Last month I blogged about DealProf Steven Davidoff's piece on a few cases of hedge funds paying bonuses to their successful board candidates. Controversy has since swirled in the law prof blogosphere. Lawrence Cunningham of ConOp summarizes the action thusly:
A hot debate rages among corporate law professors amid one of the largest proxy battles in a decade: Hess Corp., the $20 billion oil giant, is the focus of a contest between its longstanding incumbent management and the activist shareholder Elliott Associates. Ahead of Hess’s annual meeting on May 16, where 1/3 of the seats on Hess’s staggered board are up, antagonists offer dueling business visions. They battle bitterly over such fundamentals as sectors to pursue, degrees of integration to have and cash dividend policy.
The professorial debate, more civil, is about a novel pay plan Elliott proposes for its director nominees, which Hess’s incumbents condemn and Elliott defends as suited to shareholders. On one side, all quoted inElliott’s investor materials circulated April 16, are me, Larry Hammermesh (Widener), Todd Henderson (Chicago), Yair Listoken (Yale) and Randall Thomas (Vanderbilt); on the other Steve Bainbridge (UCLA), Jack Coffee (Columbia) and Usha Rodriques (Georgia), all of whom have blogged since the matter was first reported by Steven Davidoff (Ohio State) in the New York Times April 2 (for which he connected with me for comment).
As in all such cases, Elliott proposes to pay nominees a flat fee of $50,000 each for their troubles and to indemnify them for legal liability. The novelty is that Elliott will provide incentive compensation to the group: if any Elliott nominee is elected as a result of this year’s contest, all nominees receive a bonus at the end of three years if Hess’s stock performs better than a group of industry peers. Elliott, not Hess, pays all bonuses.
Steve has since offered a response to Lawrence. My original post was pretty cursory, and given the subsequent debate, I've been thinking more about the issues. I have two points that are really more questions than answers:
First, Lawrence argues that the bonuses are "surgically tailored to tie the payoff to Hess’s stock price performance compared to competitors." But directors are supposed to act "in the best interests of the firm." Doesn't Elliott's scheme predispose the directors in question to a certain version of "the best interests of the firm" in an impermissible way? I.e., even if (and it is an "if" in some circles, at least) we're all agreed shareholder wealth maximization is the goal, these schemes enshrine one particular version for these directors. That may not be kosher.
Second, Jack Coffee suggested that, if successful, these directors should not be considered independent:
In the new world of hedge fund activism, we need to look to whether individual directors are tied too closely by special compensation to those sponsoring and nominating them. Once we recognize that compensation can give rise to a conflict of interest that induces a director to subordinate his or her own judgment to that of the institution paying the director, our definition of independence needs to be updated. Although not all directors must be independent, only independent directors may today serve on the audit, nominating, or compensation committees.
Director independence has interested me for a long time. In the Fetishization of Independence I distinguished between Delaware's situational notion of independence and securities law's static conception of independence meaning independence from management. SOX 301, unlike the exchanges, takes into account bare share ownership when assessing independence, since affiliates of the issuer are not independent. The question whether successful Elliott directors would be deemed affiliates would turn on the extent of Elliott's control of Hess. Coffee suggests that, even if Elliott is not an affiliate, its bonus program should be enough to render its nominees nonindependent.
This notion has intuitive appeal for me, but I'm having some trouble squaring it with how the logic of independent committees. Take compensation. It's clear why we want compensation committee members to be independent of management--managers have a conflict of interest when setting their own pay. But it's not clear that the Elliott nominated directors, even with their juiced incentives, have any particular disqualifying bias when it comes to setting executive compensation. Or maybe the concern is that they could wield their comp-setting powers in order to extort private benefits from management?
Currently under Dodd-Frank factors to consider in evaluating independence of comp committee members include the sources of the director's compensation and whether the director is affiliated with the issuer. So I have a hunch we're at the start of a long conversation about director compensation and independence.
