that Tavis Smiley's view of hedge funds was that basically, you know, Visigoths with spreadsheets. (Laughter.) And so when he said to me, you know, what on earth good for society is this, I mean, one of the answers is that two-thirds of the money in hedge funds now comes from institutions, whether it's endowments, nonprofits, pension funds and so forth. So I talk a bit about where the money comes from.

You raise a question about, you know, the sophisticated investor question, and it's a tough one. I mean, on the one hand, you know, I want -- I mean, small investors should buy index funds, right? That's what they should do, because they don't have the due diligence capacity to figure out how to beat the index.

But we don't legislate that small investors shall not buy technology stocks in 1999. Plenty of risky things that day traders do is actually no more risk to put your money in a hedge fund. Frankly, people have done studies on the volatility of hedge funds versus the -- (inaudible) -- of only one stock. And the hedge fund is actually less volatile than only one stock.

So I think it's, you know, part of the double standard I mentioned about how hedge funds are viewed in society, which doesn't make sense. It's not that I want individuals to go out and buy hedge funds.

EINHORN: I think Swensen's first book spoke of alternative investments and really explained what the return was and was very encouraging of what this was about. His second book was written to explicitly warn retail investors against dabbling in any of it. And it wasn't because the fellow who has a friend from law school, who's doing a hedge fund, would be in danger if they were allowed to do it. It was because the major mediators between the retail investors and the small collection of hedge funds would likely be the same funds or the same intermediaries who found many, many other ways to fleece investors.

So I think that's part of what the barrier to entry question is. And I don't know if that changes it for you or not.

MALLABY: You know, I guess I sort of stick with the view that it's a double thing. On the one hand, it's probably not a good idea for individuals to put their money in hedge funds if they're not big and sophisticated in their portfolios, just like it's not a good idea for them to buy technology stocks or day traders.

You know, there's still a double standard there between hedge funds and, you know, day trading.

EINHORN: Good. Okay, so we have one question here, and we do have one question on that side. So let's do that.

QUESTIONER: Hi. I'm Peter --

EINHORN: Sorry, Peter, I'm going to save you for the last question. And it's the gentleman there.

QUESTIONER: Hi. My name is Jerry Johnson with RLJ Equity Partners.

I just have a question about hedge fund compensation. And the top 25 hedge fund managers, I believe, last year, on average, earned about $1 billion. And David Swensen didn't earn $1 billion. So is there a connection between fund performance and compensation? And how do you think about that?

MALLABY: Well, David Swensen was once asked by a hedge fund manager, David, look, if you weren't doing this for Yale and you ran your own hedge fund, you know, you'd be a billionaire. What are you doing? And Swensen said, it's a genetic defect. (Laughter.) I mean, he basically made a life choice that he's happy running an endowment for a university that he believed in, where he got his own Ph.D., which loves, and he's doing it because he wants to help Yale. And he finds the intellectual challenge of allocating money to hedge funds fascinating. He's written books about it. He's perfectly comfortably off, thank you very much, and he just doesn't want more money than God.

That's a perfectly fine choice, and he's not bitter about it.

Now, it's true that, you know, the top 25 make extraordinary money. I chose the book title for a reason. In 1913 when J.P. Morgan died, his sort of moniker was Jupiter, because he had this god-like power over Wall Street, and his fortune in today's dollars is $1.4 billion. People like Jim Simons, who I mentioned earlier, comfortably make more than $1.4 billion in one year. So they're making more money than Jupiter or more money than God in one year.

So you're right about the compensation. It is extraordinary. I think we should probably tax it more.

EINHORN: That's interesting. Don't prevent them from earning it, just decide what you want to do about taxing them.

MALLABY: Yeah, absolutely.

EINHORN: Now, sir.

QUESTIONER: I'm Jim Slatterly with Wiley Rein.

And I'm just curious if you would comment on just the explosion of the derivatives market, the global derivatives market, and particularly the whole issue of how risk is hidden. It's one thing to spread it, which is great, and it's another thing to hide it, which is very problematic, as we've painfully learned, because you can't price it if you've hid it.

