Hedge Funds Can’t Fix Connecticut’s Fallen Revenue

Date: Thursday, February 5, 2009
Author: Michael McDonald, Bloomberg

Philip Duff, Morgan Stanley’s former chief financial officer, last month fired 80 of the 100 people at his 11-month-old hedge fund, and now he’s looking to sublet excess office space in Greenwich, Connecticut.

Record losses and terminations at hedge funds like Duff Capital Advisors have reduced Connecticut’s tax revenue, and that means the city schools in Bridgeport, 25 miles north, may soon have less space. Anticipating $12 million in budget cuts as state aid drops, Superintendent John Ramos says he may be forced to close some of his 35 schools.

Officials across the state face similar cuts. After income- tax-fueled surpluses of $3.6 billion from 2004 through last year, Connecticut’s budget now has a $1.1 billion gap that will reach $6 billion by 2011, according to state Comptroller Nancy Wyman. Quarterly taxes on bonuses and capital gains -- which make up 40 percent of income tax collections -- dropped 20 percent in one year to $568.2 million last month, Governor Jodi Rell said.

“It’s not like they didn’t know this was coming,” said Jonathan Pelto, the Democratic deputy majority leader in the Legislature from 1984 to 1993 and a political consultant at Impact Strategies Inc. in Storrs. “While Connecticut is a wealthy state, most of it comes from a single industry. It was a classic bubble.”

Personal income taxes account for about half of all revenue in the 43 U.S. states that levy them, according to the National Association of State Budget Officers. As the economy grew, and the S&P 500 index gained 11 percent a year from 2003 through 2007, states amassed $62.9 billion in reserves, the Washington- based group said.

Surplus to Shortfall

Last year, the S&P 500 tumbled 38 percent, the most since the Great Depression, after the collapse of Lehman Brothers Holdings Inc. froze credit markets and financial firms lost more than $1 trillion. State budgets were overwhelmed; California faces a $42 billion shortfall over coming 18 months.

States that depend on Wall Street incomes have additional problems. New York Comptroller Thomas DiNapoli said on Jan. 28 the state would lose $1 billion this year after Citigroup Inc., Goldman Sachs Group Inc., and other Manhattan-based banks cut employees’ bonuses 44 percent to $18.4 billion.

“A very small percentage of wealthy people are making up a very large percentage of the tax collections,” said Nicole Johnson, a Moody’s Investors Service analyst in New York. “That could be a huge problem” for states as profits in the financial services sector shrink, she said.

Wealthiest State

Connecticut, the wealthiest U.S. state with per capita income of $54,117 in 2007, has profited from its proximity to Wall Street since rail lines from the city reached north to Fairfield County more than a century ago. According to Forbes magazine, the state’s richest residents now are hedge fund managers including Steven Cohen and Paul Tudor Jones, who live and work in and around Greenwich. Cohen earned $900 million in 2007 while Jones made $300 million, according to Institutional Investor magazine’s Alpha publication.

Duff declined to comment through his spokesman Steve Bruce of Abernathy McGregor as did Tudor Jones. Jonathan Gasthalter, a spokesman for SAC Capital Advisors, also declined to comment.

Eleven firms operated hedge funds in Connecticut when the state income tax debuted in 1991, according to HedgeFund Intelligence, a London-based company that tracks the industry. There were 196 as last year began, with 35 firms managing more than $1 billion, including Cohen’s SAC Capital Advisors and Tudor Investment Corp.

More to Come

Since then, a number of them reduced operations. Daniel Benton told investors last August he was closing Andor Capital Management LLC and retiring after seven years. JD Capital Management said last month it was liquidating a fund of about $1 billion after losses. Both are based in Greenwich.

Hedge funds are private, largely unregulated pools of capital whose managers participate substantially in profits from investments. After posting losses of 18.3 percent last year, the $1.2 trillion industry may shed $450 billion in assets this year through market losses and client withdrawals, Morgan Stanley analyst Huw van Steenis said in a report last month.

Connecticut’s problems may not stop there. UBS AG, which moved its investment banking headquarters for North America to Stamford in 1997, announced 2,000 layoffs globally in October. Doug Morris, a spokesman for the Zurich-based bank, declined to say how many of the 4,000 people in Stamford have been fired.

The state income tax applies to salaries and bonuses earned in Connecticut, as well as capital gains; commuters pay taxes to New York on income earned there. Income taxes from Greenwich grew 150 percent from 2003 to 2007, when the city of about 61,000 accounted for 11 percent of the $6.75 billion collected.

‘In a Freefall’

The number of workers in financial services in Fairfield County dropped by 700 to 46,100 from July to December, according to the state’s labor department.

Duff, 51, started two fund companies since moving to Greenwich in 1992. The first was FrontPoint Partners LLC in 2000, which he sold six years later to Morgan Stanley for $400 million. Now, after cutting staff, he’s trying to sublet space in a building that also houses Strategic Value Partners, the hedge fund firm formed by Merrill Lynch & Co. veteran Victor Khosla that last year liquidated one of its funds.

“The Greenwich market is definitely in a freefall, and that’s because it’s become a one-industry town,” said John Goodkind, a partner at Greenwich-based commercial real estate firm Newmark Knight Frank.

Spent Surplus Funds

Connecticut had a $1.1 billion budget surplus less than two years ago as income tax collections from Fairfield County outpaced expectations. Rell, a Republican, and the Democratic- controlled Legislature used most of that money to finance an 8.8 percent increase in spending in the fiscal year beginning July 2008, including boosting local aid by 10.5 percent.

Rell today unveiled a proposal for a two-year budget beginning July 1 that would eliminate 850 state jobs and give local governments the same level of aid they received this year. The budget must be approved by the Legislature. Bureaucrats like Bridgeport’s Ramos are left to handle the fallout.

“The ripple effect is clear,” said Ramos, who plans to take unpaid leave from work to help cut costs. “Everything’s on the table, from schools closing to maxing out class sizes.”

To contact the reporter on this story: Michael McDonald in Boston at mmcdonald10@bloomberg.net.