The Hedge Fund Meltdown: Another Reason Wealth Needs Spreading

Jack Nash, a key pioneer of the global hedge fund industry, passed away this past summer. Much of the rest of the industry may soon join him six feet under. The industry, one insider told the Financial Times last week, has embarked on "a sort of death march."

Hedge funds now appear to be the next chunk of high finance headed for meltdown. They may actually do their melting before most Americans even know what they are.

A quick primer: Hedge funds have been operating in the financial world's immensely lucrative shadows ever since Jack Nash co-founded Odyssey Partners, the granddaddy of the modern hedge fund, in 1982, just one year after Ronald Reagan slashed tax rates on America's highest incomes.

The new tax rates -- the lowest the rich had seen since the early 1930s -- meant that wealthy Americans suddenly had plenty of new cash sloshing in their pockets. Nash promised these affluents high annual returns if they gave him their money to invest -- and then delivered. Over the next 14 years, Odyssey delighted investors with a 24 percent average annual return.

Nash started up Odyssey with a mere $50 million in capital. By 1997, his fund was managing $3.3 billion.

The hedge fund gold rush had begun. The number of funds would ultimately soar to about 10,000, with close to $2 trillion, as of last year, in total assets. Over half these funds sat in the United States.

All these funds operated with virtually no regulatory oversight -- because they accepted funds only from wealthy investors, not the general public. They then "leveraged" this capital, borrowing billions more that they invested exotically, often "hedging" their bets by making investments set up to pay off when stocks and other assets lost value.

No one benefited more from all this hedging legerdemain than hedge fund managers themselves. They became the planet's highest-paid power-suits. In 2002, 25 hedge fund managers pulled in over $30 million each. In 2006, reports the trade journal Alpha, the top 25 hedge fund managers each made at least $230 million. Last year, 43 of them walked off with at least that many millions.

But now the hedge fund bubble is bursting. High-leverage strategies don't work when banks aren't lending. And new regulations have put a crimp on "short selling," the betting on assets to fall in value. The result? Last month ended up as the hedge fund industry's second-worst year on record.

So far this year, the industry's top index has dropped 13.9 percent. Some analysts are predicting that as many as half the world's hedge funds may shut down before the current crisis ends.

That has wealthy investors spooked. In September alone, investors yanked $43 billion out of U.S. hedge funds, shifting their cash to investments less risky. Hedge fund managers have become so alarmed they're offering to slash their standard -- and exorbitantly high -- fees if investors agree not to ask the funds to redeem their investments.

Taking a little pleasure from all this angst among the hedge fund set? Don't. Hedge funds may be crashing, but the prime victims won't be either hedge fund managers or wealthy investors. These hedgers and hedgees will walk away still worth mega millions. Average Americans won't be so lucky.

How can the hedge fund collapse be hurting average Americans who've never invested a nickel in a hedge fund?

Here's how. With nervous wealthy investors demanding their money back, hedge funds are having to sell off vast quantities of the stock they own to raise cash. This stock sell-off is contributing mightily to the stock market's current plunge, and millions of about-to-retire average Americans are feeling that plunge intensely -- in their 401(k) retirement plans.

What about those average Americans still fortunate enough to have a traditional pension plan? They're feeling the hedge fund implosion, too.

Pension funds have become enthusiastic hedge fund investors. A year ago, public and private sector pension funds had $76.3 billion invested in the industry, well over double their hedge fund investment in 2005. The industry's growing losses are putting pressure on these funds to downgrade benefits.

Why have pension funds put so much money in investments as risky as hedge funds? Many pension fund managers feel they don't have much choice. The revenues they used to count on -- the annual contributions from employers -- have been shrinking.

In the public sector, for instance, budget-squeezed state and local governments haven't been contributing into pension funds as much as they should to meet their actuarial obligations. With employer contributions down, public employee pension fund managers have had to seek out nontraditional investments -- like hedge funds -- that promise high returns.

One more question: Why have state and local governments been shortchanging their pension funds? One prime answer: They're not collecting the revenues they should from wealthy taxpayers. Governments in the United States, at all levels, have spent the last 30 years cutting taxes on the rich.

We've come, in effect, full circle. Tax rate cuts on America's highest incomes created the hedge fund bubble. Those same tax cuts are now going to make average Americans the biggest victims of that bubble's bursting.

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