Update: for even more from Steve and Lawrence, see here (including the comments).
From yesterday's Deal Professor comes Steven Davidoff on the "newest trend in activist investing": hedge funds incentivizing their directors by paying them extra if they win a seat and the company takes off. For example, Elliott Management has nominated 5 directors for the Hess Corporation. If any win a seat and Hess stock outperforms a peer group, the directors could make $9 million over 3 years. Jana Partners is offering its nominees a similar deal for serving on Agrium's board, again for a potential of millions if it profits. Plus both funds offer a $50,000 retainer, over and above whatever the directors collect from the companies themselves, likely a six-figure director fee.
In John Steinbeck's East of Eden (Go out and read it if you haven't already. Now. Go), one character says "You can't make a race horse of a pig." "No," replies another, "but you can make a very fast pig." For my money, these hedge funds are trying to make a faster pig. I know this is activist hedge fund's m.o.: get seats on the board, make quick changes, see stock rise, sell. But today's public company board, composed of independents who are by definition part-timers, shouldn't be making managerial calls at all. They should only take action when there's a conflict with management. Or so I argue in A Conflict Primacy Model of the Public Board.
Allowing boards to manage gives hedge funds an in, and creates problems like, in Davidoff's words:
this kind of pay arrangement sets up two classes of directors doing the same job but being paid very different amounts. It could not only create resentment, but disagreement over the path of the company.
Creating a subclass of directors focused on the short term doesn't sound like a particularly good way to run a company, at least to me.
Today's WSJ brings news that private equity giant Carlyle Group is "lowering the velvet rope" : letting some people buy into their funds "with as little as $50,000." While this doesn't exactly open up private equity for your average Joe, it lowers the traditional private equity buy-in bar, which was $5 -20 million at Carlyle, at least. The article characterized Carlyle's move as part of a trend among private equity to broaden their investment offerings. KKR now offers mutual funds investing with a minimum of $2,500 ad Blackstone launched a fund "that for the first time lets affluent individuals invest in hedge funds."
Do you have $50,000 lying around? Think the acquisition market will be heating up and want to catch the next buy-out wave? Not so fast, buddy. To qualify for Carlyle's new fund you also have to be an accredited investor, with $1 million in net worth or $200,000 in income ($300,000 if filing jointly).
I've written recently about the fact that the rich get access to more investing opportunities than everyone else. In Securities Law's Dirty Little Secret I speculate that this differential treatment might be getting harder to maintain. I speculate that investors may not be content for much longer with being shut out of buyout funds and the like. Indeed, I'm working on a short piece now that will argue that JOBS Act Section 201's elimination of the prohibition on general advertising will make the contrast between the investing opportunities available to haves and have-nots all the more stark. It used to be that we couldn't hear advertisements from hedge funds and other private investment opportunities. No more. In the post-JOBS world the airwaves and Internet may tout investment after investment that only the wealthy can actually take advantage of.
Today's WSJ article suggests that there's pressure on the sell side as well as the buy side. It observes that as pension funds-- "the cash cow that for decades has filled [private-equity firms'] coffers" --dry up, buyout shops need new sources of investing dollars. One logical choice is the wealth of accredited individual investors. But the WSJ suggests private equity hunger for still more riches: "Some private-equity executives long to offer their funds to typical workers through 401(k) savings plans, calling access to that pool of money their 'holy grail.'"
Yet more evidence that the old lines between accredited and nonaccredited investors may not hold.
This is the third installment of a series of previews of the papers being presented at the AALS Financial Institutions & Consumer Financial Services Section meeting this Sunday from 9 am to 10:45 am at the Marriott Wardman Park.
Anita Krug (Univ. of Washington) authored the third paper in our Sunday Panel, Institutionalization, Investment Adviser Regulation, and the Hedge Fund Problem (forthcoming in the Hastings Law Journal). Professor Krug looks at the regulation of investment advisers, a corner of financial regulation that has mushroomed in importance in practice, but has not enjoyed enough focus in legal scholarship (for one exception, see Laby).
