Midsummer Market Meltdown: Is the End Near?

Print
Dean Baker
Truthout, July 30, 2007

See article on original website

Last week's stock market tailspin has many of the big-time money folks worried. They have suddenly discovered risk. It turns out leveraged buyouts are not always successful, and mortgages and other debts sometimes don't get paid off. Who could have known?

While some of the big rollers who helped propel the housing and debt bubbles of the last five years will lose substantial sums, the fact is most will still end up much richer as a result of their efforts. This is because most of the risk they take is with other people's money. The biggest risk these folks face is a smaller paycheck.

This is most obviously the case with the standard contract used to pay hedge fund managers. Typically, these contracts give managers a fee equal to 2 percent of the value of the funds being managed, plus 20 percent of earnings in excess of some benchmark. Under such a contract, if a hedge fund controls $4 billion, and manages to get a return that exceeds its benchmark by 5 percentage points, the manager walks away with $120 million. Of this sum, $80 million comes from the 2 percent flat fee and the other $40 million comes from the commission on the excess return.

Now suppose the genius fund manager managed to lose half the value of the fund's assets by speculating on bonds backed by subprime mortgages. The manager still gets the $80 million in fees, even though he lost the fund $2 billion. Perhaps the fund manager will get fired, but with $80 million in the bank (which gets the special low fund manager tax rate), he will be able to take his time looking for a new job. Many of the people most directly responsible for the subprime meltdown will also be in a similar boat. Some of the big issuers of subprime mortgages have already gone belly-up after they were unable to meet obligations on bad mortgages. While the people who hold the mortgages are out of luck, many of the top executives of these mortgage-lending companies will walk away with millions of dollars in profit.

When you see people making vast fortunes in this economy, it is usually a good start to ask what the government did to allow for their success. In the case of the fund managers, a substantial chunk of their business comes from pension funds. Some of these pensions involve government money in the form of public employee pension funds. Others carry a government guarantee; so, if the fund managers blow the wad, the government picks up the tab. In both cases, it would be a good first step if regulators let the pension fund trustees, who hand billions of dollars to fund managers, know that they will lose their jobs if these investments don't pay off as promised. Ripping-off the public to make the richest people in the country even richer is not funny, and pension fund trustees must understand this.

As far as the mortgage industry, this is a complete mess. The current regulatory system provides enormous opportunities for sharp operators to pilfer millions, while leaving investors out of luck and homebuyers out on the street. This will be a topic for future columns. But, it is long past time we hold the people who control the investment of public funds or publicly guaranteed funds more accountable. If they want to give the fund managers huge paychecks, then they should do it from their own pockets.


Dean Baker is the co-director of the Center for Economic and Policy Research (CEPR). He is the author of The Conservative Nanny State: How the Wealthy Use the Government to Stay Rich and Get Richer (www.conservativenannystate.org). He also has a blog, "Beat the Press," where he discusses the media's coverage of economic issues. You can find it at the American Prospect's web site.