Why the Tea Party tolerates Etch-a-Sketch

Missing so far in October’s political commentary is an obvious question about Mitt Romney’s latest Etch-a-Sketch redrafting of his positions. (Just yesterday Romney “softened” his position on opposing abortions and repealing homeowner and charities tax deductions.)

Question: At what point will the Tea Party see Romney as just another RINO (Republican in Name Only)? At what point will the latest sketch drive out the hard Right wing of the Republican Party?

Romney’s campaign has obviously asked the same question ... and answered it. Indeed they probably answered it months ago. After all we first heard the Etch-a-Sketch analogy from the Romney campaign on the day Romney won enough primaries to ensure his nomination.

Might the Tea Party abandon Mitt?

Not to worry.

They’ve likely been clued in that this is the essential means to the end of taking over the White House. Rest assured, Tea Party, after the November victory, the sketch will change again and you will like what your see.

Meanwhile, the rest of us want in on the secret. What will we see if Mitt wins?

We know where to look for clues. Follow the money.

What was once said about the piper can now be said about the sketch artist. Whoever is paying the artist guides the pencil.

The problem for us outsider citizens is this:  while we know where to look to find out how much money (hundreds of millions) is going into the campaign, we don’t know who is giving it.

We have our Supreme Court to thank for our ignorance.

In fairness, the same “Citizens United” secrecy applies to the Obama campaign and its financial backing, but at least the president is consistent. Compared to Romney, the president paints in vivid, lasting oils, albeit they are smudged by the Republican opposition. To be sure, much of Obama’s artwork is bad.  Regarding war he paints in blood red and black boxes. His portrait of the environment is decidedly ungreen and is increasingly pitch black and oily surrounded by blank space.

A sobering concern is that the very same people may be paying both candidates. “Hedging” is the by-word for our times. PACs are really nothing more than arcane policy/financial hedge funds managed by political consultants.

So, to change images, will the Tea Party fall off the wildly swerving Romney wagon as the candidate lurches to the middle?

I doubt it. I think that Paul Ryan and friends have clued in their fellow travelers. So far the polls show that the Right has received the message and is holding on.

Finally, there’s this nasty part of Tea Party thinking that has nothing to do with Left, Right or Center. For reasons that reside in the conspiracy-obsessed heart of “birther” darkness, large portions of the Tea Party hate Barack Obama. He is “the other”  — and Romney isn’t. The visuals of television debates, far from hiding differences, only make them more apparent. They are visceral — beyond discussion and debate.

Understanding Tepper Time

On the business page of the Times yesterday we learned that, while the economy was tanking last year, “top” hedge-fund managers were doing just fine, thank you.

How fine? The word “surreal” comes to mind.

David Tepper, the top earner, hauled in $4 billion (That's with a "B").

George Soros snagged $3.3 billion. James Simons tallied $2.5 billion.

And on and on.

The lowest paid among the top ten, the relatively impoverished Philip Falcone, garnered a mere $825 million.

Indeed, the Times told us, the 25 top hedge-fund managers averaged $1 billion each.

The untethered, billowing numbers float before our plebeian eyes.

We know that this is insane, but we can’t quite reel in the madness.

The Times is not helpful. It casts the story as some kind of race with Tepper crossing the line ahead of a Gucci-heeled pack. He rose to the “top spot” in the hedge fund sweepstakes. Soros was the “runner-up.” One manager’s compensation “edged out” another’s , etc.

It’s all just another horse race, score card or post-season play-off bracket.

Right.

No, let’s put Tepper’s $4 billion into the larger “societal context,” as they say.

That's the context that includes us. We live day by day. It turns out Tepper and friends do too, but with a massive monetary difference.

Let’s do the math on Tepper by breaking his compensation into “Tepper time.”

In one average day last year, Tepper took in nearly $11 million.

That’s for EACH of his 365 days.

I presume, no doubt falsely, that this guy works Saturdays and Sundays, 24/7, to earn $4 billion.

In just one hour of that 24-hour day, Tepper made $458,000.

Are you still with me?

One hour....$458,000.

What do you make in an hour? What do you make in a year? And how hard do you work to make it? Do you perform some useful, worthwhile service?

Pay attention here. This is important.

When Tepper awakens from an eight-hour sleep, he’s just pocketed $3.6 million in his PJs.

In a single minute, Tepper makes $7,633. That’s every minute of every 24-hour-long day.