Her paper remedies that and points scholars to securities law beyond the ’33 and ’34 Act. As scholars focus on longstanding debates, high stakes turf wars have erupted in the world of regulatory practice over the boundaries of investment adviser regulation, the regulation of broker-dealers, and hedge fund regulation generally. At the same time Krug’s work fits into a body of work (e.g., Langevoort) that focus on another seismic shift by examining the regulatory consequences of the fact that capital markets investing is now dominated by institutions not retail investors.
Moreover, Krug’s paper fills a scholarly void at the nexus of securities regulation and financial institution regulation and shows the wide scope of the latter. Here is her abstract:
This Article contends that more effective regulation of investment advisers could be achieved by recognizing that the growth of hedge funds, private equity funds, and other private funds in recent decades is a manifestation of institutionalization in the investment advisory context. That is, investment advisers today commonly advise these “institutions,” which have supplanted other, smaller investors as advisory clients. However, the federal securities statute governing investment advisers, the Investment Advisers Act of 1940, does not address the role of private funds as institutions that now intermediate those smaller investors’ relationships to investment advisers. Consistent with that failure, investment adviser regulation regards a private fund, rather than the fund’s investors, as both the “client” of the fund’s adviser and the “thing” to which the adviser owes its obligations. The regulatory stance that the fund is the client, which recent financial regulatory reform did not change, renders the Advisers Act incoherent in its application to investment advisers managing private funds and, more importantly, thwarts the objective behind the Advisers Act: investor protection. This Article shows that policymakers’ focus should be trained primarily on the intermediated investors – those who place their capital in private funds – rather than on the funds themselves and proposes a new approach to investment adviser regulation. In particular, investment advisers to private funds should owe their regulatory obligations not only to the funds they manage but also to the investors in those funds.
We are fortunate to have Kristin Johnson (Seton Hall) act as discussant for this paper.
I’ve never been fully on board with the idea that hedge funds should be required to register with the SEC. It finally became law, however, as part of the Dodd-Frank Act, which imposes the requirement on hedge-fund advisers with more than $150 million in assets. Looking at the new legislation, I think you can make plausible arguments in favor of the rule, though my feeling is that the new requirement may be more symbolic than substantive.
The increased transparency and oversight could be justified as mechanisms to address the risk of hedge-fund fraud, as well as the systemic risk that some of these funds pose. But the registration requirement does not seem to map all that well onto either goal.
The idea that registration could help protect investors from fraud is reasonable. It might deter fraud or make it easier to detect. But the Madoff scandal gives reason for pause. Madoff was registered as an investment adviser and his operations had raised red flags with the SEC. Yet the agency failed to uncover the far-reaching misconduct. What this shows is that registration alone is insufficient, and perhaps secondary. More importantly, the SEC needs to right the ship in terms of enforcement. If this happens, then perhaps the rule will prove to be a useful investor-protection tool. While the Act does beef up the SEC’s powers in this regard, my intuition is that the problem is cultural rather than regulatory.
Registration as a response to systemic risk is also questionable. As the LTCM collapse illustrates, hedge funds can give rise to this concern. But the Act’s systemic-risk provisions address this. The Act holds “nonbank financial compan[ies]” that pose a risk to the financial system to certain prudential standards. In addition, hedge funds will be required to open their books to regulators, so that they can determine which funds to subject to this scrutiny. While it’s arguable that the SEC could see something in registration-related reports that would otherwise be missed, this seems like a rather thin justification given the SEC’s traditional area of expertise.
Considering this provision reminds me of a line from one of Donald Langevoort’s recent articles wherein he shares his view that
“part of the motivation for the substantive and procedural disclosure requirements of U.S. securities regulation increasingly is disconnected from shareholder or investor welfare per se, and instead relates to the desire to impose norms that we associate with public governmental responsibility—accountability, transparency, openness and deliberation—on nongovernmental institutions that have comparable power and impact on society.”
