Kenneth Griffin, Founder & CEO, Citadel (Economic Club of Chicago, 5/20/13)

The slate is approved, and thank you, Michelle, and the nominating committee for bringing in such an excellent slate of candidates. And we also want to express our appreciation to those directors and officers who have served this past year. I am particularly excited to have my close friend, Ken Griffin, as our speaker tonight. Ken graduated from Harvard in 1989 and came to Chicago that year to join Glenwood Partners. He started Citadel in 1990. Today, Citadel is one of the largest and most successful hedge fund firms in the world and the largest in Chicago. Citadel is well known for some of its bolder moves, acquiring Amaranth's portfolio in partnership with J.P. Morgan in 2006. This was done over a few days after Amaranth had lost billions of dollars, more than two billion, in a two-week period alone on natural gas bets gone astray.

The rescue of E-Trade in the fall of 2007, which included a two billion capital infusion led by Citadel. And Citadel has become the largest equity and options market-making firm in the U.S. markets, if not the world. Ken is an active supporter of causes that drive community improvement, and he serves on the board of directors of the Chicago Public Education Fund, the Art Institute of Chicago, and the Museum of Contemporary Art. Ken is a member of World Economic Forum, G100, and the Civic Committee of the Commercial Club of Chicago. And Ken is also a director of The Economic Club of Chicago. Please help me welcome Ken Griffin.

John, thank you for the kind introduction. I'm delighted to be here tonight to share with you the history of Citadel: how we rose, how we prospered, how we nearly failed, and how we recovered to prosper again. I'm going to focus on three important concepts, three themes that are part of our story: the importance of talent, the importance of execution, the importance of taking decisive action, and how these three themes can guide us in achieving the mission of The Economic Club of Chicago, which is to address the important economic and social questions of the day. Before I begin with the history of Citadel, I think it might be helpful to share a bit about myself. Let's take a journey back through time.

Yes, this is me on the beach as a young boy with the business section of the paper. And here's a report that I wrote in sixth grade where I set out to understand how the stock market works. I'm still working on this 30 years later. And since my teenage years, I've had a love for computers. Next to the definition of geek, you could find my picture. In fact, here it is. Yeah, I do look like a geek there. In 1986, I went off to Harvard to study economics. And in the middle of the winter, there was a great story published in Forbes about Home Shopping Network. Now, Home Shopping Network was going to change the world, or so said the bulls, who bid the stock up 500% from the time of the IPO. But the author, Gretchen Morgenson, made a compelling argument that the stock was a fad and ripe for a correction.

I really liked her argument, and I bought two put contracts on Home Shopping Network, effectively betting the stock would fall. And fortuitously, within days of doing so, the stock did collapse, and I made a few thousand dollars, which, as a college freshman, that is all the money in the world. Now, when I went to liquidate my options, the market maker paid me $50 less than their intrinsic value. And his trading approach really got me interested in learning about the pricing of derivatives. I used to walk across the river to Harvard Business School, where I'd spend hours in the library reading books on derivatives and trying to understand the pricing and financial theory behind derivatives. And I came across a strategy known as convertible bond arbitrage.

Now, I'm in Boston. I'm a kid in college. I'm pretty resourceful. I called a broker at First Boston to ask for advice on this strategy that I came across. And this gentleman, Doug Snyder, was quite generous with his time. He said, 'Look, this is really not a strategy that our clients do, but the firm does it with their own money.' Now, I may have been young, and I may have been naive, but I was no fool. If this is good enough for the firm's money, this is what I want to do with my money. So, with two friends, we started a small hedge fund in 1987. We raised $265,000 from friends and family. And yes, I started it in my dorm room. Now, I was armed with all the modern technology of the day. I had a fax,

I had a phone, I had an IBM PS/2 personal computer. And it is true, I put a satellite dish on top of the building, ran the cable through an old unused elevator shaft, pulled it through a window and into my dorm room so I could have real-time stock quotes. I had all the technology to begin my career as a hedge fund manager. And it was the perfect fit for me. It was a chance for me to marry my interest in the markets with my passion for technology, technology that was used to compute the pricing relationship between convertible bonds and the underlying stock. Now, we started just weeks before the crash of '87. I didn't see the crash coming, but the portfolio that I had built would benefit from periods of market volatility, and volatility I did have.

The portfolio did well, and people took note, and soon we were managing a million dollars of capital. Now, as I approached graduation, something very fortunate happened in my life. I was introduced to Frank Meyer, a fellow Chicagoan. Frank was the co-founder of Glenwood Partners based here in our great city. He was also a pioneer investor in hedge funds. And he offered me an opportunity to come to Chicago and to join him at Glenwood. It was a pretty simple proposition. I could manage a small pool of capital for Glenwood. If I did well, I could leave. I could start my own firm, and he'd be my partner in doing so. If performance wasn't so good, I would pick a different path in life. As he said, 'You can always go back to business school.'