In the time it takes this guy to shave and shower, he’s made what the average Jill and Joe make in a year — if they are fortunate enough to have a decent paying job.

In a New York second, Tepper is $127 richer.

Inhale, exhale. With each breath, Tepper is pulling in roughly $500.

Which gives real meaning to "living and breathing money."

Remember in January when we were voting on a tax package in order to keep the schools and other public services alive? The opposition labeled the measure “job-killing” taxes. It was a nasty little campaign. A few million got dropped just to get the word out.

Do you happen to recall how much money were were arguing over?

$733 million.

Tepper raked in that in just over two months, 66 days to be exact.

While Tepper’s clock was running at the annual rate of $4 billion last year, the Portland School district had an annual budget of $631.7 million.

Let the record show that Tepper’s annual compensation would have run six plus school districts the size of Portland’s. His annual take is roughly what 6,666 teachers (paid $60 grand each) make in a year.

Which leads to three obvious questions:

1. What does Tepper actually do to make him 6,666 times more valuable than a teacher? Basically, he and his fellow hedgsters gamble with other people's money.

2. What does it do to democracy when plutocrats have this kind of money to throw at legislation and politicians?

3. In a world where the poorest members of the masses are on the streets struggling to get by on $2 a day, just what are Tepper and his billionaire buddies doing with their hedge fund largess? I'll leave it to them to answer.

Let’s say you are scraping by on $700 a year in Bangladesh or Burundi. In the time it takes a Tepper to tee up his Titleist or sip a martini, he’s got you covered — for the year. If only.

Consider this: in Tepper time, it took the eight seconds to read the previous two sentences about grinding world poverty. On the Tepper-meter, that clocked out at $1,000.

Face it, the message isn’t worth Tepper's time of day — or night.

Hedge-fund managers have more compelling places to do think about than Bangladesh or Burundi. Switzerland or the Cayman Islands perhaps? Burmuda or Bimini?

Back to me

I know more about the hedge fund business now that friend and former student Chris Clair, who works for Hedge World, the industry newsletter, has explain how the funds work.

For a review of my original post, which inspired Chris, go here. For his response go here, here ,here and here.

Silly fellow that I am, I still maintain that when one person "earns" $2.8 billion (with a "b") in one year, something is amiss. With that amount, you could meet the salaries every wage earner in Beaverton and Gresham.

You could feed entire impoverished populations for a year. Children would not starve.

You could save thousands of lives.

But $2.8 billion is what one mortal man, hedge fund manager James Simons, took in last year. Others in the industry, if that is what it is, merely made hundreds of millions.

At its heart, my issue is not a financial one but a moral one.

In his conclusion, Chris maintains that the question of "how much" these guys should be paid (and they are guys) is "settled by supply and demand" and "this annoyingly elusive concept of 'quality.'"

Supply and demand? The world has only one Chris Clair and Rick Seifert. We are in short supply. A mere one of each of us. We do good work. We are in demand. We are paid adequately. We are paid enough and should be thankful for it and the skills we have to make us "worth" as much.

Where's the short supply and pressing demand for hedge fund managers that justifies nine- and 10-digit payments?

No, these guys pay themselves these amounts because they can and because they love money. They live and breathe money. No doubt they are pleasant enough people. They tuck their kids into bed at night, kissing them lovingly on their foreheads. Most are ,no doubt, gracious, kind, engaging.

But they must be blind to the world we live in.

This is not a matter of "supply and demand;" this is a matter of blinding greed.

I'm not inclined to quote Scripture, but these men would do well to ponder the passage from Matthew:

For where your treasure is, there your heart will be also.

As for quality, how can you measure quality when the job description is satisfying greed? As Chris suggests, "quality" is a big topic. It is also amoral. I'm sure there are quality child molesters, hit men, embezzlers, terrorists and torturers. Should society reward them for their quality work?

As far as I can tell from reading Chris' account, hedge fund managers are skilled gamblers who stake other people's money (and sometimes their own) and rake off their mind-boggling cuts. Oh, and they manage to do this at the lowest possible tax rate. You and I make up the difference.

While the world runs on the labor of farmers, truck drivers, teachers, nurses, cops, carpenters, secretaries, the editors of industry newsletters etc. Simons receives $2,800,000,000 for clever gambling.

What's wrong with this picture?

Or is it, as Chris has said, simply "hogwash" to question the "worth" of this "industry," and its lavish individual compensations?