Perhaps similar logic is at work here. Rather than clearly reflecting any specific normative goal, perhaps hedge-fund registration is a populist response to the unease caused by the vast accumulation of capital in secretive, profitable, and risky endeavors.
At least, that's how it seemed this morn in the WSJ. Top headline: Showdown on Fund Taxes, about a proposal to tax carried interest as ordinary income rather than capital gains. Glom faithful, hearing this issue, will fondly remember our esteemed emeritus Vic Fleischer, recently quoted in the Economist, who wrote about this 3 years ago and counting.
Inside the WSJ, word of banks "unleash[ing] a last-ditch effort to strip new debit-card restrictions from the proposed financial-overhaul legislation," including debit-card interchange fees. You may recall that Truth on the Market hosted a credit card symposium this past February. If you missed that great event, interchange fees are the fees banks charge merchants to process credit or debit cards used by customers. Today George Mason's Mercatus Center hosted a conference titled The Economics and Regulation of Payment Card Interchange Fees.
The Senate, but not the House, version of the financial overhaul bill addresses debit card interchange fees. Boiled down, it 1) limits how much banks can charge merchants, and 2) also allows merchants to prefer some kinds of cards (or cash) to others. On the first issue, I'm uncomfortable with the government getting into limiting fees. The Journal article has a fascinating few paragraphs about one word in the bill.
The legislation calls for the Fed to determine that the rates are "reasonable and proportional" and that they would cover the "actual incremental cost" of the transaction.
The banks are concerned that the word "incremental" would reflect only the transaction itself, and wouldn't include other costs associated with maintaining a debit-card business, such as fraud prevention and technology expenses.
"The word 'incremental' is an important word that you wouldn't want to see in there. It is certainly troublesome," said a senior executive at a large bank.
Seemingly unaffected institutions are lining up against the rule. Small banks with less than 10 billion in assets (who are exempt from the legislation) say that government-mandated lower fees for big banks would force them to lower fees, too, in order to stay competitive with merchants. And state treasurers, who depend on debit cards instead of checks for services like unemployment benefits, worry that banks will charge the state more to offset reduced interchange fees.
On issue #2, however, the legislation strikes me at first blush as right. Debit card network rules that prevent merchants from offering discounts for using cash, for example, instead of a debit card, seem unfair to me. Here's how Athens wine merchants work: you get 10% off a case of wine if you pay with cash or a check, 8% if you pay by card. Because, as they say, the banks charge them 2%. Tying merchants' hands to prevent them from steering customers to cheaper payment methods or not allowing them to set minimum transaction limits for debit cards just doesn't seem fair--incrementally or otherwise.
Earlier today, the SEC brought a 10b-5 and Section 17(a) claim against Goldman Sachs (and a GS employee) for its role in structuring and selling to investors a "synthetic" collateralized debt obligation (“CDO”). At first blush, this case looks to take on a practice of Goldman and other banks that has been widely criticized in the media – selling asset-backed securities (ABSs) to investors then using credit default swaps to profit should those securities default. Which has been likened to a doctor taking out a life insurance policy on a patient.
A closer examination of the facts asserted in the press release suggests that the SEC carefully chose a test case. An underwriter that sells ABSs has a stronger argument that buying credit default swaps (which would pay out should the ABSs default) is legitimate when the underwriter is holding on to some of those ABSs. The credit default swap then looks like a legitimate hedging of risk (and some believe that we want to encourage underwriters to hold part of an offering to retain some “skin in the game.”) In other words, the doctor is taking her own medicine, and the life insurance policy covers her own life.
