A Hedge Fund Like No Other
by Simon Johnson, Peterson Institute for International Economics
and James Kwak, Yale Law School
Op-ed in the Washington Post
September 23, 2008
© Washington Post
Given the panic in Washington over the financial markets, it is virtually certain that Congress will soon pass some form of the bailout plan the Treasury put forward last week. This is not an ideal proposal, particularly since it does not address the underlying problem with mortgages and negative housing equity. No troubled mortgage holders would benefit directly, and key commercial banks might still end up undercapitalized.
However, no legislator wants to risk allowing the economy to collapse on his or her watch, and, according to Treasury Secretary Henry Paulson and Fed Chairman Ben Bernanke, that is what's at stake.
Within these political realities, there is a key issue on which lawmakers should focus, quickly, in designing this legislation: governance.
The draft proposal authorizes the Treasury to "purchase . . . on such terms and conditions as determined by the secretary, mortgage-related assets from any financial institution having its headquarters in the United States." In effect, this would invest $700 billion (for starters) of taxpayer money in a hedge fund controlled by a single person, the Treasury secretary. Given the urgency of the effort and the complex nature of the securities involved, this de facto fund would be government-run but overseen largely by Wall Street veterans; any actual management would probably be outsourced to existing fund management companies.
Ordinarily, the interests of hedge fund managers and investors are at least somewhat aligned by the fee structure of hedge funds, in which managers are paid 2 percent of assets under management plus a share of the returns over a certain threshold (commonly 20 percent). In addition, competition in the industry dictates that fund managers with below-market returns are less likely to be able to raise new funds. But neither of these incentives exists in this case.
Management fees cannot be tied to fund returns in the usual manner because the fund is highly likely—some would say designed—to lose money. To restore our nation's banks to health, the fund must pay above-market prices for mortgage-backed securities; if it paid market prices (about 22 cents on the dollar, based on the largest known recent transaction), that would simply trigger the massive write-downs that everyone fears. Because there is no competition for this fund, and no one involved is planning to raise another, the second incentive doesn't apply. Worse, the Treasury-appointed fund managers negotiating with banks to buy their mortgage-backed securities not only come from those banks but will almost certainly be looking for jobs at those banks once the need for the fund has passed, creating enormous potential conflicts of interest.
While the usual mechanisms for aligning incentives are unavailable, the stakes are unprecedented. Every dollar that the fund loses is a dollar handed from taxpayers to the banks and their shareholders. While previous bailouts, including that of AIG, have been designed to give the government at least some of the potential upside, the only upside here is that these securities may turn out to be worth more in the long term than the market thinks they are worth today. Despite this possibility, paying more for something than anyone else is willing to pay is, simply put, a sucker's bet. It is most likely that "governance" over the fund will be provided by periodic hearings of the relevant Senate and House committees during which the Treasury secretary and the fund managers will be asked why they overpaid for banks' securities and will answer that there was no choice if the financial system was to be saved.
While there is still time, Congress should consider alternative means of aligning incentives. For example, lawmakers could set a target for what return the fund is expected to get, and managers' compensation could be tied to their actual return relative to that target. Would-be fund managers should bid in an open process what target return they are willing to base their compensation on—the management company that is willing to accept the highest (or least negative) target for a set of assets would get the contract for those assets.
In any case, the fund should provide full disclosure of the securities it buys, its valuation of them and the price paid, which would help ensure that the fund is managed in the country's best interests. Its leaders should be open about overpaying relative to market price, and on that basis, the fund should receive preferred stock in any participating bank. This would, among other things, give taxpayers some much deserved and long overdue potential upside.
Simon Johnson is a senior fellow at the Peterson Institute for International Economics and a professor at MIT.