How Capitalism Will Save Us (28 page)
Read How Capitalism Will Save Us Online
Authors: Steve Forbes
Paulson operates in the complex, high-risk world of hedge funds, a far cry from your traditional mutual fund. Hedge-fund managers employ mind-boggling arrays of strategies, using puts, calls, options, and short sales. They deal in everything, including, of course, stocks, bonds, commodities, and currencies. What makes hedge funds high-octane vehicles is their use of borrowing on a scale that can take your breath away—a process that can magnify gains and losses.
Paulson earned his historic reward because his hedge fund invested with exceptional success for the multibillion-dollar pension funds that are his clients. His investments in 2007 yielded an astounding $15 billion gain—a 600 percent return. His subsequent trades generated more than 17 percent gains for his clients despite a down market in 2008.
The news media has characterized his trades as a “bet,” as though
Paulson was playing the slot machines in Vegas. But his investment decisions were based on anything but luck. Paulson’s analysis led him to conclude that the housing market—fueled by so many low-interest, ill-advised subprime loans—was dangerously overheated. As he told journalist Gary Weiss, “We felt that housing was in a bubble; housing prices had appreciated too much and were likely to come down.”
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Mortgage-backed securities created by investment firms from bundles of mortgage loans were, as a consequence, drastically overvalued. His trades were predicated on the belief that the market would eventually tumble, and that banks like Lehman Brothers, Washington Mutual, and Wachovia would find themselves in major trouble.
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Paulson’s two-year “megatrade”—as it has been described—involved an assortment of tactics and financial instruments. One strategy was to sell short, risky, mortgage-backed securities called collateralized debt obligations, or CDOs, betting their value would soon decline. Another tactic was to buy credit-default swaps, which are a form of insurance against the failure of mortgage-backed securities if their underlying mortgages go bad. Paulson steadily bought credit-default swaps before the housing bubble showed any sign of bursting—when the instruments were cheap.
He took on a staggering amount of risk. According to one account, he invested some $22 million in credit-default swaps alone long before the financial crisis hit.
As all of us know by now, he was right big-time: homeowners began defaulting on their loans, and the value of Paulson’s credit-default swaps soared. When the federal government declined to rescue Lehman Brothers
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his $22 million investment in credit-default swaps paid $1 billion.
Paulson made a fortune for himself and his clients precisely because he went against the then-prevailing wisdom. The very fact that most others lost in the market attests to the fact that he served his clients better than other money managers did.
Paulson was hardly the only trader to see the downside of the subprime market. But unlike others, he surmised correctly that banks were not fully aware of its potential perils. Weiss writes:
Other traders refused to short the big banks because they couldn’t believe that such huge institutions would be so unaware of their
own risks. Once that fact dawned on Paulson, he bet, fast and big, that the banks would fail.
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While appreciating this foresight, Weiss questions “the moral dimension of Paulson’s achievement.” He asks, “If he saw all of this coming, was it right for him to keep his own counsel, quietly trading while the financial system melted down? Do traders who figure out a way to profit from our misery deserve our contempt or our admiration, however grudging?” What Weiss and others should remember is that many bright people thought Paulson was wrong. Several economists, including New York University’s Nouriel Roubini, warned of the impending housing disaster and were routinely ignored.
Paulson did not really “keep his own counsel.” His massive investment of client money in positions predicated on a market decline constituted a powerful signal to other big investors that trouble was brewing.
Short sellers traditionally play an important role in helping to cool overheated markets. Without traders like Paulson signaling to more traditional investors that a decline is coming and it’s time to slow down, markets would be prone to even more violent swings. Had he remained on the sidelines, the overheated trading in mortgage-backed securities would likely have gone on longer than it did, funding more bad mortgage lending.
If more people had the foresight of John Paulson, some of the excesses that produced the financial crisis might have been avoided.
As we explain elsewhere in this chapter, the wealth created by hedge funds like Paulson’s benefits not only the “fat cats” on Wall Street. It quickly makes its way to Main Street, boosting the coffers of pension funds that support millions of retired employees, as well as endowments that fund university budgets.
Paulson made money for his clients in a dangerous market at a time when other hedge funds were racking up losses. He may have netted a multibillion-dollar reward. But he’s one in a million in terms of his acumen, the wealth he created, and his critical role in the economy.