But Frank offered more than capital and more than moral support. He gave me great advice. He said, 'Don't focus on just a single investment strategy. Focus on building a firm, a platform that attracts the best and brightest people, and that deploys capital across an array of investment strategies. Think big.' And I took his advice to heart, and I spent a lot of time focusing on hiring the best and brightest people. Well, with Frank's support, in November of 1990, I did launch Citadel. And within a few short years, Citadel was engaged in a wide variety of investment strategies, such as Japanese Equity Warrant Arbitrage, Merger Arbitrage, and Statistical Equity Arbitrage. Let's talk about what hiring the best and brightest looks like in practice.

There are great stories. In 1998, for example, Jamie Dimon shut down Salomon Brothers' legendary fixed income trading team. And we swooped in and hired five of the seven most senior people from that team. In 2001, Enron collapsed. And the day they filed for bankruptcy, we flew 16 people to Houston to interview every single talented person we could get our hands on. And we picked up some really incredible people. There's a great Enron story. One of the senior professionals there who ran a big part of the trading floor, she stood up on top of her desk that morning and told the employees at Enron that they would survive, they will persevere, they will make it through this crisis. And as she's telling this story with all of her heart and soul, behind her on the TV is the breaking news story of their bankruptcy filing.

It wasn't really her finest moment. But shortly thereafter, we went to Aquila, which had shut down their energy trading operation, and we did something quite unconventional. We paid the company a few million dollars to be able to interview all 600 of their energy trading professionals. And again, we picked up some really incredible people. And they helped us build what is today one of the most successful energy trading operations in the world. And then there's just plain effort. One of my business heads kept meticulous records of the interviews that he conducted over the course of a decade. In 10 years, he interviewed 5,000 people.

That works out to two a day.

A day in his life: research, trade, manage, interview, repeat. But talent is everything. And if you want to build a great business, I think you need to heed the advice of Jim Collins: get the right people on the bus, the wrong people off the bus, and the right people in the right seats. And the right people are capable of great accomplishments. On a Sunday morning in the summer of 2007, one of my partners received a call from one of the two heads of Sowood Asset Management, a competitor of ours based in Boston. Sowood had a very large and complex book of credit-related instruments. And as the credit crisis started to unfold, they found their portfolio did not behave as expected. They had lost hundreds of millions of dollars in the blink of an eye.

And they needed to liquidate almost all their portfolio before the open of business on Monday to meet margin calls. We assembled a 50-person team as fast as we could. We flew eight people to Boston to facilitate due diligence and information sharing. To acquire some or all of their $30 billion portfolio overnight was going to be a Herculean task. Now, Sowood had brought in another large bank to provide a competing solution, or potentially to partner with us. We worked feverishly through the day and into the night, and I still remember that night, the senior point person on the deal from the other bank calling me from what I'm sure was his beautiful house in Greenwich. And it was certainly a beautiful house in Greenwich.

And he said, look, it's getting late. This isn't going to get done tonight. I'm heading off to bed. I'm telling my guys to go home. And we'll pick this up in the morning. And I said, there will be nothing to pick up in the morning. We're going to get this done. He sort of laughed and hung up. 6 AM, before the opening of the markets, we bought that entire portfolio. We bought the entire portfolio. Solve Sowood's crisis. Which brings me to a quote that describes the ethos of Citadel. Things may come to those who wait, but only those things left by those who hustle. Now, here's what I really love about this quote. Who said this? It was one of our country's greatest leaders. It was President Abraham Lincoln.

who, like us, calls Illinois home. Going the extra mile, doing what it takes, always being active, this is what has driven our success. It often seems chaotic, frenetic. It's not like the well-oiled machine you envision when you read the business books. It's not. It's not. I remember discussing the topic of what great businesses felt like with Jack Welch's former head of human resources. GE bought hundreds of companies. They've seen it all. They've seen great companies. They've seen bankrupt companies. And I asked, "What do the great companies feel like compared to the bankrupt companies?" I really wanted to know. And he said, "Look, the great companies all felt pretty much the same." He said, "Imagine you're in a Formula One car."

And you're hurtling down the straightaway at 225 miles an hour. And the corner's coming up. And you're full-on on the brakes. The tires are squealing. They're locking up. You're trying to pull the car around the corner. You're sliding up towards the wall. You just missed the wall as you get through the corner. And then you're back on the gas, hurtling towards that next corner as fast as you possibly can. He said, 'That's what our great companies all felt like.' It was a sobering moment. I said, 'Well, what did the companies that you bought out of bankruptcy feel like?' He goes, 'Well, that's easy. Picture you're in a big Cadillac. The top's down, the sun's shining, and you're going down the road in Texas on the highway at 60 miles an hour.'

