Hedge Fund Managers Are the Heroes of this Crisis

Why the Fawning

But leading members of Congress didn’t fawn over these men merely because they are rich or, as some cynics might suggest, because of political contributions. Yes, hedge fund managers gave $14 million during the latest election cycle, two-thirds to Democrats. But those numbers are peanuts compared to donations from banks and insurance companies, and legislators have been skewering executives of those companies.

Instead, the hearings sought to praise these men, not to bury them, for the valuable role their funds have played in the markets. They have reduced risks and stabilized prices by buying low and selling high. They have been an early warning signal by uncovering bad news. They have generated value for investors by pressuring entrenched managers to focus more on shareholders. In a recent Journal of Finance study I co-authored with professors from Columbia and Duke business schools and Vanderbilt law school, we found that hedge fund activists generated large positive returns to investors for precisely these reasons.

Legislators might envy a billion-dollar payday, but they see that these men make money from incentive fees only if their clients make money. Moreover, unlike the Wall Street banks that collapsed this year, these hedge fund managers didn’t try to make money through massively leveraged bets.

Paulson is a typical example. His central investing insight is simple: “Watch the downside, the upside will take care of itself.” He made his fortune by buying insurance against a decline in the prices of securities tied to subprime mortgages. In early 2005, he saw that “exuberance in the credit markets and the massive liquidity was severely mispricing these securities.” As he told Pensions and Investments, “We thought it was a terrific risk-return tradeoff where you can risk 1% and make 100%.” He spotted early problems in the mortgage markets, and questioned the risks held by major banks and insurers. He put his money where his mouth was. Congress should have listened to him a long time ago.

Too Much

At certain points, the legislative kowtow went over the top. It was fine for John Yarmuth of Kentucky to call everyone’s testimony “candid and thoughtful.” Or for Elijah Cummings of Maryland to thank George Soros for his philanthropy. But then New York Democrat Carolyn Maloney held up her copy of Soros’s book, thanked the men for “insightful and important testimony,” and even asked Soros for an autograph.

It was too much when even Republicans nearly wept as Philip Falcone described “a father who was a utility superintendent and never made more than $15,000 per year, while my mother worked in the local shirt factory.” Congress can subpoena testimony from nearly anyone, yet Representative Waxman nevertheless praised Falcone just for showing up, and noted that he “had to reschedule an overseas business trip to join us today, and I particularly appreciate the fact that he is here.” No one had asked about Richard Fuld’s travel schedule when they hauled him in to discuss Lehman Brothers.

Still, we can excuse a few toady moments in exchange for some confidence that during its financial manhunt Congress can tell friends from enemies. Not all hedge funds are equal, and some are as much to blame as the bankers, traders, and credit rating agency executives who mislabeled complex investments, hid risks, and nearly destroyed our financial system.

But the five billionaires who testified on Thursday are the good guys. Four of them even agreed to new regulations requiring increased disclosure, especially of derivatives. During these times of crisis, it is heartening that our legislators seem to know where to paint the bulls-eyes. Or at least where not to.

Frank Partnoy is a law professor at the University of San Diego and has written several books about financial markets, including The Match King (forthcoming 2009 from PublicAffairs), about Ivar Kreuger, the wayward financial genius of the 1920s, and the greatest financial scandal in American history, at least until today.