As the credit crunch descended, the so-called “shadow banking” system, which includes hedge funds and private equity, attracted more than its fair share of opprobrium. In Germany, these groups, a symbol of free-wheeling Anglo-Saxon capitalism, were labelled “locusts”, and here in Britain the government launched a tax clampdown on private equity just as the financial system was seizing up.
Reputations were not helped when the world’s largest convicted swindler, Bernard Madoff, fund manager to Hollywood and the Florida and New York rich, was regularly described in the media as a hedge fund manager, which was not strictly true. Mr Madoff was a regulated broker-dealer who appeared to run a conventional fund management operation and which turned out to be a giant Ponzi scheme: money flowing in from new investors was used to pay-off the existing investors.
Several hedge funds, including London-based Lansdowne Partners, were accused of worsening the pressure on the banks and insurance companies by short-selling their shares. While it is unfortunate that their role in targeting Northern Rock, Bradford & Bingley et al may have hastened the collapse and nationalisation of flawed banks, no one disputes that their judgment — based on careful analysis — was correct. Indeed, in much the same way as they were short holders of the banks on the way down, they have become longer term investors in the banks post re-capitalisation.
The US government now believes that hedge funds and private equity, with their sharp analytical skills, can play a key role in rescuing the US banking system. Instead, investors such as John Paulson, who made billions of dollars out of his bets against the banking system and were seen as Wall Street’s destroyers, are being embraced. Indeed, the rally in New York share prices last month was largely based on the belief that the shadow banking system can play its part in restoring stability to American finance.
The US Treasury Secretary Tim Geithner, the former president of the New York Federal Reserve, has been under almost continual siege since taking office. Initially it was his own careless tax affairs which caused him difficulty. Latterly it was the $165m of bonuses which he allegedly authorised for executives of the American credit insurer AIG. This payout led to a nationwide witch hunt which almost drove Mr Geithner from office and provoked a fierce backlash on Capitol Hill.
Mr Geithner drew the fire of his critics with the launch of what has become known as his “public/private investment programme” to save the banks. Under the scheme, the government will use $75bn to $100bn of capital, provided by Congress under the “Troubled Asset Relief Programme” (TARP), to generate $500bn in purchasing power to buy toxic/legacy assets from the banks. The scheme could expand to repatriate up to $1 trillion of assets.
So how does the scheme work? The US government provides most of the initial finance and bears most of the risk. In this it is not dissimilar to Alistair Darling’s asset protection scheme, under which the Treasury has insured the bad assets of Royal Bank of Scotland and the Lloyds Banking Group.
The difference is that in the American scheme, the private sector values the assets by deciding at what price it will buy them off the bank books, then holds them until it can sell them at a profit. Enter stage right the hedge funds and private equity firms. It is generally judged that these groups in the “shadow banking sector”, usually acting on behalf of rich investors, are the most likely buyers of the distressed assets.
If the Treasury takes the risk and hedge funds can see the upside in some of the bad debts, they could make handsome profits. At the same time, by relieving the US Treasury of the responsibility of valuing the assets, investors like George Soros and John Paulson could eventually be seen as saviours rather than the predators who helped to cause the financial crisis in the first place. The scheme could start the process of cleaning up bank balance sheets, although the critics believe it will not be enough and that a further recapitalisation of America’s banking system, costing trillions of dollars, could still be necessary.
What is fascinating about this, and the investment by UK hedge funds in UK bank shares, is the realisation that private equity and hedge funds, despite the poor image they have in the media, have a critical role to play in restoring capitalism back to health.
As trusted and successful managers of savings, they have the ability to attract capital when more conventional savings vehicles — ISAs and pension funds in the UK, and money market funds and 401K self-invested pension schemes in the US — are struggling.
This new lease of life for “shadow banking” could be much welcomed in the environs of Mayfair — home to many of the London-based hedge funds and private equity enterprises.