Felix Salmon

How money flows to hedge funds

By Felix Salmon
September 28, 2010

Why do American hedge funds make so much money? Macroeconomic Resilience reckons that most of it comes, ultimately, from the government:

Just because hedge funds do not directly benefit from a state guarantee doesn’t mean that central bank policy towards the banking sector is irrelevant in determining their returns… the “alpha” that Magnetar generated would likely not have existed if it were not for the skewed incentives faced by bankers which in turn were driven by the rents they could extract from the state guarantees provided to them.

The example of Magnetar merely illustrates a more general principle that is often ignored: the ultimate beneficiary of any economic rent may be far removed from its initial beneficiary.

Essentially, when the government backstops its banking system, rents will end up flowing to some part of the economy, and not necessarily to banks. In the UK, banks are the primary beneficiaries. In Germany, it’s big companies. And in the US, it’s often hedge funds.

If the Magnetar trade is too recondite for you, then consider the case of David Tepper:

In February and March 2009, when consensus had coalesced among market watchers that certain financial institutions were insolvent and would have to be nationalized, triggering a massive sell-off that drove shares of companies like Citigroup and Bank of America into the single digits, Tepper decided to tune out the chatter. After all, the Treasury Department had said it would hold up the banks—why wouldn’t they keep their promise?

That trade made Tepper something over $7.5 billion. In Europe, he would be excoriated as a profiteer: a billionaire using public policy to ratchet up his net worth to ever-more-stratospheric levels. In America, by contrast, he’s a hero, the living embodiment of everything CNBC viewers admire. His big bets are always on the long side: he makes his billions by seeing opportunity and placing huge bets on things turning out well.

It’s un-American to begrudge Tepper his wealth, even if largely because he has a pair of cartoonishly huge and grotesquely veiny brass testicles attached to a plaque in his hedge fund’s offices. Which makes me wonder what the White House economic team thinks of people like Tepper. My guess is that the more politically-minded among them are deeply appalled, even as the Summers and Geithner types reflexively look past the personality and consider him a pure economic actor who at the margin will help to fuel any recovery.

And I wonder, too, what Tepper thinks of them. Does he thank them for his billions? Or are they just another actor in a game he plays better than anybody else? And if he’s the winner of the game, does that make them losers?

14 comments so far | RSS Comments RSS

i find it ironic that you somehow seem to demonize Tepper for “using public policy to ratchet up his net worth” when the point of public policy is to ratchet up The People’s net worth…

If America weren’t so dependent on our inflated paper assets, then the Fed wouldn’t have to work so hard to keep their prices inflated…

Posted by KidDynamite | Report as abusive


I’m not quite sure what to make of Felix’s disparaging of Tepper either. At least as Felix describes it, Tepper didn’t have insider knowledge, and wasn’t looting the public fisc, as Soros did when he broke the pound. He made a bet with people who didn’t trust the government guarantee and won.

That said, this transaction (as opposed to the guarantee generally) didn’t change “The People’s” net worth. Transaction costs aside, every dime that accrued to Tepper was one that would have accrued to the sellers. And I’d imagine generally, the point of public policy is not to transfer wealth to hedge funds from others.

Posted by AnonymousChef | Report as abusive

Sorry Chef, what I meant was that the Fed’s reflationary measures are designed to increase The People’s Net Worth. Tepper (like others before him – vocally, Bill Gross) merely figured that out and traded accordingly.

Posted by KidDynamite | Report as abusive

KD and Chef, how exactly did Felxi demonize or disparge Tepper? I’ve read his post a few times and don’t see any negative judgement from Felix.

I don’t take Felix’s comments as an attack on people like Tepper, but rather an indictment of the system that lets him make as much as he does. A relative handful of people have benefited, some tremendously, by the government guarantees of incompetently run banks.

Posted by OnTheTimes | Report as abusive


That I can agree with completely.

Posted by AnonymousChef | Report as abusive


It could be read somewhat neutrally, but that’s certainly not how it jumped off the page to me.

Imagine that I’m European, and I’m known to ravage CNBC (which it richly deserves).

I tell you that you’re engaging in rent-seeking behavior that would be considered profiteering in Europe, even though CNBC would consider you a hero. I then highlight a piece of your art in unflattering terms and imply that the people who pay attention to your personality are “appalled,” while people who can look past that see you as marginally useful.

Posted by AnonymousChef | Report as abusive

You guys – KD & Chef – have completely missed the point. There is no way to separate the Magnestar/Tepper trades from the banking activity that drove them; they are two aspects of the same thing. When the taxpayer pays banks to engage in negative-skewed trades, then it necessarily pays funds to take the positive-skewed other side. It is logically impossible to have one without the other. To say that you are against bank bailouts at the same time as you applaud the genius of bank counterparties is a contradiction, devoid of meaning. It’s like saying “your end of the boat is sinking.”

