Hedge funds must be part of the new financial world order

Could hedge funds be part of the solution? Could short-selling hedge funds be doing the market and regulators a valuable service? Surely you jest. However, that's exactly what ex-Wall Street Journal columnist Jesse Eisinger hints at in his story about restructuring the financial system in the current issue of Conde Nast Portfolio.  

"We need more dissidents.  We need to make the world a safer place for short-sellers to criticize companies.  Regulators should publicly praise short-sellers, rather than periodically ban their activities.  Critics and whistle-blowers, no matter how self-motivated, should be regularly consulted about suspicious companies, not dismissed as cranks once they expose wrongdoing."  Really.  Page 47.  

For hedge funds to be a respected part of a new financial world order, two things need to happen.  Regulators, analysts and shareholders need to aggressively seek the opinion of independent parties and be much more skeptical of corporate claims and the CEO bully pulpit.  That shouldn't be too hard.

Second, short-sellers and hedge funds of all stripes need to admit they are part of the system and behave like they have an interest in stability in the market, preventing fraud and encouraging financial fair play.  Once they take their positions, they must go public in cases where systemic risk, fraud, or deceptive accounting is afoot.  Profits will still be made, but full-blown crises might be averted.

What hedge funds cannot do is sit on the sidelines grinning like the Cheshire cat.  In a new financial world order, it is not sufficient to be the smartest guy in the room.  You also need to be responsible.  

In the same issue of Portfolio, John Paulson, whose funds made $15 billion in 2007 by betting against homeowners, banks and mortgage companies in 2007, is scrutinized along these lines.  "Left unexamined is the uncomfortable moral dimension of Paulson's achievement.  If he saw all of this coming, was it right for him to keep his own counsel, quietly trading while the financial system melted down?  Do traders who figure out a way to profit from our misery deserve our contempt or our admiration, however grudging?" 

Financial firms risking more than reputation by continuing lavish spending and bonuses

Wall Street bonuses have always drawn the attention of journalists. In the best of times, the topic of bonues at investment banks has been covered much like auctions at Christie's -- phenomena to behold, but not quite believe. These are not those times and the issue of bonuses at Merrill Lynch was toxic enough to send John Thain into retirement. How can Citigroup buy a new corporate jet on the heels of more financial support from the government? How can AIG pay $450 million to workers at the unit that brought down the firm? It is hard to fathom that the culture of compensation and the perception that it requires bags and bags of money to retain talent in the financial sector is so pervasive that the same hand that is begging for taxpayer-funded relief is signing whopping bonus checks.

Bankers need to look at the case of Detroit for a reality check. Automakers were denied a government bailout partly because public sentiment was against them. Financial firms will lose political support in hurry if they continue to enrich their own at public expense.

By comparison, the 2/20 compensation system for hedge fund managers, long criticized by media, seems aligned with the interests of investors. Not that you are going to read that anywhere soon!

Maureen Dowd turns her wit on John Thain and Wall Street bonuses in today's New York Times.

Bloomberg outlines $450 million in payments at AIG's financial products unit.

A former Merrill banker writes about the bonus culture on Wall Street in an op-ed in the New York Times.

Wall Street paid $18.4 billion in bonuses last year, the sixth biggest bonus year on record, according to the New York Times.

John Thain's$1.22 million office renovation is detailed on the DailyBeast.com.

Of course the antique commode purchased by Thain for his office at Merrill is too tempting for the Daily Show to pass up.  The first three minutes of last nights intro segment lampoon John Thain.

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Classic IR tactic not working for banks

Insider buying by CEOs and other top executives is a classic tactic to signal that the market has the wrong perception about a company.  The problem is that it is simply not working for banking CEOs these days.  Confidence is just too low in the financial sector and would-be investors simply don't trust banking CEOs.  Trust in CEOs overall might be at an all time low and companies need to understand that and adapt to a new communications environment where new efforts are required to earn trust. 

Earlier this week Ken Lewis and other chiefs at Bank of America purchased more than 513,000 shares.  It won't make a difference.  The Wall Street Journal writes "credibility is a series of small, successful gestures [and] bank executives must see that their gestures are being read by the market as empty ones."  In fact, research by InsiderScore.com and other analysts suggest that buying by insiders should be a strong sell signal for everyone else.  Turns out that execs, of late, have been wrong more often than they have been right.

BreakingViews.com writes, "given how erroneous the public statements on Wall Street's top banking executives have proven to be, it would be hard to take their prognostications seriously."