Some observers have complained that short sellers like Paulson benefited from the weakness in financial stocks artificially created by the removal of the uptick rule and the advent of mark-to-market accounting. It’s true that these short sellers made immense amounts of money because of
those two factors. But you can’t blame the short sellers for successfully responding to distorted market conditions that the government created.
REAL WORLD LESSON
There’s a world of difference between lotteries, slot machines, and other gaming activities and investing. Gambling is a form of entertainment; investing is how we finance future innovation and growth
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Q
D
OES SOCIETY REALLY NEED RICH PEOPLE?
AY
ES.
E
XPERIENCES OF NATIONS THAT HAVE DESTROYED THEIR MERCHANT CLASS ILLUSTRATE THE IMPORTANCE OF WEALTH BUILDERS IN AN ECONOMY
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T
he title of author Hunter Lewis’s recent book posed a question that has been asked by the critics of capitalism:
Are the Rich Necessary?
The book, which looks at both sides of the debate, offers a good explanation of why, in the Real World, “rich people” are not only necessary but essential:
An economy expands by becoming more productive. We become more productive by learning how to produce more and more, better and better, with the same number of workers. Productivity increases as we give workers better tools. In order to afford these tools, we need…to save, so that we can invest the savings in the tools we need.
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The poor cannot be expected to save, because they need every dollar for basic needs such as food and shelter. Middle class people will save something for emergencies, children’s education, or old age. The rich, however, are different. They have so much money that, in aggregate, they simply cannot spend it all. They are, in effect, forced to save.
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The author is essentially saying that because they are “forced” to save, the rich have the capital to invest in the tools—the businesses and innovations—that increase productivity and economic growth. What happens when there aren’t enough rich people? There isn’t enough investment capital. The economy suffers.
People who buy into the Rap on capitalism fail to see the role that the rich play in an economy as society’s entrepreneurs and investors.
All too often, they see “rich” and “poor” as fixed groups with opposing interests. In her 2007 essay in the
Nation
on the “bloated overclass,” Barbara Ehrenreich angrily declared that “it no longer takes a Marxist, real or alleged, to see that America is being polarized between the super-rich and the sub-rich everyone else.”
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Ehrenreich, as we saw earlier in this chapter, holds rich people culpable for countless sins, ranging from “exploiting” low-wage labor and displacing people through gentrification to enriching themselves and not others through their fortunes.
Society would be better off, she says, if these selfish rich people weren’t around. In her piece, Ehrenreich quotes a fellow writer, Roger Lowenstein, who, while more accepting of inequality, acknowledged that the nation might be a more “egalitarian” place if “the upper crust were banished to a Caribbean island.”
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Ehrenreich does him one better. The Caribbean, she insists, is not a sufficiently remote location: “why give the upper crust an island in the Caribbean? After all they’ve done for us recently, I think the Aleutians should be more than adequate.”
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Well, about thirty-five years ago, Idi Amin, the dictator of Uganda, more or less did what Ehrenreich is proposing. In 1972, the dictator expelled the nation’s population of Indians, who made up the merchant class. Amin accused them of being “bloodsuckers” who had undermined the nation’s economy, avoiding taxes and not investing their profits back in the economy. He gave them ninety days to leave. Some eighty thousand did.
Amin rid his country of most of the people who were supposedly the cause of its woes. The result? Deprived of the services and capital produced by these entrepreneurs, Uganda’s economy collapsed. An account in the British daily
The Independent
describes what happened:
After the expulsion, Uganda’s inflation soared and imported goods became impossible to get hold of. Few Ugandans saw material benefits from the expulsion. Instead of equally distributing the property and land the [Ugandans of Asian descent] left behind, Amin gave the confiscated property to a handful of his favourite soldiers who had no business skills or money for investment. Uncared for, the shop fronts crumbled and farmlands returned to the jungle, and international investors became increasingly reluctant to put their money in the country.
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More than a decade later, the bloodthirsty Amin, a man who had butchered tens of thousands of his own people, had gone into exile and a new regime attempted to undo the damage that the Asian exodus had done, returning confiscated property and inviting the exiled Asian Ugandans back. So much for the notion of the rich being a drag on the economy.