Private Equity and Hedge Funds

Washington Post business columnist Steven Pearlstein was online Wednesday, March 21 at noon ET to discuss private equity and hedge funds that are going public.

Read today's column: Making a Play For the Dumb Money.

A transcript follows.

About Pearlstein: Steven Pearlstein writes about business and the economy for The Washington Post. His journalism career includes editing roles at The Post and Inc. magazine. He was founding publisher and editor of The Boston Observer, a monthly journal of liberal opinion. He got his start in journalism reporting for two New Hampshire newspapers -- the Concord Monitor and the Foster's Daily Democrat. Pearlstein has also worked as a television news reporter and a congressional staffer.

His column archive is online here.

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Silver Spring, Md.: Steve - I have a very simple question, but let me set it up here.. The way I view economics is that currency is just a complicated way of trading my talents and skills for little bits and pieces of many other people's talents and skills. I think that's fairly straight forward, difficult to disagree with? So everytime we talk about a good economy, a bad economy, a bubble, etc.. etc... all it really means is that we've misinterpretted the way we balance the supply and demand for various talents and skills. The actual economic output of the country typically doesnt change as violently as the stock market and it doesn't burst like the tech stock bubble. When the "economy is doing poorly" it has little to do with me designing few electronic circuits or designing them any less efficiently or with the farmer who supplies my local giant producing any less or the builders who built my apartment comples working any less efficiently. All that being said, what do you consider to be the actual indicators of long term economic health and viability? So many "economic indicators" seem to describe nothing but the fluff that we use to describe the economy and not the economy itself.

Steven Pearlstein: You raise some interesting questions and issues. There is a significant difference between the real economy, where people make widgets, and the financial markets, where financial assets are traded. That said, they affect each other in significant ways, which are changing over time. Some bubbles straddle the line, like housing: people do produce real houses, but the value of those houses can be artificially high or low because of what is happening in the credit markets. And if prices rise and people start taking equity out of houses for present consumption, then that affects the demand (and probably supply) of goods and services. The bits and pieces of talent construct probably isn't a good way to think of this.

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Berlin, N.Y.: Elaine Supkis, Economics editor, Culture of Life News: Steven, we now know nearly all if not all 'hedge funds' are actually entities exploiting the Japanese yen as 'carry trade' whereby they use the differential between the interest rate for loans in yens which is ridiculously low and use it to buy other higher-yield instruments. Due to all this, the FOREX reserves of Japan (China is imitating Japan here) have shot up to a trillion dollars while our own funds have been falling from a mere $86 billion to $66 billion and dropping. Why didn't our officials attack Japan for running this scheme which is destroying our industrial base and our reserve funds? Why did they attack only China who has been raising interest rates and raising the value of the yuan? And when will Congress investigate hedge funds for destabilizing the dollar vis a vis the yen?

Steven Pearlstein: There was some concern about Japan a few years back when it was manipulating its currency, to make sure it didn't rise. But we were muted in our criticism in part because we realized that it was important for the world economy for Japan's economy to recover and deflation to be slayed, and the currency manipulation and low interest rates were part of that. The unpleasant side effects in terms of the carry trade came with that package. Now, Japan is said not to be manipulating its currency, but the carry trade is helping to keep the value of yen down against the dollar, so intervention is not needed. But the problem, as you state it, remains. The only solution is to push Japan to start raising its interest rates, which it has now begun to do.

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Arlington, Va: Steven,

This article states that investment flows into the US has turned negative for the first time since 1929

http://www.financialsense.com/editorials/weiss/2007/0319.html

"Even investment inflows - which had been positive in every single year since the great crash of 1929 - have turned negative. Instead of investment money flowing into America to the tune of $11.3 billion in 2005, now it's flowing out, with $7.3 billion leaving last year alone."

Is this another sign that our markets are in a world of hurt ?

Steven Pearlstein: It is a bad sign that the U.S. now, on a net basis, pays out more in interest and dividends to the rest of the world than it earns in interest and dividends from investments abroad. This is the consequence of running huge trade deficits over an extended period. Its not a healthy sign, although it's hard to connect it to the volatility in the financial markets. It does, however, make the markets more vulnerable to a shift in sentiment regarding interest rates or the dollar.