And what’s with the kooky stuff about the “Fed’s reflationary measures”? The issue is the implicit and unfunded guarantee to banks, not any specific means by which tax money is paid to them.

Posted by Greycap | Report as abusive

Greycap – I’m very much against bank bailouts, and I’m not smart enough to buy stock in these zombies myself with the anticipation that the gov’t will come to the rescue (in other words, I’m very bad at putting on the Greater Fool Trade myself). But I don’t begrudge those who did. Obviously, it’s not a contradiction.

Bill Gross told the world in early 2009 what his strategy was: shake hands with the government.

What’s the answer? blame the government (and work to get policy changed) if you don’t like it – in fact, that’s probably precisely the point – right back to the first line of Felix’s post.

Posted by KidDynamite | Report as abusive

also, Greycap,if you want to get philosophical, note that while there is no way to separate Magnetar from the banking activity that drove its trades, that doesn’t mean that the banking activity was sufficient to imply Magnetar’s profits – after all, there were very few people who saw the light. I absolutely applaud their genius and I think they should be given a medal: gold star trade of the year.

{said differently, Magnetar could not have profited if banks weren’t stupid, but stupid banks were not a sufficient condition for Magnetar to profit – Magnetar’s insight, understanding, and trade construction was essential}

Note, by the way, I think MacroResiliance’s article which felix references somehow implies that the banks were trading as if they were too big to fail in 2005 ( “driven by the state guarantees provided them”.) I don’t believe that’s the case at all – I don’t believe there was a single bank who was trading with the attitude “hey, if we screw this up, we’ll get bailed out by the Treasury and the Fed.” They may NOW be – but again, that’s a result of failed gov’t policies.

That’s not to say that there weren’t always skewed incentives (ie, make a lot of money trading –> big bonus, lose a lot of money –> downside is pretty much capped at a pink slip and a zero bonus, but I don’t have to give back my prior comp), but those are very different from Govt backstops.

Posted by KidDynamite | Report as abusive

Tepper doesn’t have the government to thank, he should be grateful to the sellers of the shares he bought. The government didn’t lose any more money because he bought the shares – if anything the more people being confident would make a bailout cheaper. On the other hand the sellers are $7.5b worse off, directly because they sold shares to him.

I’d be interested if there are examples of funds profiting indirectly from government guarantees, but this seems a poor one.

Posted by Mr.Do | Report as abusive

Tepper took on the risk, therefore he deserves the reward.


Posted by jalsck | Report as abusive

The author at macroresilience here – as i have emphasised many times on my blog, I don’t blame the hedge funds or anyone else who profits from the subsidy. The essence of the evolutionary argument is that no deliberate intention to exploit is necessary for incentives to take effect which in my opinion is rather scary. Copying from a reply on the post to a similar query,

“I don’t assume that agents deliberately try and maximize wealth. The core of my evolutionary approach is the folowing: selective forces such as principal agent relationships and the Hayekian spontaneous order that arises from agents acting on partial and dispersed knowledge and incentives will drive the system towards a state that maximizes the extraction of the moral hazard subsidy even if agents do not deliberately intend to put on moral hazard trades – longer explanation here http://www.macroresilience.com/2010/01/0 1/moral-hazard-a-wide-definition/ . In fact, it is likely that the agents who rise to the top genuinely believe that they are doing the right thing and that they are deceiving no one as I explain here http://www.macroresilience.com/2010/02/1 7/natural-selection-self-deception-and-m oral-hazard/ .

This is what I was trying to explain when I mentioned that in a complete market ( i.e. In the language of selection, the universe is sufficiently diverse ), you need all agents to be “omniscient angels” for the system not to arrive at this state of maximum extraction sooner or later.

This of course explains why most people at the centre of the crisis claim that they weren’t doing anything wrong and I believe them! Hence my insistence that we need to change the incentives.”

Posted by macroresilience | Report as abusive

I don’t fully understand from the article exactly HOW Tepper made his 5.7 billion, but if he’s a long only trader presumably he did no more than buy bank shares when they were undervalued? What’s wrong with that? Sure, he had the benefit of using huge amounts of someone else’s money to buy the shares, which meant his personal risk was small, but it was a bit of a no-brainer to invest in banks at the time because normally their profits are both enormous and robust, as events over the last year have shown.

Posted by FifthDecade | Report as abusive

I believe he bought the debt not shares. If it was shares then he was taking a genuine risk because back in 2009 people were talking about nationalising C and he would have been wiped out. I struggle to see a scenario in 2009 where C debt would have been wiped out, at worst he may have come under a liquidity squeeze.

Posted by Danny_Black | Report as abusive

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