Just What Do Hedge Fund Honchos Do For a Million Bucks an Hour?

Les Leopold's new book reveals that hedge funds make their super-profits by doing what the rest of us would call cheating.

It's a common belief that people are compensated more or less in proportion to the value they produce. Sure, it's an imperfect measure – why should teachers make a fraction of what personal injury lawyers take in? – but if someone's making billions of dollars per year, they must be doing something positive for society.

But what do those at the pinnacle of the economic pile – hedge fund managers whose compensation dwarfs that of the best paid corporate CEO – actually do? “A straight answer is hard to come by,” writes Les Leopold in his new book, How to Make a Million Dollars An Hour (Wiley). "Mostly these guys (and yes, they are nearly all guys) keep their efforts hidden from view. Trade secrets and mystical lore shroud their every move. Neither regulators nor the public have any idea how so much money is minted."

AlterNet caught up with Leopold to discuss the new book.

Joshua Holland: Les, congrats on the new book. We hear a lot about CEO pay, but really, it seems that these hedge fund guys are just putting most corporate CEOs to shame. Can you put the kind of spoils these guys are getting into perspective for us?

Les Leopold: Josh, you know this is America, and we are very accustomed to hearing about the rich and famous. To start the book I thought it would be good to take a look at the 10 richest musicians, athletes, movie stars, CEOs, lawyers, doctors, authors and other celebrities, and then compare them with these hedge fund managers. I couldn't believe what I found. Hedge fund managers make up to 100 times more.

For example, while the top movie stars averaged about $21,000 per hour, (which is nothing to sneeze at), the top hedge fund guys averaged a whopping $843,000 per hour. It was a revelation.

JH: So, what's the thesis of your book, in a nutshell?

LL: My thesis really flows from one basic question: How is it possible for a small firm like a hedge fund, with maybe 50 to 100 employees, to make as much money as a firm like Apple with more than a half-million employees and contractors worldwide?

In our free-market economy, what you earn is supposed to reflect the value you produce for the economy. The more you earn, the more value you allegedly produce in the form of goods and services. So if you make a lot of money making music, like U2 or Lady Gaga, it's because lots of people really enjoy your music. So hedge funds must be producing an astounding amount of value ... or there's something really screwed up about our economy.

What I discovered is that something really is screwed up because hedge funds do not produce value that comes anywhere near to what they are hauling in. Instead, they are siphoning away our wealth.

JH: You and I can't buy into them -- you have to be a "qualified investor" with a bunch of capital. And these qualified investors are supposed to be smarter than the rest of us, which is a kind of dubious claim given that they pumped up the housing bubble, and that's just a decade after they pumped up the tech bubble.

But hedge funds are at least supposed to serve a larger purpose for the financial sector, allowing wealthy investors to control the amount of risk in their portfolios. Is that not a valuable service?

LL: Well, you're diving right into the heart of it. What are these valuable services that hedge funds deliver to "earn" all that money? There are supposedly a bunch of financial good deeds that hedge fund cheerleaders tout -- like bringing liquidity to markets, increasing productivity, making prices more efficient, and the one you've hit on: they are supposed to help investors avoid too many risky investments.

In fact, hedge fund apologists take it one step further. They claim hedge funds dissipate risk throughout the economy; that hedge fund managers are the brave, bold entrepreneurs who are the only ones willing to take risky investments off the timid shoulders of those who don't want them. This not only helps cautious investors protect their portfolios, we are told, but it makes the entire economy safer.

Sounds great, doesn't it? Except it's not true. Just go back to the housing bubble. Rather than dissipating risk, hedge funds helped to increase and concentrate it. Rather than making the system more stable, they helped it explode. As I show in the book, step by painful step, hedge funds did all they could to build up, and then crash, the housing bubble so that they could do one thing, and one thing only -- extract enormous profits.

Josh, I really didn't expect to find what I ultimately discovered -- that hedge fund super-profits actually come from what the rest of America would call cheating. I think readers will be as amazed as I am to learn about the various ways hedge funds rig the game. (I've even got a confession from Jim Cramer of Mad Money.)

JH: Les, I want to get your reaction to a fit of pique from John Paulson, who heads the Paulson & Co. hedge fund. When Occupy Wall Street was in the public eye, he issued a press release. Let me quote it:

The top 1% of New Yorkers pay over 40% of all income taxes, providing huge benefits to everyone in our city and state. Paulson & Co. and its employees have paid hundreds of millions of dollars in New York City and New York State taxes in recent years and have created over 100 high-paying jobs in New York City since its formation.