But, based solely on the SEC’s allegations, that is not what happened here. The allegations are that a large hedge fund, Paulson & Co., pushed Goldman to sell a CDO to investors. The hedge fund allegedly (a) played a large behind-the-scenes role in helping Goldman structure and select the assets (collateral) that backed the CDO, and then (b) bought a number of credit default swaps that “shorted” the CDO. The SEC alleges that Goldman told neither investors nor the CDO’s collateral manager (akin to the investment manager for the CDO) of Paulson’s role in selecting assets or its short position – which would suggest a conflict of interest. It is hardly shocking that a securities law case boils down to disclosure.
A few other interesting tidbits from the SEC. The CDO involved is a “synthetic” one. Unlike many asset-backed securities transactions, in which the investment vehicle actually purchases cash producing assets (like mortgages, bonds or other ABSs), in a synthetic transaction, the investment vehicle enters into credit default swaps and other derivatives to mimic what it would be like actually to hold a real portfolio of cash-producing assets. (Partnoy & Skeel have a good discussion of synthetic CDOs).
Would this make a difference in litigation? Arguably no; it shouldn’t matter what the CDO actually invested in as long as “it” was accurately described. But a court may struggle with the synthetic nature of a CDO – either because of a suspicion that there is more room for abuse when there are derivatives coming in and derivatives coming out or because of a gut reaction that there is not a socially productive investment at stake. Non-synthetic ABSs theoretically perform the functions of spreading credit risk from borrowers (like homeowners taking out a mortgage), while funneling credit back to those borrowers. Synthetic ABSs look more like pure gambles.
It is important to note that all of the foregoing are from the SEC’s statements. Let’s see if the SEC’s version of the facts holds up. Everybody should get their day in court, even institutions Rolling Stone writers hate.
Correction and clarification: According to the SEC Complaint, the collateral manager, ACA, knew of Paulson's role in selecting assets for the CDO, but did not know Paulson & Co was betting against the CDO. Rather, ACA was led to believe the hedge fund was investing in the CDO.
The recently passed "rescue" legislation contains a new Section 457A to the Internal Revenue Code. The effect of this new section appears to be to eliminate the ability for hedge fund managers to defer income tax on their performance and management fees. This ability to defer taxes is part of what Tom Brennan and I called a "tax subsidy" for private fund managers. Looks like the new law will apply only prospectively. So given the recent performance of most hedge funds, it isn't such a big deal that they now have to pay taxes on their earnings. That's a "rich man's problem," as they say. Nor is the tax change likely to be the reason we see large liquidations of hedge fund portfolios. That will be driven by redemptions by disappointed investors and margin calls in a declining market.
It will be interesting to see how this change affects the market for human capital. Assuming we have any chance of separating all the potential causes, this may be one more reason the best and the brightest explore callings other than that of adding liquidity and price discovery to support an efficient asset market. Sexy as that sounds.
But before they all start thinking about law school, I urge them to ponder the NPV of a JD.
Thanks GLOM for letting me spout off. It was fun.
Day 3 as a guest blogger - I promised on Monday to comment on why I am so enthused about hedge funds. In fact, my interest is in a broader category of business structures that includes all private investment funds, including venture capital and LBO funds, among others. My real interest lies in the way that these entities have managed to address internal agency costs by aligning the interests of fund managers and investors. I've written two articles on the subject, the first was published in the American University Law Review last December and can be downloaded here. The second is still in draft form but will be published in volume 60 of the Alabama Law Review this coming fall. Here is a link to my most recent draft. In addition, below is the abstract for the second article:
Progressive legal scholars argue that institutional investors should play a greater role in disciplining corporate managers. These reformers seek to harness the talent and resources of mutual funds and public pension funds to increase managerial accountability to shareholder interests. Conservative scholars respond that empowering institutional investors would do little more than relocate the underlying agency costs. Although shirking by corporate managers might indeed by reduced, institutional investors suffer from their own set of agency problems and so would need their own monitor. Ultimately, someone must watch the watchers.