Unfortunately for bank CEOs, the market is not doing as they say nor, when it comes to insider buying, is it doing as they do.  The herd is going the other way.

Communicating with current investors is job one

The New York Times' DealBook blog profiles JHL Capital Group, a Chicago-based hedge fund run by James Litinsky.  While JHL returned up to 18 percent to investors last year certainly bucks the current trend, it is not the only thing notable about the fund.  From his quarterly letter to investors, Mr. Litinsky clearly realizes that resting on the laurels of exemplary performance is not sufficient in today's environment.  Good returns alone might not prevent newly risk-conscious investors or investors who have suffered losses elsewhere from cashing in their chips.  Managers must give investors compelling reasons to stay in the fund or risk redemptions.  

In the case of JHL, Mr. Litinsky uses his quarterly letter to reinforce his investment philosophy and detail the business case for two primary investments, the bonds of The New York Times Company and Lamar Advertising.  For each, the fund explains its view of why the debt was undervalued, but secured.  It also explains why neither company is likely to default in the near term and goes on to give worst-case scenarios for both investments.

Mr. Litinsky writes: "In both the NYT and LAMR situations, we modeled out the path to paydown.  We not only had asset coverage well in excess of our basis but also had a priority interest on family heirlooms.  If conditions deteriorated further, the management teams would likely be most focused on maintaining long-term control of the assets rather than extracting an extra dividend or attempting something more overtly hostile.  Those are the kinds of borrowers we like."

This level of transparency is one way to give investors the confidence to maintain or even increase their commitment to a hedge fund.  Right now, getting the right information to current investors is job one, superseding any new marketing and fundraising.

 

Hedge fund "convergence" is good for embattled industry

All About Alpha.com writes about "convergence" in the asset management industry.  Citing recent examples of Putnam launching an "absolute return" mutual fund and quant fund manager AQR starting its Diversified Arbitrage mutual fund, the story discusses how hedge funds are morphing into diversified financial institutions that are providing traditional asset management and investment banking services among other offerings not typically associated with the hedge fund business.

While this trend is good for hedge fund business, it is also good for the reputation of the industry.  The media don't appreciate the extent of the role hedge funds play in the global capital equation, particularly now, as commercial banks are severely constrained and the investment banking options reduced.  Why can't hedge funds and private equity firms be a driving force behind recapitalization of the banking industry and the broader economic recovery?  By stepping into the breach created by troubled banks, new institutions can be part of the solution -- and maybe, just maybe get credit for it.

See a previous post about hedge funds and their importance to the broader market.

As early as 2005, the New York Times was writing about hedge funds getting into corporate lending.

Read the Wall Street Journal's account of the new AQR fund.

Read the FT's story on hedge funds morphing into investment banks.

Transparency at issue in bank system fix

The New York Times writes about the Obama administration's options in dealing with the ongoing banking crisis.  The story notes that one of the main differences among options being discussed is the level of transparency about the ultimate cost to taxpayers and the degree to which banks would be required to disclose the true magnitude of likely losses.  

According new analysis by the Congressional Budget Office, costs to taxpayers are highest when bailouts involve opaque transactions that are difficult to understand.  TARP is the poster child for a program with limited transparency.  The CBO estimates that taxpayers will end up absorbing 26% of $247 billion in disbursements to financial institutions through December.  The AIG bailout, another complex program, is estimated to cost taxpayers more than $20 billion.  November's decision to guarantee $306 billion of toxic assets on Citgroup's books is estimated to cost the public $5 billion.  

The new administration must do a better job in disclosing the real costs and real value behind its plans for the banking system.  More transparency and better communication with voters and the media are needed to both ensure the best solution is reached and help stabilize reeling bank stocks.  In addition, more transparency will increase the likelihood that hedge funds and other private investors buy some of the assets in question and invest in the banks themselves.

The Times notes, however, that "banks may not want that kind of openness, because accurately valuing the toxic assets could force many to book big losses, admit their insolvency and shut down."

MFA's Baker Interviewed

Fortune interviews Richard Baker, head of the Managed Funds Association.  The short Q&A covers the Madoff affair, the ban on short-selling, and prospects for increased regulation of hedge funds.  This blog has commented that the MFA and similar bodies in the U.S. have struggled to defend the reputation and interests of the hedge fund industry, but the article notes that the lobbying restrictions on Baker, a former Congressman, lift next month.