That kind of leverage is the direct outcome of the 1% interest rates the Fed ran for a while (banks borrowed at 1%, lent to the hedgies at 4-5%, pocketing a nice spread, and the hedgies used that cheap money to run their own leveraged speculation ...) They get 20% of the upside if they win, and get to walk away if they lose.
The net result is a transfer of wealth from productive classes of society towards speculative classes. This is what primarily caused the heightened inequality we witnessed in the last several years. I say all this as an entrepreneur with a libertarian bent.
From an individual point of view, it is perfectly rational to speculate this way. It is the Fed policy that created the incentives to speculate.
My point is that Wall Street riches have not been fairly earned in a capitalistic marketplace, but in an artificial environment fostered by the Fed.
People have found ways to lever themselves rather through derivatives, rather than simple borrowing of cash... e.g. if you want levered exposure to a portfolio of high-grade corporate bonds, you don't borrow money and invest in cash bonds. You get an investment bank to structure a bespoke synthetic CDO tranche which, according to your single-factor Gaussian copula model, gives you exactly the risk and return that you want. If you want levered exposure to interest rates, you don't borrow money and speculate on Treasury notes; you pay (or receive) on an interest rate swap whose notional amount is far greater than the amount of cash you have. With the current state of derivatives regulation, people will be playing these games whether Fed funds is at 0% or 10%.
I will grant you that giving fund managers a call option on their returns isn't a great idea. It has the advantage of being cheap, since the value of a call option is less than the underlying. But at the same time, the value of a call option increases in value as the volatility of the underlying increases. So not only do hedge fund managers have incentive to get good returns, they have an incentive to get volatile returns as well -- this leads to perhaps more risk-taking than is necessary.
Edit: and the funny thing is that JWM Partners, Meriwether's post-LTCM fund, is supposedly down 20% this year. To be fair, they apparently did a pretty good job from 2000-2008 or so.
Yet, banks have freely lent to them, because they could, in turn, borrow from the Fed. The Fed (i.e us taxpayers) have operated as the ultimate patsy in the system, providing a one way bet to the speculating class. The evidence of it is the relentless expansion of the total credit in the system (as a percentage of GDP). Literally, the Fed has allowed the creation of total system-wide credit at 2-3 times faster rate than GDP growth, for many, many years running.
No matter what happens now, most hedge fund managers got theirs. As has already been observed, 8 years of feverish levered returns followed by one year of total wipe-out of capital still makes the managers ahead!
Regardless, it still makes plenty of economic sense for a bank to lend to a hedge fund, whether or not the Fed is involved. This type of lending is typically short term and rolled over as loans expire. If a bank lends to another bank, it only receives LIBOR, but if it lends to a hedge fund, it can charge slightly higher, say LIBOR + 40bps. Given that the bank itself can borrow at LIBOR, this is a decent way to make money. It's really no different than short-term lending to any other kind of corporation.
I won't deny that credit has greatly expanded lately. I just don't think the expansion of credit to hedge funds has much to do with the Fed.
Here is why finance has changed so much and become such a big deal since the early 90s:
The TMS is heterodox measure, but it has been in use for years.
I don't think it's quite true. Most of the people I work with are pretty smart, but I haven't come across too many geniuses (I am certainly not one). Wall Street draws different types of people: the type of "talent" attracted to a corporate finance/investment job is very different from the type of "talent" attracted to trading. Different kind of intelligence, different tolerance for risk, different personality.
One thing is for certain: investment banks and hedge funds aren't going to be hiring as many people in the next year or two.
There are exceptions, of course, but the average fresh-out-of-college Wall Street employee isn't having much fun.
There's an element of risk-transference in the high financial industry salaries. When times are good, lots of money flows into the financial industry, which props up salaries. When times are bad, firms go under, people get laid off, and salaries drop. However, the loss is never entirely born by the employees - after all, somebody out there lost all their principal because Bear Stearns imploded. So on average, Wall Street employees will make more than people in steadier, more risk-free jobs.
Same goes for entrepreneurs, for that matter. If the company does well, they get multi-million-$ payouts. If the company folds, their investors bear part of the loss. So on average (mean), an entrepreneur will do better than an equivalent employee, even though on average (median), the entrepreneur ends up with nothing.
It's not "Society" that is sending people into jobs in banks, it's individuals making individual decisions to accept individual contracts. That's their right, as it should be and there is no act of theft involved.
I don't understand why this chap feels that he should object to that. Nobody's forcing him to do it.
The paragraph that begins "It helps that investment banking has a low barrier to entry" doesn't make a point, nor does the one following.
Perhaps some of the statisticians will come back to work on fundamentally (as opposed to monetarily) interesting problems, more of the sharp deal-makers will again be available for non-financial-sector positions, and the equilibrium to which the author alludes will briefly allow for a bit of overcorrection in favor of societal benefit.
It's a bit optimistic, to be sure, but not impossible.
Is it possible to attract such talent in NYC through a great start-up working environment (like described in Joel on Software) while paying less, or are money and prestige too though to beat?
This is the part of the argument with which I take issue. Allocation of investment is the heart of a capitalist economy. In a socialist economy, investment is dispensed from a central location. In a capitalist economy such as ours, where there are many competition-driven individual firms, we benefit from each of them making wise investment decisions.
Investment firms literally decide how we spend our accrued wealth. I can't think of a better place to send our best and brightest.
Allocation of capital is at the core of a capitalist economy. That's not what most people in finance are doing. They are speculating with funny money. There isn't really that much actual capital involved; savings rates are abysmal after all.
In 2000, there were 100+ optical networking companies in the 10 mile radius around Palo Alto. That was the result of that period's credit bubble, which worked its way through credit -> stock market/debt market -> telecom companies -> start-ups.
There are a lot of smart people there, but also many people with advanced degrees that are more book smart than street smart. So they sell book-smart snake oil, or help others do that indirectly via a stable of credentialed eggheads. (Cf Nassim Taleb on derivatives shenanigans.)
Street smart is a lot more important than book smart on wall street.
Too bad I'm so book smart :)