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Bowie, Md.: I suspect today's topic about hedge funds isn't going to take the full hour, so could we go back to mortgages; specifically your column Friday and Saturday's about minority lending.

Apparently there's some basis for the assertion that unsophisticated borrowers were steered into worse products than they could have obtained.

Now, because of the inverted yield curve, a lot of fully indexed ARMs are at higher rates than fixed-rate 30-yr mortages. (With T-bills and short-term constant maturities at about 5%, a lot of indexed ARM's should be at about 7.5 percent, while 30-yr fixed are available at about 6-6.5 percent)

It seems to me that any owner who can pay a 6% mortgage should be converted to one; and anyone who can't, shouldn't be in their home.

washingtonpost.com: Help for Homeowners, Not a Bailout for Mortgage Pushers (Steven Pearlstein, March 16); High-Cost Home Loans More Common in Pr. George's (Kirstin Downey, March 17)

Steven Pearlstein: Careful, that wasn't minority lending I wrote about, but lending to households with blemished credit histories. Not the same thing by a long shot. Not sure about the impact of the inverted yield curve -- I though most of mortgage lending and rates, including ARM rates, are keyed off the 10 year. But I could be wrong.

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New York, N.Y.: I recently read an interesting point (can't remember where) indicating that one of the many reasons private equity firms have such incredible profits is that they are taxed at a capital gains rate, rather than as an operating company. Although they do have some potential gains, even the fees earned for managing others' money was being taxed as a gain, even though no capital was at risk (according to this piece, anyway).

Steven Pearlstein: Not sure if that is a factor in their relative return on inivestment against other investors. But it is an issue now, whether the Blackstone and Carlyle partners will be forced to record their "carrY" (their share of profits earned by the fund) as capital gains rather than ordinary fee income. The fact that it varies according to trading gains make it appear a bit like a capital gain. But the fact that they have no downside risk makes it more like a fee. To my eye, the fee argument ought to win out. But since this will probably be decided by Congress, I wouldn't count on it.

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Boston, Mass.: Help for home owners? How much more help do they need? The mortgage interest deduction is more than enough help as it is. I really don't understand the idea of helping people who took risks and are now getting burned. No one forced them to take the loans, or take second mortgages instead of making down payments. Bailing people out will only make them take more risks in the future. The market is working, risky lenders are going under, people who can't really afford their houses are getting the boot, and the 'housing bubble' is slowly deflating. Media driven government regulation will just ensure that the many are shut out of the housing market to help out the few.

Steven Pearlstein: Yes, the market is correcting as we speak. We'll see what happens, and whether you think the social and economic costs of the correction are less than the marginal benefit from doing a bit better job of regulating the industry and trying to restrict credit to those who can truly handle it. You or I can't debate that cost and that benefit yet because we don't know the costs. But I would say that, as a matter of historical precedent, we have regulation of financial and credit markets today because of past bubbles and bursts, and we decided as a democracy to move away from a pure, pure free market model to one that involves some regulation. Your argument is that its all a mistake and that markets are self-regulating in a way that maximizes social and economic welfare. Politically speaking, that is a minority view.

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Re: US money flows : I think that numbers needs to be taken with a grain of salt. Hedge funds(at an all time high) assets are not regulated, therefore their assets(in flows) cant be measured accurately.

Steven Pearlstein: I think the inflows can be managed accurately. The current value of assets is another matter.

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Rockville, Md.:

I thought your article about funds going public was excellent. I used to be a lending officer and presently have a job that utilizes a significant amount of credit analysis. I've been amazed at how easily junk credits can get more financing than they want and at can get it at spreads that are very tight. I attribute this to the liquidity provided by the hedge funds. If this is a bubble, do you expect to see many large corporate bankruptcies in the near term as financing dries up? thanks

Steven Pearlstein: Not sure about that. The level of debt at some of these takeover targets is high and makes them vulnerable to an economic downturn. And if credit begins to dry up, it could make it harder for the private equity guys to refinance and get their money out quickly. The quality of the junk bond out there now, on average, is lower rated than just before the junk bond crash of the late 80s, but I'm not sure that tells you much.

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Steven Pearlstein: Thanks, folks. See you next week.

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