How Hedge Funds Helped The 1% Profit From The Great Recession

And now they're driving wealth inequality by attacking worker pensions.
Investor John Paulson, whose firm made $20 billion from the 2008 financial crisis, asking then-candidate Donald Trump questions at the Economic Club of New York luncheon in September 2016. (Seth Wenig/AP)

Investor John Paulson, whose firm made $20 billion from the 2008 financial crisis, asking then-candidate Donald Trump questions at the Economic Club of New York luncheon in September 2016. (Seth Wenig/AP)

  • Who did the banks owe all that money to in 2008?
  • Much of the billions of bailout money streamed from the taxpayers to the hedge fund investors- and was probably one of the largest single transfer of wealth from the 99% to the 1% in recent history.
  • What are the hedge funds doing now?

Lessening the ever-rising income and wealth inequality depends on our understanding of the role of hedge funds in creaming off wealth to the very top of the 1 %.

Hedge fund is the trendy name often used for pretty much any group of wealthy investors who pool their money and give control of investing it to a money manager. These groups may be called equity funds, investment or wealth management firms as well; earlier the money manager was often just called a stockbroker. I’m going to call all these just hedge funds for simplicity.

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Recall in 2008, both the commercial and investment banks bet billions with the hedge funds that the housing market would continue to increase. In making these dicey bets, the banks made no provision for a reserve in case they lost the bets. The premiums paid by the hedge funds went directly into bigger banker bonuses (of which they kept every cent). Thus the need for the bailout. The bailout money flowed from taxpayers through the banks, and with invisible ease, to the hedge funds.

Michael Lewis, in his movie The Big Short, gave us the fascinating tale of a few of the more colorful of these hedge fund managers. While we may have cheered at the comeuppance of the smug bankers who foolishly bet that the housing market would continue to rise, we should also realize that these bankers were using our deposit money, among other bank assets, as collateral for the bets that they lost.

A Geek Interlude: The betting instrument was the Credit Default Swap which is in effect simply mortgage default insurance disguised under a fancy name so it looks like high finance we can’t possibly understand. I have explained it in more detail in a previous article: How Bankers Made Billions From The 2008 Financial Crisis - And How They Could Do It Again.

Sometimes hedge funds perform banking functions such as lending money to large businesses. As such, they are sometimes confusingly referred to as non-bank entities. Because they are not subject to much government oversight, they are also called shadow banks as much of their operations are known only to themselves.

A Geek Interlude: Hedge is taken from the shrub we sometimes use to mark the boundary of our front lawns. In this context, it has the same meaning as to “hedge your bets”. The classic financial hedge depends on the fact that usually, the bond market increases if the stock market decreases. Investors then put some of their money in both. If the stock market drops, the bond market will increase thus offsetting some of the loss.

The ‘Greed is Good’ Core Motivation

Carl Icahn, a role model for Gordon Gecko (Reuters)

Carl Icahn, a role model for Gordon Gecko (Reuters)

Probably the best-known money manager is the fictional Gordon Gecko, played so realistically by Michael Douglas in the 1987 movie Wall Street. The appeal of that movie endures because it is, in fact, realistic. It was written by the son of a stockbroker (money managers were then mostly called stockbrokers) and modeled on a few that the son knew. One of the main character’s role models was well-known hedge fund manager Carl Icahn.

In the movie, Gecko uses insider information from his apprentice to take over a small airline. The airline could be saved with all employee jobs, but it would take a few years before the investors would see a return on their money. It was better from an investor point of view to wind up the business and sell the assets for an immediate profit. Gecko had no hesitation.

This maneuver was based on how Icahn had killed one of America’s largest airlines, Trans World Airways (TWA). Economist Larry Summers characterized this dismembering of TWA as “essentially a transfer of wealth from existing flight attendants…to Icahn.”

Or, as The Daily Beast once put it so aptly:

It was not a hedge fund manager who invented the iPhone, after all, but it was a hedge fund manager who ran TWA into the ground.

BTW: Gecko is the English pronunciation of the Afrikaans for a species of lizard.

Trump admires Icahn so much he was Trump’s first choice to head the Treasury Department as part of cleaning out the Washington swamp. Icahn refused, saying on his blog he didn’t want to have to get up so early.

