What a difference two years and a financial crisis make. When Congress last floated the idea of regulating the hedge fund industry in 2006, proposing a bill that would have forced them to register with the Securities and Exchange Commission, the industry revolted and the bill died in committee. But on Thursday, in the face of growing economic tumult and an incoming pro-regulation Democratic administration, top hedge fund managers signaled they are now willing to deal on the thorny issue of oversight.
Testifying before a congressional oversight committee, fund managers Philip A. Falcone, Kenneth C. Griffin, John Paulson, James Simons, and George Soros agreed that hedge funds may require increased government regulation. Even minor regulation or increases in transparency would be a big change for the hedge fund industry. "Currently, hedge funds are virtually unregulated," said Henry Waxman (D-Calif.), who chairs the House Committee on Oversight and Government Reform, which held the hearing. (Mother Jones also covered Waxman's previous hearings on Lehman Brothers, AIG, credit rating agencies, and federal regulators.) The 1998 rescue of Long-Term Capital Management (LTCM) demonstrated that the failure of just one highly leveraged, unregulated fund could require government intervention. Because LTCM was considered "too interconnected to fail," the Clinton administration arranged for a bailout of the fund by Wall Street banks. Most of the committee members (and, naturally, the hedge fund managers) believe that hedge funds were not the cause of the financial crisis. But with the economy already in dire straits, members of Congress are determined that the hedge fund industry not produce another LTCM. "In our prior hearings, we have focused on what went wrong in the past," Waxman said. "Today's hearing lets us ask what could go wrong in the future so we can prevent damage before it occurs." With President-elect Barack Obama entering office in January, the writing is already on the wall when it comes to increased regulation of the financial sector. By demonstrating their willingness to accept some increased regulation, the hedge fund managers who testified on Thursday made the imposition of new rules on their funds' behavior almost inevitable.
Why would the most successful people in an industry that previously opposed government regulation suddenly change course? The hedge fund managers may have simply remembered the old Washington saying that "If you're not at the table, you're on the menu." With the markets in chaos and Congress desperate to take action, the no-way-no-how position the hedge fund industry originally took toward regulation is not likely to be well received. By accepting the need for modest regulation and slightly increased transparency, the hedge fund managers were showing they were willing to negotiate.
The fund managers have a lot at stake. Not only do these five men make some $5 billion a year collectively, but they also receive favorable tax treatment on some of their income. In a practice known as "carry," or carried interest, some of the cut that hedge fund managers take of their firms' profits is taxed as capital gains, rather than normal income. In theory, this is allowed because hedge funds are investment partnerships. (Long term capital gains are taxed at 15 percent and exempt from payroll tax.) According to Joseph Bankman, a professor of law and business who testified before the managers, "A fund manager who in 2007 earned $80 million paid tax at a lower average rate than a high school principal who earned $80,000."
Last year, legislation passed the house that attempted to correct this alleged loophole, but stalled in the Senate after fierce lobbying from hedge fund and private equity executives. The tax treatment of carried interest was brought up in Thursday's hearing, but in general the proceedings were remarkably non-confrontational. The hedge fund managers probably didn't want to appear uncooperative in the face of a national crisis, and the committee members may have been reluctant to anger five billionaires who have showered politicians (mostly Democrats) with nearly $400,000 in campaign contributions this election cycle alone.
The pace of congressional hearings investigating the financial crisis and the bailout doesn't seem likely to let up anytime soon. A House hearing on Friday will feature testimony from Neel Kashkari, the 35-year-old former Goldman Sachs banker who is in charge of overseeing the bailout. Check back for our coverage.
Photo from flickr user Artemuestra used under a Creative Commons license.