Hedge Hog "Hogwash" — Part IV: The Bottom Line

This is the conclusion of Chris Clair's four-part answer to my questions about the "worth"of hedge funds (Do they actually contribute to society?) and their exorbitantly paid managers (How much is enough? How much is simply obscene?) continues.

For a review of my original post, which inspired Chris, go here. The first three parts of his response are here, here and here.

As noted previously, Chris, a friend and former student, writes for Hedge World, an industry newsletter.

Part IV — The Bottom Line

Hedge funds are like bogeymen. They are little understood by anyone outside the investment world. They have operated under exemptions from regulation. Some managers make lots of money.

Going forward they, and the rest of the financial system, will likely be more tightly regulated. There will be fewer managers and assets.

Already, hedge fund assets are half what they were in late 2007, when the industry topped out at $2.8 trillion. For reference, when I started covering hedge funds in 2001, they had about $800 billion in assets, compared to mutual funds with $8 trillion. As more investors sought positive returns after the bear market of the early 2000s, hedge funds became popular. Assets flowed in from foundations, endowments, pension funds and the nouveaux riche.

Lots of people started hedge funds to capture some of the inflows. Not all were qualified, and many are now out of business, having lost not only their own money, but their investors' money as well.

A smaller hedge fund industry, with fewer high-quality managers fed by knowledgeable investors is a better scenario. This business isn't for everyone. Done correctly, hedge funds smooth out price inefficiencies and can contribute to better functioning capital markets. Done incorrectly, hedge funds can exacerbate market declines and add to volatility.

At the end of the day, hedge funds are like any other industry – their contribution to society (or the economy or whatever) is only as great as the individual contributors.

Are there some greedy bastards out there? Yes.

Are there also managers who sincerely believe in a mission of fulfilling a fiduciary responsibility to their clients - which include pension funds? Absolutely.

None of this is meant as a defense of the industry at large, only as a partial explanation of a very complex corner of the investment world and a rebuttal to the contention that hedge fund managers, as a group, contribute nothing and therefore should be paid nothing. Some … most, even … do contribute and should be paid something.

How much? Everyone can make his or her on judgment on that, but the way the system is set up now the question of “how much” is settled by supply and demand and this annoyingly elusive concept of “quality.” Now that would be a fun and high-level discussion. What is quality? Robert Persig wrote a whole book (Zen and the Art of Motorcycle Maintenance) about that. And I’ll stop now before this reaches book-length.

Back to you, Rick....

Hedge Hog "Hogwash" — Part III: How funds do it

Chris Clair's on-going answer to my questions about the "worth"of hedge funds (Do they actually contribute to society?) and their exorbitantly paid managers (How much is enough? How much is simply obscene?) continues.

I've decided to extend Chris' response to four parts. Part III appears here. Part IV, a summation, will come later in the week.

For a review of my original post, which inspired Chris, go here. The first two parts of his response are here and here.

As noted previously, Chris, a friend and former student, writes for Hedge World, an industry newsletter.

Part III — How the funds make their money

For the most part hedge fund managers trade securities, just like mutual fund managers. The key difference is that hedge funds can bet on falling securities prices as well as rising prices through a process known as “shorting.” In a short sale, the hedge fund manager borrows securities – let's say stock in a company the manager believes is overvalued by the market – and sells them. When it comes time to repay the borrowed securities, the manager hopes the price has fallen so they can be repurchased at a lower price. The manager pockets the difference, and the brokerage pockets the borrowing fee.

Hedge funds also bet on what are known as "spreads" or the difference in price between securities. Sophisticated pricing models can be employed to estimate securities prices. If the manager sees a too-large or too-small discrepancy between the prices of two securities, the manager can bet on the spread to either narrow or widen.

Those are just two examples of many different strategies managers follow.

Often hedge funds are engaged in what Roger Lowenstein called “vacuuming up pennies” in his book When Genius Failed, about the failure of the hedge fund Long-Term Capital Management. As he explains, "vacuuming up pennies" involves leveraging loans 100 or more times over.

LTCM was using that kind of leverage, which worked fine as long as the models were correct. However when Russia defaulted on its debt, bond spread characteristics changed beyond the model's ability to handle the calculations. Because LTCM worked with so much borrowed money – hundreds of millions of dollars – when its bets appeared to go wrong, the banks called for more collateral. To them LTCM was a counterparty, and to a certain extent its losses became the banks' losses, at least as far as balance sheets were concerned. This was why the government had to step in and back LTCM, so that the hedge fund's counterparties wouldn't be dragged down by its problems.