New York currently has the highest income taxes of any state in the country and thousands of businesses have fled New York to states with no income taxes such as Florida, Texas and Nevada, or moved offshore.

Instead of vilifying our most successful businesses, we should be supporting them and encouraging them to remain in New York City and continue to grow.

Your reaction?

LL: Josh, are you trying to raise my blood pressure? I could write another book about how out-to-lunch Paulson's comments really are. First off, Paulson himself is not suffering. He took in $4.9 billion in 2010 -- that comes out to about $2.4 million an hour. And with all that profit he created only 100 jobs? That's a disgrace.

Second, hedge funds like his take advantage of an incredible income tax loophole called "carried interest." At the time of his rant, Paulson was probably using a federal tax provision that limited most of his income to a 15 percent tax rather than the top rate of 35 percent. His overall tax rate was probably less than his chauffeur's. And note how he neglects to mention payroll and sales taxes that the average New Yorker pays in a higher proportion than he does. And, he fails to note that whatever he pays in New York state and local taxes is deducted from his federal taxes.

As for businesses fleeing, Paulson seems to be blissfully unaware that study after study shows how marginal tax rates have little or no impact on where businesses and individuals locate. And he'll need to explain why Wall Street's casinos haven't already fled the higher taxes in New York for low-tax Las Vegas. Maybe it's because the casinos in Nevada are more regulated than those on Wall Street?

In terms of vilification, I plead guilty. I am one of those who has asked a lot of pointed questions about how he makes his money. One day he might want to explain to the public his role in the infamous Abacus deal which federal investigators said netted him a cool billion dollars. In that trade Paulson worked hand-in-glove with Goldman Sachs to build a financial security that was designed to fail, so that he could bet against it. It was precisely like designing and selling a car that would immediately crash so that the maker and seller could collect the insurance on it. Only in Paulson's world is that a permissible activity.

Well, not quite. Goldman Sachs paid a $550 million fine for misleading investors who lost $1 billion in that toxic deal. But due to the letter of security laws, Paulson got to keep his booty. So, before Paulson gets so high and mighty about all his wonderful contributions to the economy, maybe he could explain what value that shady deal produced for anyone other than himself.

I do thank Paulson for his $100 million contribution to Central Park. But, I'd much rather that money go to the city via fair taxation so that it could benefit all its parks, not just the ones that border the richest real estate on Earth.

JH: OK, so these guys have a ton of money. They're not paying much in taxes. And many of them are heavily invested in politics. Is there a pattern that you can discern in their political spending? There was a coalition of fat cats pushing these crazy austerity policies. These guys don't worry about retirement security or paying for healthcare. But is that typical of the industry?

That's a very good question and I must admit my answer is only anecdotal. As I researched the book, I came across various sources who claimed that hedge fund managers (and their cousins who work the proprietary trading desks inside large banks) put up $1 billion dollars to lobby against new financial regulations.

Also, there are various reports that suggest hedge funds and other large Wall Street donors moved en mass toward supporting many more Republicans in the last federal elections than they had previously.

But of this I am sure: The more the national conversation focuses on austerity, the less it focuses on reining in Wall Street. So it's in the objective interests of elite financiers to promote deficit hysteria.

JH: Did they have a role in shaping the Wall Street bailouts everyone hates? Tell me about that.

Here's a little story I came across that shows the incestuous relationships between the bailout process and hedge funds. In July 2008, it became clear that Fannie and Freddie were in trouble. Treasury Secretary Henry Paulson (no relation to John) goes public with the word that the government was confident that the two large government sponsored mortgage companies were sound. This signaled that stockholders would not be wiped out through a government takeover.

A few days later, Paulson, who formerly was CEO of Goldman Sachs, has a private meeting with his old banking and hedge fund buddies in New York City. He tells them privately the exact opposite of what he said publically -- that he's going to nationalize Fannie and Freddie, which would wipe out the value of its common stocks.

Well, lo and behold, short-selling of Fannie and Freddie immediately skyrocketed after the meeting. A few days later, Paulson made an about-face and nationalized Fannie and Freddie wiping out the value of its common stocks. Those who shorted the stock, whomever they were, made a lot of money. It's all documented in the book.

Hmm. You think maybe the big hedge funds and banks helped to shape the bailouts?