In this Article, Professor Illig argues that neither corporate managers nor institutional investors are properly incentivized to serve shareholder interests. Therefore, neither is appropriately positioned to serve as the ultimate decision-maker. A better model of governance is the incentive fee structure employed by hedge funds and other private equity funds. If institutional fund managers were permitted to adopt a similar compensation scheme, their interests and the interests of their investors would merge. As a result, they would be transformed into ideal servants of shareholder interests, capable of bringing much-needed discipline to corporate America.
For the uninitiated, what makes private investment funds so unique is the manner in which they compensate their managers. This scheme has three parts and has developed in a regulatory vaccuum making it purely the result of market forces:
- First, profits are split 80% for the investors, 20% for the fund managers, such that the managers are only paid if they produce actual (and recurring) gains. Moreover, the incentive to pursue shareholder interests never dissipates, as each extra dollar of profit always means another 20 cents for the managers.
- Second, managers must invest a significant portion of their personal wealth in the fund. As a result, they feel the pain of any losses in equal proportion to the investors.
- Third, many of the best-run funds also include a hurdle rate. This means that the managers are not entitled to their 20% fee unless and until profits exceed some negotiated hurdle. As a result, these managers must produce above-market returns or receive nothing.
From a shareholder value standpoint, I believe this scheme creates an alignment of interests that far surpasses both the easily manipulated incentive compensation programs that are common among public corporations and the flat-fee non-incentive compensation earned by mutual fund and other public fund managers.
Thus, when I read in the April 2008 issue of Alpha that five fund managers each earned more that $1 billion in fees last year (yes that was a "b"), it doesn't give me the kind of heartburn that you might imagine. Certainly, these numbers are ridiculously high and the US suffers from significant disparity-of-wealth problems. However, at least these managers earned their fees by producing profits. For a manager earning a 20% carried interest to receive $1 billion in compensation, he (yes they are all men) must have produced much more in profits for his investors. Not bad for a day's (or year's) work. And remember that the investors who pay the fees - and who keep coming back - are extremely knowledgeable and sophisticated and believe they are getting a good deal. Most importantly of all, however, these billion-dollar payouts are actually far more equitable than the comparatively messily sum of $210 million that Robert Nardelli received when he left Home Depot after producing a cumulative 8% loss. Certainly, we need to reign in the raw size of executive compensation awards, but on a relative basis, compared to what many underperforming corporate managers earn, hedge fund compensation seems like a real bargain.
I should acknowledge, however, that there is a significant (but I believe temporary or at least not inherent) flaw in the system: currently, most funds charge a flat management fee in the range of around 2% of net assets. These fees were originally intended to cover expenses and thus to have a neutral effect on managerial incentives. However, as funds have grown in size (due to high investor demand for this low-agency cost model), management fees have remained steady at around 2%. Because a fund with twice as many dollars under management probably doesn't have twice the expenses, this doubling of the management fee means that a significant portion of the fee constitutes pure profit and a real drag on the incentive for managers to perform. Still, the answer to this demand-driven problem (funds can only continue to charge 2% because of increased bargaining power vis-a-vis investors) may be to increase supply...
Finally, I should note why I referred to private investment funds in my Monday post as "progressivism in conservative sheep's clothes." As I hope my comments make clear, hedge funds and other private investment funds have done a superb job at reigning in managerial discretion and creating real accountability to investor interests - goals that, while probably shared by all, tend to be favored by those on the left. Meanwhile, the primary vehicle for this increased accountability - hedge funds - is something that only those on the right (as well as their mothers, of course), could really love. To read more, check out my two articles.
Last week, we took a look at the Hedge Fund Working Group's proposed self-regulatory best practices. JW Verret has his own proposal, out in both the Delaware Journal of Corporate Law and the Administrative and Regulatory Law News. Here's the takeaway:
A self-regulatory model that utilizes the inherent advantage of firms regulating each other is a major theme of the policy recommendations presented. Crafting regulatory safe harbors, permissive information access, and designing legal defenses that encourage the operation of a self-regulatory entity to monitor this industry can help to overcome the severe disadvantage that bureaucratic regulators face in this field.
