Soros, Falcone Defend Hedge Funds at House Hearing

Date: Thursday, November 13, 2008
Author: Katherine Burton and Lorraine Woellert, Bloomberg

George Soros and Philip Falcone, in a rare appearance by hedge-fund managers before Congress, defended their industry's practices and profits while splitting over whether more government regulation is needed.

``This is not a case where management takes huge bonuses or stock options while the company is failing,'' Falcone, senior managing director of New York-based Harbinger Capital Partners, said in written testimony to the House Committee on Oversight and Government Reform.

Falcone urged Congress to oversee the industry and require more disclosure of investments, while Soros, founder of Soros Fund Management LLC in New York, cautioned Congress against ``ill-considered'' regulations because the managers are reeling from market losses and client defections.

Soros, Falcone, Paulson & Co.'s John Paulson, James Simons of Renaissance Technologies LLC and Kenneth Griffin of Citadel Investment Group LLC, who are among the world's richest hedge- fund managers, were called to testify today as part of a congressional investigation into the credit crunch that has slowed the global economy.

Committee Chairman Henry Waxman began questioning the men today about their bets against subprime mortgages and whether their industry is a risk to the financial system. Waxman's hearing is one of many Democrats are convening to explore the causes of the global financial crisis. They are examining issues such as regulation, disclosure and compensation.

`Unimaginable Success'

Hedge-fund managers have had ``unimaginable success'' and, while being ``virtually unregulated,'' many enjoy special tax breaks, Waxman said. Today's witnesses, he said, earned on average more than $1 billion last year, profits they were able in many cases to treat as capital gains rather than as ordinary income, which is taxed at a higher rate.

``That means at least some portions of their earnings could be taxed at rates as low as 15 percent,'' Waxman said. ``That's a lower tax rate than many school teachers, firefighters, or plumbers pay.''

Waxman and Representative Thomas Davis of Virginia, the panel's top Republican, suggested the need for more oversight of the industry.

``Greater standardization, registration, disclosure and some regulatory limitations could help the industry mature and survive,'' Davis said.

Main Street Impact

He said there are as many as 8,000 funds managing as much as $1.5 trillion and could account for up to 30 percent of trading volume in U.S. stocks.

``This isn't just about sophisticated, high-stakes investors anymore,'' Davis said. ``Institutional funds and public pensions now have a huge stake in hedge funds' promises of steady, above-market returns. That means public employees and middle-income senior citizens, not just Tom Wolfe's Masters of the Universe, lose money when hedge funds decline or collapse.''

Falcone said he supported more public disclosure and transparency. Investors ``have a right to know what assets companies have an interest in -- whether on or off their balance sheets -- and what those assets are really worth,'' he said.

Soros, in written testimony, warned the committee against ``going overboard with regulation.''

``Excessive deregulation has inflicted enormous losses on the general public and there is a real danger that the pendulum will swing too far the other way,'' especially while the sector is in decline, Soros said.

``The bubble has now burst and hedge funds will be decimated. I would guess that the amount of money they manage will shrink by between 50 and 75 percent. It would be a grave mistake to add to the forced liquidation currently dislocating markets by ill-considered or punitive regulations,'' Soros said.

Earning Salaries

In their written statements delivered to the committee, the hedge-fund managers also defended their multimillion-dollar salaries, saying they earned money only when their investors did.

``In our business, one of the most fundamental principles is alignment of our interests with those of our clients,'' Paulson said. His fund shares profits with its investors, taking 20 percent. ``All of our funds have a 'high-water mark', which means that if we lose money for our investors, we have to earn it back before we share in future profits.''

Waxman, who last month grilled Richard Fuld, chief executive officer of Lehman Brothers Holdings Inc., about the bank's demise, doesn't have jurisdiction over securities- industry legislation. Even so, his interest suggests the $1.7 trillion industry faces increased scrutiny and regulation next year after President-elect Barack Obama takes office.

Regulator Actions

``In an attempt to respond to public outcry and political demand, the industry expects lawmakers to implement new rules that will limit leverage, restrict the ability to short securities and increase taxes on the wealthy,'' said Ron Geffner, a lawyer at New York-based Sadis & Goldberg LLP, which represents hedge funds.

Regulators have already taken some steps. In September, the U.S. Securities and Exchange Commission temporarily banned the short sale of some stocks. The agency now requires funds to disclose the shares they are wagering will tumble, though those reports won't be made public. In a short sale, a trader borrows shares and then sells them immediately in the hopes they can be bought back later at a cheaper price.

The witnesses, all longtime fund managers, earned more than $1 billion last year according to a list compiled by Institutional Investor's Alpha Magazine.

Waxman asked the managers to provide documents, including e-mails, that discussed the likelihood that their own, or other, hedge funds would collapse and the risk to the financial system if they did.

Borrowing

He also asked for their levels of borrowing and their investments in mortgage-backed securities, collateralized debt obligations and credit-default swaps going back to the beginning of 2005. Some managers used these securities to wager on subprime mortgages and on the credit-worthiness of investment banks.

Soros, 78, is the chairman of $19 billion Soros Fund Management. He has called credit-default swaps the next crisis area because the market is unregulated, and he has recommended the creation of an exchange where these contracts could be traded.

Paulson, 52, runs a New York-based fund that manages about $36 billion. His Credit Opportunities Fund soared almost sixfold in 2007, primarily on wagers that subprime mortgages would tumble. Paulson's Advantage Plus fund has climbed 29 percent this year through October while many managers are enduring the worst year of their careers.

Griffin Struggles

Hedge funds lost an average of 15.5 percent this year through Oct. 31, according to data compiled by Chicago-based Hedge Fund Research Inc.

Falcone, 46, also profited from a drop in subprime mortgages last year, when his fund, now about $20 billion, doubled. This year the fund was up 42 percent at the end of June and has since tumbled to a loss of about 13 percent.

Simons, 70, runs his $29 billion fund out of East Setauket, New York. The former academic makes money by using computer models to trade. His Medallion Fund, made up of his own money and that of his employees, is up more than 50 percent this year.

Griffin, 40, runs the $16 billion Citadel Investment Group LLC in Chicago, and has faced the toughest year out of the five billionaire managers. His funds dropped 38 percent this year through Nov. 4.

To contact the reporters on this story: Katherine Burton in New York at kburton@bloomberg.net; Lorraine Woellert in Washington at lwoellert@bloomberg.net.