JH: Another issue that comes up when you think about the financial sector is how much it's grown relative to the rest of the economy over the past decade or so. And critics have pointed out that Wall Street's influence on corporate America -- on non-financial companies -- isn't always positive. There is that short-term thinking that comes with companies trying to meet or exceed quarterly earnings projections, and sometimes they sacrifice long-term growth strategies in the process.

What's your take on the interplay between these hedge funds and the larger economy?

LL: I believe there are multiple influences and most are pernicious. You already mentioned the focus on short-term profits and with it comes a reduction in research and development, disinvestment in employees, outsourcing to low-wage areas, and totally unnecessary plant shutdowns and relocations.

But this book forced me to focus on another main impact -- the dramatic rise in CEO pay compared to average worker pay. In 1970, for every dollar the average worker earned, the top 100 CEOs paid themselves, on average, $40. That's a $40 to $1 ratio. By 2007 the ratio jumped to a whopping $1726 to $1. Nothing in free-market literature can explain that colossal increase -- not increases in skills, experience, new technologies, or new products.

Instead, I believe a large part of it has to do with hedge fund envy -- my new entry into Freudian financial literature. Imagine a CEO in a firm with 50,000 employees watching some 35-year-old hedge fund manager with 50 employees waltz off with $100 to $200 million a year in booty. Imagine how pissed off you'd be making only seven digits. (Yes, it is hard to imagine ever whining about making all that money because we're not animated by greed.)

I believe the enormous gap between financial sector pay and compensation in the rest of the economy motivated CEOs to press their boards for higher pay packages that were more in line with what they saw going to Wall Street's new elites. They all wanted in on the feast...ultimately at our expense.

JH: According to the Wall Street Journal, in 2009 hedge funds controlled about $140 billion in high-frequency trading accounts. This seems like a rip-off for other investors -- a classic case of rent-seeking. What's your take?

LL: Josh, this was one of those out-of-body experiences you sometimes get when chasing a story. I got a chance to interview some New Jersey guys who try to protect their clients from high-speed traders. It was like walking into the Twilight Zone. They took me through the spooky ways in which high-frequency traders extract hidden fees from just about anyone who makes a trade on the stock market.

Catch this: If you're making a trade for your 401k for example, using something like E-Trade, there's a high-speed trader using automatic computer programs waiting out there for you. By the time you hit the "buy" button on your computer, that trader has bought the stock ahead of you and sold it back to you for a profit of a few pennies, which you will hardly notice. They picked your pocket. They do this again and again -- millions of times a minute. Overall, they are extracting from $5 to $20 billion a year from the rest of us -- from our pension funds, mutual funds and other retirement accounts. And in return they produce nothing of value at all.

In fact, from 50 to 80 percent of all trading on the stock market is the result of high-speed trading. Thanks to my sources, I think I do a pretty good job of walking the reader through this murky world. Actually, it's sickening that our regulators allow this industry to exist at all.

JH: Finally, Les, do you see ways of reining these big boys in? 

LL: I think the single best way to tame the beast is to move money out of Wall Street and into Main Street through a financial transaction tax -- sometimes called the Robin Hood tax or financial speculation tax. As you pointed out, Wall Street is much too large for our economy. It distorts manufacturing. It inflates CEO pay. It kills jobs. And most importantly, it's an ever-present danger to our economic stability.

A small tax on the buying and selling of all financial instruments (stocks, bonds, futures, options, derivatives, CDOs etc.) could easily move $150 to $200 billion a year out of the Wall Street casinos. For starters, that would put an end to high-speed trading. Also, it would make it much, much harder for hedge funds to game the system. (While we're at it, ending their carried-interest tax loophole would also help.)

That still leaves us with too-big-to-fail banks, predator hedge funds and financial instruments that should never see the light of day. But, the additional reforms we need won't really rein in the big boys until we rebalance the economy through a financial transaction tax.

Anyway, thanks so much for this interview. I hope the book will engender a provocative and productive debate about how to tame our runaway financial system and our obscene distribution of wealth. I encourage readers to critique the book and publish their comments wherever they can. Readers can also reach me at LesLeopold@aol.com.

Joshua Holland is Senior Digital Producer at BillMoyers.com, and host of Politics and Reality Radio. He's the author of The 15 Biggest Lies About the Economy. Drop him an email or follow him on Twitter

Les Leopold is the director of the Labor Institute. His most recent book is How to Make a Million Dollars an Hour: Why Hedge Funds Get Away with Siphoning off America's Wealth (Wiley, 2013).