18 April 2008

Why Did My High-School Guidance Counselor Never Suggest Hedge Fund Manager?

Here is a story about current financial markets. It starts with the income of one man. It could end in massive write offs – trillions of dollars.

Last year, Hedge Fund Manager John Paulson made $3,700,000,000.00 ($3.7 billion for those of you who, like me, lose track of so many zeros.) This is remarkable for at least two reasons.

It is remarkable because of the sheer magnitude of this income. Across the entire world, only 284 people have net worth greater than Paulson’s income in 2007. (And I wonder, do 1040 forms come in Large, X-Large, and Super Size to accommodate so many places?) Assuming a typical work schedule, Paulson made slightly more than the median personal income every minute. The man made about $2 million an hour.

It is also remarkable because it represents only a fraction of the hedge fund market, hinting at the magnitude of high-risk, high-return investing. 5 hedge fund managers made more than a billion last year. George Soros (the liberal conservatives love to hate) was second highest paid at $2.9 billion. Although Paulson and Soros’s incomes are obviously off the charts, there are about 10,000 hedge funds. And given that these managers make their money on a percentage of the principal they invest, the sums now in hedge funds are staggering. To compound matters, hedge fund managers tend to generate superior returns through the simple act of leverage: like a home owner who turns a 10% return on a $100,000 house into a 100% return on his $10,000 down payment by borrowing $90,000, these hedge fund managers leverage their investments.

In mid-2007, hedge funds deployed about $2 to $2.5 trillion of equity capital. But given that they leverage, the amount they were actually investing was probably a multiple of that – something more like $20 or even $100 trillion.*

I say about because no one really knows the size of this. A huge chunk of investment activity has gravitated towards unregulated sectors of the financial market. Not only are they unregulated, no one even knows for sure just how big these markets are. We do have some estimates, though. Financial derivatives (creations that include puts and calls and inventions that only your computer could understand) are one measure of how much has been "leveraged" off of more traditional values. (I know, I know - derivatives aren't necessarily leveraged and financial leverage includes more than just derivatives.)

The value of financial derivatives is about $500 trillion.* To put this in perspective, the total, global GDP is about $70 trillion. So, a swing in derivatives of just 15% will equal GDP for the entire planet.

Hedge fund managers can make so much because they know how to manage risk to maximize returns. The problem is, their risk is our risk. We simply can't let markets fall by so much, so taxpayers assume the risk while investors get the returns.

We've been here before. After the Great Depression, communities decided that regulation and transparency could provide, if you will, a good hedge against financial catastrophe. It just might be time for a little oversight. Not to keep people like Paulson and Soros from making money - just to keep them from making money on bets we have to cover.

* Numbers from The Trillion Dollar Meltdown: Easy Money, High Rollers, and the Great Credit Crash by Charles Morris


Gypsy at Heart said...

I've been told my grandfather used to hide the money he earned by driving a bus all day long, seven days a week, inside a can he buried under a rock in his yard. He paid our government no taxes and our government had no way of tallying what, if anything, it was owed by him. The astounding numbers you cite make me wish the world were as simple now as it was for my grandfather then. No risk in losing his money but that which came from someone figuring out which rock marked the place where he had hidden his dough.

Ron Davison said...

I am so glad that you commented on this. I actually thought that all these numbers were kind of interesting, but apparently finding this fascinating put us in a distinct minority. If you tried to tell your grandfather these numbers, he probably would have thought you were smoking something. Thanks.