The Corporate Raiders’ Playbook

Some hedge funds are merely passive investors. They search for good investments (‘going long’) and also bad investments (going short). Shorting is betting with another investor that a certain stock or something else, like a stock market index such as Standard and Poor’s or the housing market, will lose value. Profiting on someone’s misery. Hyena capitalism you might say. Indeed.

The antiheroes in The Big Short bet with the banks that the housing market would tank. At this point you might ask, it is clear that permitting shorting made these millionaires more money, but what good did it do for the rest of the country. Good question!

Some hedge funds do active corporate raiding. They, sometimes alone, or sometimes in cooperation with other hedge funds in wolf packs, acquire enough shares to elect their own nominees to the Board of Directors (BOD) of the target corporation. They have developed some standard- and very successful strategies- for looting a company treasury.

With control of the BOD, they can force companies to sell off assets for immediate cash that is quickly stripped out in dividends. By a favorite maneuver, they have the company sell its real estate and then rent those same buildings: immediate cash bonanza for dividends and buybacks, but long-term future higher costs–when these shareholders will be long gone. Or, a plus, they will be the landlords who get the benefit of the prime locations for redevelopment. Because it distributes generous dividends, the hedge funds have the company take out loans to meet its operating costs. Often the money is borrowed from a company owned by the hedge fund. The company gives that lender a lien on corporate assets ahead of other creditors so the hedge fund gets repaid in priority and there’s little left for other creditors in bankruptcy.

And, they can have the company borrow to do buybacks at inflated prices.

They justify their actions on the well-accepted purpose of the corporation, which is to provide ‘shareholder value’ above all else. A corporation has no responsibility to the country which gives it the opportunity to operate; nor to providing employment for that country’s citizens; nor to the workers whose labor is essential to those profits; nor to protect the environment of that country. Its sole responsibility is to create wealth by ruthless capitalism and pay it to its shareholders. That is the operating premise of many corporations since the idea was promoted by prominent economists such as Milton Friedman.

And please note, these hedge fund shareholders are not the shareholders who bought to support two guys in a garage in a risky new company. They are only buying in after the company is well-established. They buy from other shareholders, so the money does not go to the corporation. So how the shareholder value people justify saying that the sole purpose of the corporation is to benefit the present short term shareholders is a mystery.

In the days of Gordon Gecko, these guys (mostly male) were accurately called corporate raiders. However, their public relations people soon convinced the media that ‘raiders’ was a judgmental term; media should be value-neutral and call them activist shareholders – as if they were in the same class as, say, environmental activists. And so the media complied.

How To Make Money By Going Bankrupt

It’s actually quite easy if you are wealthy. Here’s how it goes. They are called engineered bankruptcies for good reason. The controlling shareholders, through the BOD, cause the corporation to seek Chapter 11 bankruptcy protection.

Geek Point: Note it is critical that Chapter 11 is used so no bankruptcy examiner, who is independent, is appointed to manage the business and report to creditors. Under Chapter 11, the CEO is left in place to run the show. For examples of the devasting effect on executives possible when a bankruptcy examiner is in charge, recall Enron and Worldcom. Want more on this, see my article Exposing The Enablers Of Corporate Corruption here.

Then the vultures descend as buyers hungrily swirl around the corporate carcass hunting for a killer deal. Most assets of a corporation sold through bankruptcy are likely to realize only about, say, $.10 on the dollar. After the sale, the proceeds are divided up among the creditors.

So, the controlling shareholder, who know the true value of those assets and the entire business operation, will bid $.11 and buy them up at an 89% discount. Now they have these assets free and clear of all creditors and, especially, pension obligations to workers.

If you follow these hedge fund maneuvers, you will see that when the target corporation is brought to the verge of bankruptcy, the executive pensions are fully funded. It is only the workers’ pensions that take a hit. The solution is simple: pass a law that if the workers’ pensions are not fully funded, as all executive pensions are, the executive pensions must make up the shortfall. Then, we will have fully funded worker pensions - no problem.

How to hedge funds use these tricks? We’ll look at the recent Sears bankruptcy in my next article.

For more on the banking system follow Jan at and on Twitter @JanWeirLaw

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News // 2008 Financial Crisis / Finance / Income Inequality