The Misplaced Regulatory Focus on Hedge Funds

Question: Did you assume that financial institutions like AIG were too big to fail? (Scott Sumner, Money Illusion)

Peter Thiel: I certainly thought that things were more fragile before the crisis in 2008 than a lot of people did. I underestimated quite how fragile they were. And so, while I think there was definitely a risk of big institutions failing, it was surprising that they all failed, more or less, in one week. That was certainly something that I did not anticipate it happening all at once.

Question: Which regulatory suggestions floating around Congress threaten hedge funds the most and why? (Dan Indiviglio, The Atlantic Business Channel)

Peter Thiel: I believe that the regulatory focus on hedge funds has been extremely misplaced and that people have been way too focused on hedge funds as the culprit rather than the larger financial players, such as banks, insurance companies, pension funds, and a variety of much more conventional financial institutions that went badly wrong.

I think part of the reason for this misplaced focus on hedge funds can be traced back to the long term capital disaster in 1998 where excess leverage threatened the entire financial system and the place where leverage showed up was in this unregulated vehicle, e.g., long term capital, but then all of a sudden impacted everybody else in unforeseen ways. And so, in some ways, since '98, the regulators have been fighting the last war and worrying about hedge funds that were excessively leverage and would blow up the system.

I think hedge funds were not excessively leveraged; even the funds that used significant leverage did so in a way that was relatively transparent and known to their investors and were perceived as high risk. The problem is not with leverage, both hidden leverage and hidden leverage existed in places like the large money center banks, AIG, the insurance companies, and perhaps the biggest of all were Fannie Mae and Freddie Mac, which were seen as relatively safe because of some kind of implicit government guarantee, but were in reality long term capital on a much bigger scale. And the real long-term capital was Fannie Mae. It was not the hedge fund industry.

It would seem like the main lesson should be that we should be most wary of institutions that are close to the levers of political power because those are the institutions that were able to abuse the political system and prevent an investigation of the kind of corrupt practices and wrong doing. Again, exhibit A of this is, Fannie Mae, Freddie Mac, the big government-related mortgage companies. And I think one of the lessons, and it's hard to know where one goes with this, but one of the big lessons of this crisis is the way in which regulation tends to be pro-cyclical. So, when everything is going well, we deregulate and we get – the boom gets to be even bigger. And when things are going badly, we regulate and make the bust get even worse than would otherwise would be.

And in theory, you want politics and government to be counter-cyclical factors. In practice, they end up being pro-cyclical because government gets captured by corporations and special interest groups that use it to advance agendas that are detrimental to the larger society.

Question: Is there too much emphasis on "going public" in the United States? Should more firms be privately held? (Arnold Kling, Econlog)

Peter Thiel: The question about what's the right number of public companies and what’s the right number of companies to be going public I think is very important. There are obviously far fewer companies going public today than there were ten years ago. The IPO window is almost closed and I think in part, this is a response to Sarbanes-Oxley to the ways in which being the CEO of a public company is simply no fun anymore. They're subject to insane levels of scrutiny. You're not able to pursue any sort of multi-year corporate strategy and instead you are held to a quarter-by-quarter earnings schedule which is ultimately quite detrimental to long-term planning.

I think that we are best off with a society in which companies are able to plan for the long-run and we have to acknowledge the fact that that a lot of publicly held companies have incentives that are going very much the wrong way.

Question: What is John Paulson’s advantage in exploiting future inflation by buying gold? (Arnold Kling, Econlog)

Peter Thiel: It’s very unclear where the economy is headed from here. I tend to think people exaggerate the inflation risk although this does not necessarily mean that gold is a bad investment. One needs to think of gold as not a protection against inflation, but as an anti-investment. You invest in gold when there's nothing good to invest in. And if you believe in inflation, you should probably be investing in land in India, or some sort of inflationary asset that does really well if you have crazy runaway inflation. But if you believe that it's going to be very hard to make good returns on investments, and that could be an inflationary environment or it can be a deflationary environment, then gold become relatively attractive. Gold does less well when you have high real returns like you did in the 1960's, or to some extent the '80's and '90's.

Recorded on December 7, 2009

Directed / Produced by Jonathan Fowler

Peter Thiel explains that the real problem lies with hidden leverage.

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