Who's Bullying Who?

Harvard economics professor Greg Mankiw asks: Is the White house Bullying Hedge Funds?

Professor Mankiw cites prominent hedge fund manager Clifford Asness who struck back at the Obama administration, saying hedge funds had the right and responsibility to hold out on last week's Chrysler LLC restructuring deal:

"Managers have a fiduciary obligation to look after their clients' money as best they can, not to support the President, nor to oppose him, nor otherwise advance their political views," Asness, who oversees about $20 billion at AQR Capital Management, LLC wrote in an undated letter.

Asness, who made his reputation and fortune in quantitative investing where computer models select stocks and bonds, spoke out days after Obama forced the automaker into bankruptcy protection and called several holdout lenders "speculators."

In a rare flash of anger, Obama scolded a small group of holdouts on Thursday and said he does not stand with these people when everyone else is making sacrifices.

The secretive and powerful $1.3 trillion hedge fund industry is seething in private. Asness responded more publicly.

In a letter, widely circulated on Wall Street and obtained by Reuters, Asness complained that Obama has gotten the industry all wrong and effectively misunderstands what investment managers must do for their clients.

"Let's be clear, it is the job and obligation of all investment managers, including hedge fund managers, to get their clients the most return they can," Asness wrote.

"If they give away their clients' money to share the 'sacrifice,' they are stealing."

A spokesman for the firm said Asness wrote the letter.

While Asness said his firm is not involved in the Chrysler matter, he decided to speak out because he is "aghast at the President's comments."

Known for writing detailed letters to investors, Asness did the same here. He also worried about the consequences.

"It's really a bad idea to speak out. Angering the President is a mistake and, my views will annoy half my clients," he predicted.

Still, he felt he needed to respond widely because no one else was. Industry managers are reacting with anger to the President's words and demands, Asness said, but he also said they were buckling to demands.

"One by one the managers and banks are said to be caving to the President's wishes out of justifiable fear," he said.

As he went on, his tone became ever more insistent.

He said it was untrue hedge funds benefited from taxpayer money.

"Last but not least, the President screaming that the hedge funds are looking for an unjustified taxpayer-funded bailout is the big lie writ large," he wrote. "Find me a hedge fund that has been bailed out."

He closed the letter by saying the system usually fixes itself: "Most importantly, it is not an owned lackey of the oval office to be scolded for disobedience by the President."

I don't know why Mr. Asness is so upset. The reality is while publicly scolding hedge funds and threatening to regulate them, the Obama administration has been privately pandering to them and other private equity funds.

Back in April, we learned that one of the president's top economic advisers, Lawrence Summers, received about $5.2 million over the past year in compensation from hedge fund D.E. Shaw, and also received hundreds of thousands of dollars in speaking fees from major financial institutions.

Moreover, the Obama administration has been courting private funds to invest in ailing U.S. banks. Coming off one of their worst years ever, some private equity firms, notably J.C. Flowers and the Carlyle Group, are bent on putting their funds to work in the banking industry, but the Fed is setting limits:

The Fed does not mind if private equity firms have a minority interest in banks — the Obama administration even wants them to invest. But the Fed will not let them take control, a stance the firms are lobbying regulators mightily to change, especially given that stress test results to be released Thursday are expected to show a glaring need for capital in the banking system.

It’s not personal, Fed officials say. It’s just that as the nation recovers from one of the worst banking crises in history, the Federal Reserve wants to make sure that it does not set the stage for the next financial implosion by turning banks over to private equity firms, some of the riskiest players in the business world.

So while Mr. Flowers was able to buy the bank here with his own money, he cannot tap into the billions his firm, J. C. Flowers & Company, has raised.

How this battle — and others being fought in the aftermath of the economic crisis — plays out will help determine the future shape of the financial industry.

For all the talk of the banking crisis, Mr. Flowers and other giant private equity players are circling distressed banks around the country, competing to buy into the industry. Bidding wars are now breaking out among private equity firms, including the Carlyle Group, which is going up against Mr. Flowers’s firm for a stake in BankUnited of Florida.

They and other investors see banks as the recession’s biggest prize: potential money machines that could one day generate fabulous returns, particularly after the federal government eats the losses of failed banks, then heavily subsidizes their sale. But like Mr. Flowers, some of them would prefer to take over the banks completely, replace their managements and take all the profit.

“I don’t think the Republic is going to be brought to its knees if private equity owns banks, personally,” Mr. Flowers said from his Midtown Manhattan office with its expansive views of Central Park. “We invest around the world — Japan, Germany, England, no problem.”

The Fed is resisting this pitch, for several reasons. Current law prohibits mixing banking and commerce, based on a fear that if industrialists own banks, they will dominate and try to manipulate the economy, as they did during the early-20th-century heyday of John Pierpont Morgan.

The government also wants the ability to stabilize a teetering bank by drawing on the funds of its parent company. That is hard to do with private equity firms, which have numerous businesses owned by funds, each of which is walled off to protect investors.

For these reasons, banks generally cannot be owned by nonfinancial companies like the Carlyle Group, whose assets are as varied as an interest in Dunkin’ Donuts and United Defense Industries, a maker of combat vehicles and missile launchers.

The equity firms counter that banking desperately needs cash if the economy is going to recover, and that they are the only big sources of money around. An executive at the Carlyle Group said the industry had an estimated $400 billion in “dry powder,” or ready-to-invest reserves.