Today, similar problems have been exacerbated because the financial world is even more intertwined now and securitization is more prevalent.

Hedge funds also were players in the securitized credit markets that resulted from packaging and repackaging loans (many of which had highly risky contents). Now some funds are hurting. Even many of those that earned positive returns last year are losing assets, as investors pull out what money they can find to cover losses elsewhere, or to live on.

Hedge Hog "Hogwash" — Part II: What they do

Chris Clair’s rebuttal of my questioning the compensation and worth of hedge fund managers continues.

For those who would like to follow the thread back to its Red Electric origins, my initial post, which invited Chris to comment, is here.

Part I of his response is here. I'll post Part III later in the week.

Note: Chris, a friend, journalist and former student, has reported on the hedge fund industry for the past eight years. He lives and works in Chicago and is the managing editor of Reuters HedgeWorld.


PART II

So what are hedge fund managers doing to earn positive returns? The best and brightest hedge fund managers exploit price inefficiencies in the market. They bet against securities (stocks, bonds and their derivatives) they believe are overvalued and buy securities they believe are underpriced or that have growth potential. Different managers do this in different ways and employ varying degrees of risk. Some funds are very low-risk and are designed to provide steady, incremental returns – say, 10% to 15% per year – in all market conditions (whether stocks are way up, way down or flat). Some funds use lots of leverage (borrowed money) to increase returns, or trade in complex securities that few understand, thereby raising the level of risk. The type of strategy any particular hedge fund follows and its riskiness is outlined in its offering documents.

Speaking of offering documents, I have to digress for a second here to talk about the “gambling” issue. Rick, you wrote, “Then there’s the question of whether the top 25 actually did anything to “earn” their largesse besides gamble with other people’s money.” Hedge funds invest money on behalf of other investors, but most hedge fund managers also place their own money in the funds they manage. In fact, outside investors often won’t even consider a relationship with a hedge fund manager that does not place a substantial amount of his or her own net worth in the funds that manager runs. It’s about alignment of interests. So while the managers are investing other people’s money, they are also investing their own money.

Additionally, it's not like the hedge fund managers stole the money they invest from somewhere; when the system works correctly, investors conduct extensive due diligence on managers and make a careful and conscious decision to gamble their own money. It's up to the investor to understand what he or she is investing in. Caveat emptor!

If one wants a risk-free investment, one should buy Treasury bills or open a savings account. Historically - like over the past 100 years – stocks have returned about 11% annually and bonds something less than that. When you experience years like we had in the 90s, (between 1990 and 1999 the average annual return of the U.S. stock market was nearly double what it was from 1926 through 1999), and the same in the middle part of this decade, you can bet there's going to be a reversion to the mean. In other words, people who got in at the end are going to lose money, at least in the short term.

Instead we seem to keep buying into the notion that every time we enter a bull market, it's a "new paradigm" and the "old rules" don't apply. That's just stupidity. So of course any investment in the stock market or anything else (even Treasuries when you get right down to it) carries the risk of loss. Hell, stuffing money in your mattress carries the risk of loss (fire, flood) but without any possibility of earning a positive return.

The hedge fund manager’s job is to earn money in all markets – to be smart enough to avail himself or herself of all the investment tools at his or her disposal to earn investors a positive return no matter what. Historically, the good ones have done that, which is why they can get away with charging higher fees. In the process they have helped boost university endowment returns and protected workers’ pensions. Even last year, the worst year on record for hedge funds (the average fund was down 19%) they still performed only half as bad as the stock market. And since the bulk of a hedge fund manager’s compensation comes from the performance fee, when a hedge fund manager loses money he gives up most of his or her income. And not just for that year, either. Most hedge funds have what are known as “high water marks,” whereby the manager must make up all that he has lost and then some before he can begin collecting the performance fee again. After 2008’s debacle, some hedge fund managers may not collect performance fees this year or next year.

I make that point simply to illustrate that not all hedge fund managers are John Paulson or George Soros, that some of them are essentially small businessmen and that they also face the same risk of loss as their investors.

Hedge Hog "Hogwash" — Part I: Contributions

Chris Clair, friend, journalist and former student, has reported on hedge funds and the financial industry for eight years. He lives and works in Chicago and is the managing editor of Reuters HedgeWorld.

