Inside investment: Alice in Cohn land
Goldman Sachs’s Gary Cohn thinks hedge funds, not banks, are likely to cause the next financial crisis. He needs to take a long hard stare in the looking glass.
By now we should be inured to the great clouds of guffery that emerge from the World Economic Forum in Davos. Such are the quantities of hot air it is surprising that the skiers in nearby Klosters have any on-piste fun in late January. Every once in a while, however, something so unintentionally hilarious is uttered that you pause and think perhaps the meeting does have a purpose after all: the outing of gilded galahs.
Exhibit A from this year’s jamboree follows: "The drive to impose more regulation on banks could cause the next crisis by pushing risky activity towards hedge funds and other lightly supervised entities...in the next cycle, as the regulatory pendulum swings, we are going to have taxpayers’ money bail out unregulated businesses."
This fart of fatuousness was emitted by Gary Cohn, president and chief operating officer of Goldman Sachs. It is hard to find many excuses for Cohn’s apparent ignorance of recent history, including that of his own firm (perhaps he has been spending too much time communing with his inner cephalopod?). So, let’s put in words a response that even someone stumbling through the self-serving miasma of their own denial can understand. Mr Cohn, hedge funds were not, are not and will not be the problem. Big banks are.
Goldman Sachs took $10 billion from US taxpayers via the Troubled Asset Relief Program in October 2008. As AIG’s largest counterparty, on the line for $12.9 billion, the firm was the single biggest beneficiary of the $85 billion government-funded bailout of the insolvent insurance company. Hank Paulson, then Treasury secretary and a previous occupant of Cohn’s chair at Goldman, thought this was the right thing to do.
These are the hard numbers that are a matter of public record. The value of a quasi-state guarantee, interest rates at close to zero for the longest period on record, almost limitless cheap funding and liquidity provided by the world’s central banks, the Federal Reserve’s Term Auction Facility, the Primary Dealer Credit Facility, the Term Securities Lending Facility and two bouts of quantitative easing are all but incalculable.
Over the same period, approximately 1,500 hedge funds went bust. Few made headlines. None received a single cent from the government or taxpayer. None was the beneficiary of special assistance from the Federal Reserve. However, all have seen the leverage available to them cut and margin and collateral requirements tightened; a product of the folly of their banks and prime brokers and their pressing need to hoard capital.
Those hedge funds that went under did so in an orderly fashion. Creditors, debtors and investors received what was their due in accordance with the law. There was no "taxpayers’ bailout" and never has been. In the most notorious example of a hedge fund collapse, Long Term Capital Management (LTCM) in September 1998, there was a bankers’ bail-in to clear up a mess of their own creation. A fund with equity capital of just $4.7 billion managed to borrow $120 billion in bonds and create off-balance-sheet derivatives with a nominal value of $1.25 trillion. Who were the counterparties to these repos and derivatives? They were banks and brokers, including Goldman.
The biggest hedge fund collapse in recent times was Amaranth in 2006. Amaranth had more than double LTCM’s funds under management. Via futures at some points it controlled about 5% of the US natural gas supply for a year. These positions were 50,000 times bigger than what regulators defined at the time as a "large trader". In spite of these huge punts, when Amaranth failed, it went quietly. There was no systemic risk and the heating stayed on in Kansas City.
Cohn’s notion that hedge funds are "unregulated businesses" is also at best only a partial truth. All UK-based funds have to register with the Financial Services Authority and are subject to its stipulations. In the US, funds do not have to register with the SEC, but industry lobby group the Managed Futures Association reports that more than half do.
In the wake of the Madoff scandal any hedge fund serious about growing its business would choose to be regulated and transparent. It is also abundantly clear that more regulation, some good, some less so, is coming. In the US the Financial Stability Oversight Council (FSOC) is due to set out its definition of systemically important non-banks in April. The European Union seems determined to press ahead with the flawed Alternative Investment Funds Directive.
Hedge funds perform a valuable role in the financial system as risk-takers of last resort, particularly in times of crisis when banks are pulling up the drawbridge. It will be interesting to see what FSOC comes up with in April. With the possible exception of LTCM, a monster born as a prop desk and funded enthusiastically by banks, it is far from clear that any hedge fund has ever posed a systemic risk. As we all know to our cost, the same is not true of Goldman Sachs, big banks and the too-big-to-fail mob.
Andrew Capon has worked as an analyst, strategist and financial journalist for more than twenty years, winning multiple awards for commentary on markets, investment and asset management. He welcomes comments from readers, including literate cephalopods and can be reached at email@example.com