Though the title of his history of hedge funds — More Money Than God — might sound a bit extreme, Sebastian Mallaby had his reasons.

“J.P. Morgan was known as Jupiter because of his godlike power over Wall Street,” Mallaby explained to the crowd at MOCA Grand Avenue. The titan had at his death in 1913 $1.4 billion in today’s dollars. “A lot of characters around hedge funds make $1.4 billion in a single year.”

In an event presented with the UCLA Burkle Center for International Relations, Mallaby, a senior fellow at the Council on Foreign Relations, explained how hedge funds came into being, what exactly they do, and why they may actually be good for the economy.

From Marxist to hyper-capitalist

Mallaby began investigating hedge funds because they were to him, as they are to so many, “the bastion of secrecy.” They also exposed what he described as an “interesting double standard in American culture.”

“Americans like entrepreneurs,” said Mallaby, who has lived in the country for 15 years. But they prefer, say, West Coast software start-ups to East Coast hedge funds. “People think that hedge funds are the most unstable and toxic and destabilizing part of the financial system. The opposite might be true.”

Hedge funds began somewhat unexpectedly with one Alfred Winslow Jones, Mallaby said – an anti-Nazi activist who attended the Marxist Workers School in Berlin. “An interesting place for the future inventor of hyper-capitalist hedge funds,” Mallaby said. Jones worked for the State Department in clandestine operations in Germany before heading to Spain, witnessing the Civil War and hanging out with Ernest Hemingway. The illustrious career and expertise in secrecy made him something of an ideal held hedge fund creator. And he got an assist from his lawyer, Mallaby said, who set up the tax structure that lets hedge fund managers pay a capital gains tax rather than an income tax on their profits.

Skin in the game

Jones invented a new kind of investment vehicle, Mallaby explained, where everyone who works at the company has to put his own savings in the fund. “They have skin in the game,” Mallaby said. They also receive one-fifth of profits, creating strong incentives to innovate and create new  ways of making money.

And of course, hedge funds hedge. They’ll bet on General Motors to go up, Mallaby explained by way of example, and Ford to go down. “You don’t care whether the S&P goes down because you’ve hedged it out,” he said. “You don’t care if the car sector sells more or less vehicles.” Finally, hedge funds leverage, using borrowed money.

You think your boss is bad

Beginning with Jones, hedge fund managers became the “it boys” of capitalism, Mallaby said. In the 1970s the flashiest among them was Michael Steinhardt, a Wharton-trained analyst who liked to smoke two cigarettes at once. “When he lost his temper, which was often, he would start to go red around here in his face,” Mallaby said, pointing at his chin, “and it would rise up.” Steinhardt set up an intercom system so that he could broadcast his tirades against one employee to all his colleagues. One poor soul who made a bad sale confessed to Steinhardt that he wanted to kill himself. “Michael Steinhardt said, ‘Can I watch?’” Mallaby said. “So he was a tough guy to work for.”

But Steinhardt made money systematically over two decades, buying and selling huge blocks of stock when ordinary traders didn’t have the capital to do it. He had the liquidity that big savings institutions sought. Mallaby explained that, for instance, Steinhardt would get a call to buy 400 shares of IBM. He’d agree, as long as they lopped one dollar off the price of each share. If the seller refused, Steinhardt would begin selling the stock in what’s called a front-run trade, Mallaby explained, pushing down the price and buying it back at a profit 30 minutes later. “This was a system for just coining money,” Mallaby said.

The Nobelist who bet against his theory and won

Also about 40 years ago, the Nobel laureate Paul Samuelson helped set up the Commodities Corporation. Samuelson preached that markets were efficient because they moved completely randomly and were impossible to beat. His philosophy? “The average professional money manager would contribute more to society if he gave up and became a plumber,” Mallaby said. But Samuelson also “gave his money to the Commodities Corporation and said, ‘Please go beat the market,’” which it did. The company studied detailed price data to discover that if prices moved up in, say, two hours, they were likely to move further up in the next two hours. “You buy stuff that’s going up. You sell stuff going low. On average you’ll make money,” Mallaby said. Program a computer to do the work, and that money multiplies. “Paul Samuelson put money in a program that was the opposite of his own theories.”

Many investors today follow his lead, employing computer programs modeled on everything from military code setting to language translation programs. “You have to believe that you know more than the market,” Mallaby said. “If you’re going to bet you’re smarter than that, you have to be very smart.” And while the gospel is that markets are efficient and unpredictable, Mallaby said, “Those who know they aren’t are sunning themselves on some nice beach and not telling anyone else about it.”

No hedge fund talk would be complete without a mention of George Soros, whom Mallaby called “one of the most notoriously schizophrenic people I’ve ever had the pleasure of getting my mind around.” Even as his fund bet on the decline of the Thai baht in 1997 and almost induced it to go down, Mallaby said, Soros turned around and advised the South Korean president on how to beat speculators that same year.

Small enough to fail

Despite the personalities, the secrecy, and the big profits, hedge funds actually stabilize the financial system, Mallaby argued.  In 2007, as other investors lost money, hedge fund profits were up 10 percent, largely because they didn’t invest in bad asset-backed securities – subprime mortgages – because they had done the costly research on them. As the crisis deepened hedge funds were down only half as much as the S&P 500. And when they failed, Mallaby said, “They’re not too big to fail. They were small enough to fail.” In a good year, 800 go out of business; in 2008, 1,500 went out of business, Mallaby said during Q&A. “You want people who put a million at risk to be at risk. You don’t want the losses to be absorbed by taxpayers.” Hedge funds received no bailout money, and most investors get 100 percent back on the dollar, protecting the rest of the financial system from contagion. And even hedge funds’ secrecy is somewhat natural, Mallaby argued, in a system that offers patents for software or pharmaceuticals but not for financial innovations.

“Pivot away from the train wrecks of banks,” Mallaby said of regulators. “Look over here to the part of the system that worked, and be happy if more capital and more risk flows into that part of the financial system.” Mallaby predicted that hedge fund assets are  going to triple in the next decade, just as they did in the last.

But if hedge funds start to resemble bigger investment vehicles, Mallaby said in Q&A, different rules should apply. “If they look like an investment bank and they act like an investment bank, they should regulated as an investment bank.”

Watch the video here.
See more photos here.
Read an excerpt of the book here.
Buy the book here.
Read Sebastian Mallaby’s In the Green Room Q&A here.
Read the experts on what’s missing from financial reform here.

*Photos by Aaron Salcido.