The SEC should take steps to encourage creation of a private market intermediary. One step might be to make information gathered through a compliance process available to a select few officially chartered private rating agencies.
The SEC should request the [industry association] to put together a proposal for a disclosure statement requirement in accordance with an original suggestion of the SEC staff SEC Report.
The SEC should enhance coordination with other regulators. It should also exempt CFTC registrants from any future registration requirement. This would continue to encourage funds to register with the [industry group], thus continuing the benefits of self-regulation in this exceptionally complex and rapidly changing environment.
The SEC should establish some statutory recognition to hedge fund best practices through safe harbor rulemaking to encourage registration with a self-regulatory body. It could provide a defense to regulatory enforcement action to any hedge fund that follows guidelines promulgated by such a body, in much the same way it recognizes such for firms that follow Generally Accepted Accounting Principles (GAAP), accounting rules promulgated by the FASB or broker-dealer best practices promulgated by the NASD.
The Martin Act should be amended by the New York legislature to limit the powers of the New York Attorney General, so that activities in compliance with SEC regulations are statutorily exempt from the definition of fraud.
But there's more in the article, including some modeling, some more recommendations, and a bit of a history of hedge funds. Worth reading.
The Hedge Funds Working Group, a British-led endeavor, has come out with both a defense of hedge funds (we hedge! plus we invest in all sorts of asset classes! and so we're safe!) and a list of best practices, to which the funds are invited to sign on. I say it's an effort to forestall regulation and a disclosure-to-client-oriented approach. But have a look yourself.
With the markets all ashudder, what do the hedge funds think about their risk obligations? Here's the HFWG best practice:
A hedge fund manager should put in place a risk framework which sets out the governance structure for its risk management activities and specifies the respective reporting lines, responsibilities and control mechanisms intended to ensure that risks remain within the the manager’s risk tolerance as conveyed to and discussed with the fund governing body.
And it should tell this risk policy to investors. Hmmm. It's not exactly Basle Accord style capital adequacy. But maybe it'll keep the regulators focused on other financial institutions, like French banks with easily circumvented risk analysis software.
Abnormal Returns has a great roundup of posts on the "quant bloodbath." Quantitative models aren't much better at accounting for unusual market moves than they were in the pre-LTCM days. The killer quote from Lehman's Matthew Rothman in a WSJ article:
"Wednesday is the type of day people will remember in quant-land for a very long time," said Mr. Rothman, a University of Chicago Ph.D. who ran a quantitative fund before joining Lehman Brothers. "Events that models only predicted would happen once in 10,000 years happened every day for three days."
Of course, like it or not, quants are here to stay. More quants will try to come up with models to deal with (and capitalize on) unusual market moves, and perhaps the next quant bloodbath won't be as severe.
I wonder if the quants are hindered by the human element that goes into predicting risk? It's only a small part of the credit market shakeout, but I suspect some blame will fall on the rating agencies, which once again have proved to be not very good at predicting default risk. One of the reasons credit spreads were so artificially small before the shakeout was that many still-quite-risky pools of securities were rated as investment grade. USC's Jonathan Barnett has a great paper coming out this fall that helps explain why so many certification intermediaries fail to do their jobs in the way we would expect them to.
The most recent issue of the New Yorker has an interesting story about an economist/ statistician who has written a computer program to mimic the medium-term returns of specific hedge funds using a relatively mechanical futures-trading strategy. Harry Kat, now a professor of risk management at Cass Business School (City University, London), worked trading derivatives before moving into the academy. To design his software, he relied on databases of historical hedge fund performance to figure out how to mimic the most important statistical properties of each fund's results--returns, volatility, correlation with the stock market, the likelihood of large losses. The program is called FundCreator, and it has developed some following among institutional investors. Kat undercuts the hedge funds' two-and-twenty (see Vic--the go-to guy on the tax issues--here and here and here) by a wide margin, charging only about one-third of one percent of money invested.