I invited him to respond to my recent post, "Top Hedge Hogs of 2008." He has been kind enough to do so.

As you will see, he takes serious exception to my suggestion that hedge fund managers don’t earn their keep. I’ll run his response in three parts over the next few days.

Thanks, Chris, for taking the time to share your observations.

PART I

The quick and dirty response to your observation, "By comparison to most American workers, hedge fund managers contribute zilch and should be paid accordingly," is “hogwash.” The devil is in the details, however, so let’s get into some.

There are probably 4,000 or 5,000 hedge fund managers in the world, give or take a thousand. To say none of them contribute anything casts the net too wide. One can examine a sample of 4,000 or 5,000 anything – waitresses, teachers, nurses, policemen, construction workers, politicians, journalists – and find a certain percentage who don’t appear to contribute to the economy or to society, or who don’t contribute on a par with what they earn.

If you ask which bothers me more – knowing John Paulson earned $2.8 billion or knowing a half-dozen politically-connected trucking firms were paid millions of dollars by the city of Chicago for doing nothing – my answer is the trucking scandal, hands-down. John Paulson’s salary in and of itself doesn’t affect me. Having my tax dollars wasted affects me – by misallocating resources and depriving worthy and necessary projects the funds they need. And in fact, although there is a strong argument to be made that John Paulson does not pay enough in taxes on his income, at least he pays some taxes. Government waste squanders money and actually is a negative contribution to society and to the economy.

Two questions I see contained in your “Hedge Hogs” post, Rick, are “What does it mean to contribute?” and “How much money is ‘too much?’”

I’ll discuss later some ways hedge fund managers earn their money (and make money for their investors) and this notion of “too much.” For now I’ll focus on the contribution question. It’s true that hedge funds do not manufacture anything. But they do provide jobs, and not just jobs for traders with Ivy League business degrees. They hire analysts with economics degrees and clerical staff, for instance. These are good-paying jobs filled by people with all manner of experience, including some who don’t have the skills to work in construction or the temperament for teaching or the compassion to be a nurse. Hedge funds pay these employees good salaries – better than waitressing – and that money is in turn spent elsewhere.

The presence of hedge funds also means jobs for accountants, lawyers, traders in the pits at financial exchanges and others.

As other highly compensated people often do, hedge fund managers contribute money and time to philanthropic endeavors – charities, education and the arts. They do this for tax purposes, sure, but some of them also believe deeply in the causes they support. I know one manager who has plowed millions of dollars he’s made into a foundation he created that is dedicated to funding organizations that prevent child abuse and treat abused children. Another manager I know started a foundation to provide prosthetic limbs, and training on how to use them, to children in third-world countries. Neither of these managers can be found in that top-25 earners list published by Alpha.

It’s not how much one makes that matters, but what one does with the money one earns.

But where does this money come from? One might posit that the cost to society and the economy of the hedge fund managers’ strategies outweighs the contributions those managers make through their hiring, trading and philanthropic work. (By the way, I don’t consider criminals like Bernie Madoff to be hedge fund managers. They are con men, and if they hadn’t been running hedge fund cons they would have been swindling people some other way.)

To start with, it helps to understand how these guys get paid. Hedge fund managers make money from fees they charge investors. Hedge funds are restricted to investors who meet certain income/investable asset guidelines. You or I could not invest in them. Also hedge funds can't advertise like mutual funds can

Fund managers typically charge two kinds of fees: a straight management fee, usually 2% to 5%, that is based on the amount of assets they manage, and a performance or incentive fee, usually about 20% of whatever positive return they generate. A manager running a $100 million fund who earns a 15% return over 12 months, will, at the end of the year, collect between $2.3 million to $5.75 million from the management fee and another $3 million from the incentive fee.

It sounds like a lot of money, and compared to $50,000 or even $100,000, it is. However out of that pool of money the manager also must pay his or her employees their salaries and benefits, as well as office rent, brokerage fees, legal fees, accounting fees, etc. Some say hedge fund fees are too high and investors are being gouged. But hedge fund managers are paid what the market will bear. Investors know the fees going in and agree to pay them.

Most hedge fund managers manage between $100 million and $1 billion in assets. The people on Alpha’s list are those operating in rarefied air, people who have built enormous operations employing hundreds or thousands of people, or who have made exceptional bets and been right.

For Part II, What Hedge Fund managers actually do, go HERE.