The importance to Wall Street of a handful of large hedge funds was starkly illustrated by the disclosure that Citadel Investment Group paid more than $5.5bn in interest, fees and other investment costs last year.
More than 90 per cent of the investment expenses represent interests payments, including the cost of the roughly $100bn of net debt provided by investment and commercial banks. Citadel had gross assets at the end of August of $166bn, representing leverage of 12.5 times.
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Senior Wall Street executives on Friday expressed surprise at the high interest costs and Citadel’s willingness to reveal the leverage of its funds.
tomorrow the nytimes will regurgitate this story with the headline: "citadel interest expense rivals goldman's net income". no doubt the nypost will retaliate with an article comparing the magnitude of citadel's "debt load" with that of general motors (indulge me and pretend cerberus/GMAC never closed). and somehow someone somewhere will tie it all into the necessity of hedge fund regulation. $100b! these hedgies are out of control! ssdd, indeed.
truthfully, i cringe only because the $5.5b figure is altogether meaningless. the financial times itself hints at the answer:
Citadel also has huge interest income which in the current year is running slightly ahead of payments.
most of the expense number is just a passthrough of interest income. consider my (sadly hypothetical) hedge fund. armed with $10b in investor capital but no real ideas of my own, i invest $100b into floating rate bonds that pay a coupon of LIBOR+100. my PB (goldman) finances this and charges me LIBOR+50 on the $100b of principal, while paying me LIBOR on my $10b of margin. assume a LIBOR rate of 5%.
over the course of a year, i receive $6b in interest income on the bonds, and $500mm interest on my margin. of that, i pay $5.5b in interest to goldman. voila! we've recreated part of citadel's income statement. so far so good...
and now to complete the picture: my PB also has a cost of capital; goldman would never condemn $100b of partner (shareholder, if you must) capital to LIBOR+50 hell. so that money is borrowed, at somewhere in the ballpark of LIBOR. goldman pays out $5b in interest, and keeps $500mm for itself.
$500mm is a hefty sum, no doubt. but it's also an order of magnitude smaller than $5.5b. moral of the story? headline numbers are deceptive.