And the credit-default swaps and the utilization of them played a key role certainly in the real estate bubble and the secondary mortgage market and all the collateralized debt obligations and on and on and on. And I'm just curious if you would care to comment about that. And as I see the credit-default swaps, they're fundamentally an insurance instrument. And when you don't require the insurer to post any kind of reserves so as to be in the position to clearly honor the commitments being made, you create this environment where you have, in effect, hid the cost of risk by spreading it the way we did in the last few years. Am I off base on that? I'm just curious. And I'm just particularly interested in just the size of the global derivatives market and the role that credit-default swaps plays in all this.

MALLABY: Sure. So I mean, I think one of the really obviously good parts of the congressional reform package is measures that would encourage derivatives, including CDS, to move onto an exchange. Because once it's on an exchange, the pricing becomes more transparent, and also the trading becomes more efficient, it becomes more liquid, and the spread tends to narrow, which is good for the users of these instruments. And it's both more transparent, more efficient and it's good in lots of ways. It also reduces counterparty risk, so the cat's cradle of the too linked to fail doctrine, too interconnected to fail, which when Bear Stearns was bailed out, this doctrine was invented and invoked.

You know, we wouldn't have to bail people out so much if that interconnectedness was reduced, because the derivatives traders were going through a centralized clearinghouse linked maybe to an exchange. So I think that's a good reform.

(Off mike commentary.)

Well, I mean, I am, in general, in favor of taking a lot of risk out of the big banks and moving them into small institutions which are not too big to fail. So I have some sympathy with this Lincoln thing. The problem with the Lincoln amendment and in fact also with the Volcker rule is, it's very hard to sort of draw a line between proprietary risk-taking by these big institutions, which you might want to discourage and push into smaller ones, and on the other hand legitimate hedging of positions that a bank takes because it has clients that want something to be done. I think implementing that stuff is going to prove to be very messy.

But in principle, I think pushing risk into smaller institutions is good.

I mean, one thing I would say, though, in CDS and so forth is that people often say, oh, my God, 60 trillion (dollars) market, what's all this? It's just too big. That I do not agree with, because I think that once you create securitized markets, the more trading, the better, because it becomes more liquid, and the more liquid it is, that's not just -- (inaudible). That means that there won't be discontinuity in prices.

So people can have the confidence that if they buy insurance in the CDS market, that the instrument that they own can be sold without the price jumping against you.

So the robustness -- people often say, there's more risk when there's more trading. That's not really true. The more trading there is, the less risk there is to the holder of a security, because you can get out in a predictable fashion because the market is liquid. It's always there for you.

It's like, if you own a car and you don't have a good way of selling it, there's more risk to you about what price you're going to get for it. If suddenly somebody creates a terrific online car secondhand market, you know, you can get out and sell your car with less risk.

EINHORN: Yes. Okay, and I'm going to glance over here. Let me see if there are some hands. Okay. The microphone here please.

QUESTIONER: Thanks. (Name inaudible) -- Potomac Capital.

A number of the large hedge funds have been registered with the SEC and have been subject to occasional SEC audits and the courts. Have you spotted any difference in patterns of performance between one or the other? Madoff, as you suggested, was subject to the SEC.

MALLABY: Yes. I think --

EINHORN: Can you repeat that question a little, because I'm sure that --

MALLABY: Yeah, so the question is, you know, some hedge funds have already registered with the Securities and Exchange Commission. At one point, the SEC required that, and then the court struck it down, but some of them didn't de-register, having registered. Others have registered because it's sort of a marketing tool, if you want to raise money from some retirement systems, particularly public retirement systems, it helps to be registered with the SEC.

So you've got a sort of natural experiment where some hedge funds are registered, some aren't. Is there a difference in performance? I don't know. I haven't actually looked at the numbers to see, you know, could we spot a trade where you could go short the hedge funds, which are registered along the other ones or some clever thing like that. Probably Goldman Sachs has done that. (Laughter.)