To push their case at the White House, the Treasury and the Fed, Mr. Flowers and others in his industry have enlisted an all-star cast of advisers, lobbyists and lawyers. They include H. Rodgin Cohen, chairman of the Sullivan & Cromwell law firm and Wall Street éminence grise, and Randal K. Quarles, a managing director of the Carlyle Group and a Treasury under secretary in the administration of President George W. Bush. Part of their strategy, Mr. Flowers said, is to persuade the Treasury secretary, Timothy F. Geithner, to pressure the Fed to back down.

“Chris is obviously a get-it-done type of person — and he wants to get this done,” said Mr. Cohen, who represents Mr. Flowers. “He believes, as I do, that it is unfortunate to deprive the banking system in the United States of this key source of capital.”

While they press their case, the firms have found some ways around the rules.

They have formed so-called club deals, in which teams of private equity firms and other investors each buy up to the legal limit of a bank — about a quarter or a third, depending on the type of bank — with their individual pieces adding up to 100 percent control. IndyMac, the failed California bank, was sold by the Federal Deposit Insurance Corporation last fall to one such club, which includes funds controlled by Mr. Flowers; the hedge fund billionaires George Soros and John Paulson; and Michael S. Dell, founder of the Dell computer company. The investors are barred from acting in concert to, in effect, take control of the bank — an unwieldy arrangement but one that regulators insist they can enforce.

As part of the IndyMac deal, the F.D.I.C. agreed to take most of the risk from future losses on loans acquired by the partnership — leading Mr. Flowers to quip at one investor forum in New York in January that “the government has all the downside and we have all the upside.”

Mr. Flowers has come up with another way around the restrictions. There is no limit on an individual’s taking over a bank, so he purchased all of the First National Bank of Cainesville in his own name and with his own funds. But that deprives him of the billions his equity firm has set aside to buy banks, so his new bank sits in this tiny town, waiting for a change in the rules.

First National — whose second story is boarded up and whose $17 million in assets are worth about a third of what Mr. Flowers paid for an Upper East Side town house in 2006 — seems an unlikely launching pad for a new American banking empire.

It is so tradition-minded that it refused to change the spelling of its name, even after the town did so back in 1925 to honor its founder, Peter Cain.

Suddenly, in February, the First National Bank name was dropped and “Flowers Bank” was painted on the window. New bank executives showed up, passing out packs of promotional sunflower seeds with the bank’s new logo, urging the mostly elderly town residents to get ready to “Grow with Us.”

“Everyone wonders, who is this Flowers guy?” said Lefty McLain, as he finished up the ham, mashed potatoes and butter beans lunch special at the Little Store, an all-in-one restaurant, deli, pool hall and gossip post here in the one-block downtown.

Mr. Flowers, while still in his 20s, founded Goldman Sachs’s financial services merger business, helping line up the $62 billion merger of NationsBank and BankAmerica (now Bank of America) and the $34 billion takeover of Wells Fargo by Norwest.

By 1998, he had left Goldman to start his own business, focusing at first overseas, with the 2000 purchase from the Japanese government of the failed Long-Term Credit Bank of Japan, which was renamed Shinsei Bank, its name meaning “new life.”

Mr. Flowers, now 51, made a sizable chunk of his fortune when he and his partners took the bank public four years later. But the deal left some in Japan steaming, as they wondered how an American businessman could make such an enormous profit when the government was never repaid most of the trillions of yen it had spent bailing out the failed bank. The bank is now in trouble again, from investments in subprime mortgages that went sour and exposure to Lehman Brothers, which went bankrupt.

His holding in Hypo Real Estate in Germany is also suffering because of bad real estate investments, even after Mr. Flowers and Shinsei poured money into it. German regulators are threatening to take over Hypo and force Mr. Flowers out.

These kinds of high-risk investments make United States banking officials nervous, though Mr. Flowers points out, accurately, that many Japanese banks are struggling, not just Shinsei.

The private equity firms are pitching to regulators a way to let them take control of banks while respecting banking traditions. Essentially, they would separate the entities — they call them silos — that buy the banks, walling off their other private equity investments from any newly created bank holding company.

Fed officials will not speak about banks for the record, but they have told the firms that they view the silo concept as little more than a subterfuge.

Mr. Flowers and other executives have lobbied hard; their efforts have included a recent meeting with William C. Dudley, chairman of the New York Fed. At the meeting, Mr. Flowers and his colleagues bragged about how they could raise as much as $10 billion in 48 hours to help with a bank takeover if they were given the chance, according to one executive in attendance.

Mr. Flowers, in an interview, said he was confident he would prevail. Even if he cannot make the Fed reverse its policy, he will consider it a victory if the Fed approves an individual deal.

He has estimated his banking empire will one day earn at least a 35 percent return on banks it has bought in the United States. “I find it to be an extraordinary time to invest,” he said.

He was even more blunt when he spoke to an industry group in New York earlier this year. “Lowlife grave dancers like me will make a fortune,” he predicted.

Will it be private equity to the rescue? I doubt the Fed will let private equity firms control banks. The standard private equity business model doesn't fit the banking industry.

But if they did allow PE firms to rescue banks, they should do it with tight regulations and with the condition that public pension funds co-invest along with them at substantially lower fees (0.5% management fee and 5% performance fee instead of the regular 2 and 20).

The way I see it, the large hedge funds and private equity funds made billions off public pension funds during the great pension con job. Mr. Asness publicly denounces the President of the United States but he neglects to mention that it was the pension contributions from GM, Chrysler and millions of other workers in the private and public sector that enriched him and many other fund managers that collected their hefty fees.

What I would like to know is who is looking after the best interests of those common workers? Do they even realize they are getting bullied from all angles, including by their pension plans?