It may be too early to tell if the program "works," but it's certainly cheaper than hedge funds' two-and-twenty charges (or the effective three-and-thirty charges for funds of funds).
Earlier this week, this video of Jim Cramer started making the rounds on YouTube. (The video has been removed from YouTube, but it is still available at TheStreet.com.) The New York Post got to the story on Tuesday, with followups here and here. In the video, Cramer candidly describes various means of illegal manipulation of stock prices, noting "the Securities and Exchange Commission doesn't get it" and asking "Who cares about the fundamentals?"
In an attempt to mitigate the damage, Cramer called Don Imus and said, "I learned a big lesson here: you got to be a little more clear . . . you can't be as glib, because people will interpret this as being that you're a bad guy."
Henry Blodget (remember him?) speculates that Cramer may have committed "professional suicide." Hmm. I doubt it. The video was originally broadcast on TheStreet.com on Dec. 22, 2006. Cramer comes off looking like a self-important blowhard -- which is consistent with his public persona -- but it doesn't look like a confession of wrongdoing.
Thanks to Greg Call for the tip.
UPDATE: This just in from the lemonade-from-lemons department (aka, The Department of Fat Chances):
"I'm delighted if someone who understands how this works is truly on a reforming bent," says Michael Josephson, an ethics expert at the Josephson Institute of Ethics. He says Cramer should brief regulators on how to stop the practice. "It's not enough to rant on this."
UPDATE2: This story has not hit the big time. No mention in the W$J or NYT.
The SEC recently proposed a new hurdle to qualify individuals seeking to invest in hedge funds and other privately offered investment pools. Not only would these individuals have to be accredited investors (for which a million in net worth qualifies), but they’d also have to have $2.5 MM in investments, a figure that would be adjusted for inflation every 5 years.
The million-dollar net worth threshold for accredited investor status was set in 1982 and has not been adjusted since. It doesn’t seem so far fetched to think that a million bucks ain’t what it used to be, and if the idea is that being rich proxies for investor sophistication, a million in net worth doesn’t really mean you’re rich these days, especially if the lion’s share of that is in home equity. So why not include an adjusted, higher net worth threshold for investors in private investment pools? Admittedly, the new $2.5MM hurdle might be a little high. It would not include home equity, and it overadjusts for inflation if the target is $1MM in 1982 dollars. The comment period for this SEC rule change recently expired, and the comments appear to be overwhelmingly negative, to my initial surprise.
Raising the bar, of course, would reduce the pool of investors eligible for private offerings. So of course, one would expect hedge fund interests to object. What initially surprised me—and in retrospect, probably should not have—was the vehemence of the objections by individual investors who saw themselves being cut out of possibly lucrative hedge fund investments. Some saw the new hurdle as elitist:
I have no need to have the SEC save me from myself. This is elitist and completely unnecessary. Please reconsider.
Others questioned the use of net worth as a proxy for brains generally:
You have to be rich to be smart?
If I gave you $2.5 Million would it make you any smarter?
This latter criticism of course challenges the whole notion of individual accredited investor status built into Reg D. Very few comments favor the new rule.
In retrospect, I probably should not have been surprised. There is an enormous selection effect going on here. The millionaires who have no interest in investing in hedge funds are indifferent as to the new rule. It won’t affect them. So even if in the abstract they favor more investor protection, they’re not chomping at the bit to make a public comment. Only investors on the cusp—accredited investors who would not meet the additional $2.5MM hurdle—and who are interested in hedge fund investments care enough about the issue to comment. Mystery solved.
But it led me to wonder more generally just how valuable the public comment process is if there are not concentrated interests on both sides of any proposed rule change. Viewed through a conventional public choice lens, this sort of unbalanced issue must arise all the time.