But what I would observe is that, you know, the fact that Bernie Madoff was registered should caution us against supposing that you're necessarily going to get a lot of security, a lot of systemic benefit from registration. I don't think that sadly follows.

EINHORN: I'm going to -- one more question, and then Peter Ackerman on the final question please. A microphone there.

QUESTIONER: Actually, I was hoping it was the last question, because it's a little different. I was in London last month, and I went to see a show called "Enron." (Laughter.) It was a very dynamic, slick show, but, of course, with a finale everybody trooped off to jail. Now, could you imagine a show based on hedge funds? I mean, you've obviously got some colorful characters. What would be your finale?

MALLABY: Well, you know, so on the theory that if it bleeds it leads, right, and you want, you know, you want a musical with a kind of twist at the end, I'm going to recommend that the producer of the next musical, who wants to do a hedge fund, you know, you could do it on Raj Rajaratnam maybe. I mean, there are clearly hedge funds.

In fact, there was a -- this goes back to the '60s. There was a story involving Douglas Aircraft, right, which was going to issue some securities. And the advisers to this public offering were Merrill Lynch, Pierce Fenner and whatever it was called at that time.


MALLABY: Smith, yeah. So Merrill, et cetera, et cetera, et cetera, you know, they are advising Douglas Aircraft. They get called in to do it. And as they're advising them of how to issue these securities, they discover that the earnings forecast that Douglas Aircraft has is a little bit off, and we're going to have to cut it by 50 percent. And then the next week, they said, oh, actually, it will be cut by 75 percent. And then a few days later, they discover that there won't be any earnings at all, they're going to make a loss.

And so you can imagine these guys at Merrill, et cetera, et cetera, they're sitting on this story about how, you know, this insider information about how Douglas Aircraft has zero earnings, and the stock is going to crash as soon as this is discovered.

So Merrill, et cetera, et cetera, I mean, they've got, you know, institutional brokers and so forth who call hedge funds on a regular basis. And the question is, does the Chinese wall -- or it wasn't called the Chinese wall then -- but does the separation inside work? Of course, it doesn't work, right? You know, there are people in Merrill, et cetera, et cetera, who have a good relationship with Alfred Jones' fund, the leading hedge fund of the time, and with all kinds of mini Joneses who have been spun off at this point on Wall Street, also managing hedge funds.

And first of all, the thing leaks to a couple of these guys, and they short Douglas like anything. And then a couple of these guys go to this lunch run by a guy called Bob Brimberg. And Bob Brimberg is this massive sort of, you know, famous guy who was captain of the Yale chess team. And he's as wide as a truck, and his partners have put a scale by his desk. It doesn't work, he still eats, and he gives these fantastic lunches where everyone drinks cocktails and basically talks and talks about what they're trading.

And somebody at this lunch says, you know, there's something going on with Douglas Aircraft and we're short, and we're really short. And so everybody else at this lunch -- and then, you know, they say, well, why? And there's something about Merrill Lynch, et cetera, et cetera.

So after the lunch, everyone's roaring back to their office, you know, two martinis later and calling up Merrill and saying, what is going on with Douglas? And by the end of the day, you know, they've all shorted Douglas like anything.

So then the SEC does an inquiry. And guess what? You know, 13 companies are discovered to have had inside information, and seven of them are hedge funds. And since there weren't that many hedge funds in the 1960s, maybe 100, to get seven of the 13 culprits being hedge funds, that's a bit of an indictment of the hedge fund gang.

So I think for your musical, I'm going to recommend -- (laughter) -- Douglas Aircraft.

EINHORN: Right. Chairman Ackerman.

QUESTIONER: Peter Ackerman, Rockport Capital.

So in the vein of your question, would it be useful to make the play in three acts? The first act being investors, the second act being speculators, and the third act being market-makers, meaning that, if you look at your book and the way people invest, there are time horizons to find who they are. And maybe you would argue that the old Alfred Winslow types, who had a fundamental view of longs and shorts, really don't bear that much intellectual parody, if you will, with a James Simons who probably doesn't have the least idea of what his companies are doing.

