Deal Professor: Federal Reserve as a Hedge Fund: Higher Profits, Lower Pay

Harry Campbell

The year 2011 is over, and soon we’ll be hearing again about billion-dollar paydays for select hedge fund wizards.

If it makes you feel any better, not everyone is sharing in these riches. The people who operate the most successful hedge fund around are receiving a relative pittance.

That hedge fund is the Federal Reserve. Last year, the central bank turned over $76.9 billion in profit to the federal government, slightly down from $79.3 billion it provided in 2010.

The Fed made this money in interest on a nearly $3 trillion portfolio of securities. This enormous holding was built up largely in the wake of the financial crisis as the Fed bought these securities through two rounds of quantitative easing.

Deal Professor

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I call the Fed a hedge fund because it is operating like one, leveraging its balance sheet to earn huge profits. The main difference between a hedge fund and the Fed is that the Fed effectively creates its own money, so it doesn’t have any borrowing costs, meaning yet more profits. Remarkably, the Fed’s profits are also an afterthought. The Fed is trying to stabilize and increase the United States economy in the wake of the financial crisis, and its profits are a nice byproduct.

Still, these earnings blow away any other hedge fund profits.

The Fed employees who manage this operation receive a federal salary for their efforts. The money is well above the pay of the average American but still relatively modest compared with those in the financial industry. The top salary class at the Federal Reserve has a maximum of $205,570 a year. Ben S. Bernanke, the chairman of the Federal Reserve, earns $199,700 a year, while the other members of the Federal Reserve board earn $179,700.

Officers of the branch banks of the Federal Reserve system earn more. The president of the Federal Reserve Bank of New York, Treasury Secretary Timothy F. Geithner’s old position, receives $410,780. By my calculation, the 17,015 employees of the Federal Reserve received an average compensation of $87,579 in 2010.

Figures for 2011 hedge fund compensation are yet to be known, but compare the Fed’s salaries with the highest paid hedge fund managers in 2010. According to AR: Absolute Return + Alpha magazine’s annual list, the top 25 hedge fund managers made $22 billion, or an average of $880 million. The highest paid hedge fund manager in 2010 was John Paulson, who made $4.9 billion running a hedge fund that had about $33 billion in assets. (He is likely to make much less in 2011, with his funds falling as much as 52.5 percent last year.)

Hedge fund managers make their money from the “2 and 20.” Hedge funds generally charge a fee of roughly 1 to 2 percent on all assets under administration and take 20 percent of the profits. The idea is that this large cut will incentivize the hedge fund manager to earn outsize profits.

But federal employees who were paid astoundingly less made fantastically higher profits than any single hedge fund manager. The entire Fed payroll for 2010 was still less than Mr. Paulson’s 2010 salary. One man made four times more than the Fed’s 17,000 plus employees combined, and earned much less money.

The point is not that the federal government should go into the hedge fund business or that making money is relatively easy for the Fed. Rather, it is that these government employees did this service without demanding to be paid billions in compensation.

They are not alone. Treasury Department employees take on the similarly complicated, hedge fund-type task of supervising the economy for even lower pay than the Fed’s employees.

Even outside the federal government, there are those who are not paid enormous sums to perform the most complicated financial tasks.

David F. Swensen, the chief of the Yale endowment, for example, is one of the most successful asset managers in recent history, consistently earning outsize returns and often beating the best hedge fund performers. His salary too is much less than that of the hedge fund barons. In the last few years, his salary has ranged from $3 million to $5 million a year for managing Yale’s endowment, which is valued at about $20 billion.

Even so, people in private industry argue that you have to pay top dollar to get the best people and that the market demands it.

We even see this argument being made by the federal government. The regulator who oversees Fannie Mae and Freddie Mac, Edward J. DeMarco, has asserted that he had to pay the top six executives at Fannie and Freddie more than $35 million in combined pay over 2009 and 2010. He said that to do otherwise would be “irresponsible” because it would fail to retain and attract the appropriate people. Yet, the Fannie and Freddie executives are arguably doing even less sophisticated work than the Federal Reserve employees do.

Why these executives should be paid more than Mr. Bernanke and his colleagues defies reason. This is government work now.

These disparities show that compensation, like people, is a complicated issue. People are willing to forgo earnings for prestige and other benefits like job security. And perhaps top dollar simply does not need to be as high as those in the finance industry would want you to believe.

Perhaps more interesting, the Fed pay structure may show that the work that these hedge fund barons and other titans of finance and industry perform doesn’t require multimillion-dollar salaries — even when some claim that the market demands them. Perhaps they would be willing to accept lower amounts when push comes to shove.

This will happen only when the pension funds and other institutional investors recognize that a 20 percent cut of the profits paid to hedge fund managers is too much, and they push hard to lower these fees. In the private equity realm, the Institutional Limited Partners Association is leading a similar crusade, but no such movement has yet penetrated the hedge fund universe.

The Fed has unwillingly made billions, to the benefit of the United States taxpayer. The Fed and its employees have done it in a way that would make even the most ardent opponent of the Fed proud — at a low cost.

Article source: http://feeds.nytimes.com/click.phdo?i=477529b6be131e8c39d65a18d0413914