MALLABY: Right, right, right. I mean, one of the fascinations of doing this book was exactly what Peter is talking about, namely that within this hedge fund space, there are people with completely different intellectual approaches, who draw inferences from totally different places.

And so one way of dividing them up, as Peter rightly says, is by the the timeframe of their investments. So Julian Robertson of Tiger, who I mentioned before, is the kind of person who says, you know, he wants a fabulous investment, and he needs a company that is going to double in price, the stock is going to double in price over two or three years. That's what he's looking for.

And so he gets his college athletes to work the phones, go visit the companies, talk to the customers and the suppliers and just research the heck out of companies until he finds ones which just the market is fundamentally mispriced. And if you don't believe this works, you know, I've crunched some numbers in the appendix. Not only did Julian Robertson do fantastically well, but the offspring, the guys who worked for him and then went out and funded their own funds on this basis also outperform a lot.

And so, you know, that's one way of making money.

The second sort of category, I guess, is the speculators, the more short-term people, kind of the Soroses, the Paul Tudor Joneses, the macro traders, who aren't taking a two-year view, they're taking, you know, maybe they hold a position for a couple of months. They might think that, you know, the Thai baht is pegged at a value that can't possibly be sustained. They come to this view, they have a suspicion in January. They go visit Thailand in February, they interview somebody at the central bank, who says something incredibly stupid, is the story I tell in my book, where they sort of admit to the Soros guys that, yeah, this peg, it's becoming a bit difficult. And it's like a suitcase of money has been handed over to the Soros guys, and it's spilling dollar notes all over the table. And the Soros guys are sitting there, pretending nothing is noticed and just being polite and rushing back to call New York afterwards and saying, you know, you've got to short thing.

So you know, they did this trade in around February or so, and it came good in the summer, so they held it for four or five months. So that's the kind of middle zone.

And then there are the market-makers who hold a position for a couple of hours. And you know, the classic original market-maker in hedge fund space is Steinhardt, who is a guy, he's pretty intense, he gets, you know, he's on the phone all the time, and he's got two cigarettes at once. He's yelling at people, viciously. In one story I tell, you know, he's yelled at somebody so badly that the poor guy is stammering and saying, all I want to do is kill myself. And Michael Steinhardt says, can I watch? He's a tough guy.

And his strategy is basically when a big institutional investor, I think a pension plan, needs to sell some ginormous stock of IBM, it can't find a market for that, right, because it's selling so much that nobody wants to buy that much.

So Steinhardt says, I'll buy it, but you have to give me a $2 discount. He takes the big bloc of stock at $2 down, and he sort of parcels it off to other people, because he's wired into the markets. And he turns it around in a couple of hours, maybe a day, and he's made a $2 turn on it. And that's what computers do now.

You know, when people talk about flash trading and statistical arbitrage models and all this stuff, it's really an updated version of what Michael Steinhardt was doing back in the '70s.

So you know, I could go on forever about these stories. You've been very good to listen.

EINHORN: And you'd entertain us forever, because it is a wonderful book. So let me just, before we close, remind everyone that this meeting is on the record, which means that when you leave the room you're free to tell everyone how fabulous Sebastian was -- (laughter) -- and that they should buy this book right away before it runs out of print.

And then let us thank the author and the council for this wonderful occasion. And thank you all for coming.

MALLABY: Thank you. Thanks very much. (Applause.)







Top Stories on CFR


How will Australia's election result affect the region, including U.S.-China competition?

Middle East and North Africa

Hezbollah and its allies suffered serious losses in May’s parliamentary elections, and a divided Parliament will likely struggle to agree on a path out of Lebanon’s current crisis.

Middle East and North Africa

Turkey’s geography and membership in NATO have long given the country an influential voice in foreign policy, but the assertive policies of President Erdogan have complicated its role.