And you know what everyone says to those companies? 'Geez, what happened?' You see, great companies are always pushing themselves. They're always on the edge, and the great firms are never satisfied. Now, with great talent and great execution, you are still going to face challenges that will test you, decisions you'd rather not make. In the 24 months preceding 2008, we earned $13 billion of trading profits. I'll put this in perspective. That's more money than Amazon.com has made in its entire history. We had built one of the world's most successful trading operations, and we ran one of the largest balance sheets outside of the banking system. Our success drove our confidence. More profoundly, it drove our overconfidence.

And not foreseeing the financial crisis of 2008 was the greatest mistake of my career. You see, we are paid to see the unforeseen. And I did not grasp the magnitude and depth of the financial crisis that was growing in our banking system. A crisis so large that virtually every bank in America would have failed if the government had not intervened. Every bank would have failed. And after Lehman failed, we found ourselves fighting for our very survival. We were caught in the maelstrom. We were losing hundreds of millions of dollars a week, if not more. CNBC parked a van in front of Citadel, waiting to break the story of our demise. But we weren't going to give them that story. You see, each day, we took the steps needed to keep our business going.

We sold assets. We closed business lines. We let people go. We suspended redemptions. Our management team absorbed $500 million of costs on behalf of our investors to demonstrate our commitment to the business and our belief in the future. And each thing we did bought us one more day. And day by day, we bought ourselves a future. Often the choice was between painful and more painful. But the one thing we didn't do was put things off. By the end of 2008, we had lost half our capital. But we were still in business. And we kept our team. And our team kept fighting to buy us another day. You see, with the right people, with the ability to execute, and with the willingness to make the tough decisions, we were able to save our firm.

I believe Andrew Carnegie had it right when he said, 'Take away my factories, my plants, take away my railroads, my ships, my transportation, take away my money, strip me of all these, but leave me my people, and in two or three years, I will have them all again.' We know these three principles are true everywhere: great talent, great execution, a willingness to confront difficult choices. We know these ideas apply universally. Consider how these principles have driven the birth and rise of our city. Chicago was incorporated in 1837. In just 30 years, Chicago became the fifth-largest city in the United States. In 30 years. And then tragedy struck. The Great Fire laid our city to waste. It is impossible for me to fathom the difficult decisions that our city's leaders faced in those days.

The East Coast newspapers speculated that Chicago was finished. But Chicago had great leaders. One of them, Joseph Medill, wrote an editorial in the Chicago Tribune rallying our citizens: 'All is not lost. Chicago still exists. The lake, the spacious harbor, the vast empire of production, the great arteries of trade and commerce all remain. We have lost money, but we have saved life, health, vigor, and industry.' In 1871, our city lay in ashes. And by 1890, Chicago was the second-largest city in America. The commitment that rebuilt Chicago is still with us today. I remember Andy McKenna, former CEO of McDonald's, taking me to lunch a decade ago. And Andy, I'm going to recognize your presence here because I greatly appreciate this lunch.

It was something very special. He spoke with me about how those who had come before him contributed to our great city, and how the duty of civic and commercial leadership flows from one generation to another. It's a duty shared by each of us in this room. And you can see our commitment everywhere. You can see it in our great hospitals, in museums that are the envy of the world, and our world-leading universities. We have created one of the greatest cities in the world, one that we are all proud to call home, with one exception: our politics. There we've gone silent in the face of challenge. Every person in this room is painfully aware, painfully aware of our broken schools, our bankrupt pension plans, our rising crime rates, and our declining tax base.

I'm sure we all feel some shame that three of our last five governors have been indicted. That we have plummeted from eighth to 48th as a state in which to do business in one decade. A friend of mine was recently at an event for young entrepreneurs, the best and brightest in our city, and the future of our great city. And a story that wasn't funny to share is sort of as follows: The question was posed to these young entrepreneurs, the individuals who we look to to help create our future, 'Have you considered leaving our state because of our business environment?' And what percent of the people in that room raised their hand and said, 'Yes'?

Half.

Half. Half our future is thinking about walking out of our great state. You know, when we look at the facts, it's like we've opted out of caring about the governance of this great state and this extraordinary city. And we permit this. We permit this. In the last election cycle, I called a local CEO to talk to him about supporting a pro-business candidate. We're aligned on the values of what a good candidate should look like. That wasn't a point of contention, but his answer was straightforward and simple: 'No. No, I'm not gonna write a check. You see, if Illinois is not hospitable to my business, we're just gonna move.' And then, I learned what the word hospitable meant. For a few weeks later, it was announced that his company received tens of millions of dollars of tax incentives.

And his silence was bought and paid for. This story is sadly not unique. As the Tribune has reported, our state has given away tax breaks to countless Illinois companies.

Here's a partial list.

What is the cost of this cronyism? It is far higher than the lost tax revenues. It is the devastating loss of leadership from our business community. Edmund Burke wrote, 'All that is necessary for the triumph of evil is that good men do nothing.' And we are good men and good women. And it is time for us to do something. You see, we have a powerful voice, a voice that can play an important role in fixing our schools, in protecting and providing for our retirees, and in creating good jobs. A voice that can't wait until the next election cycle, a voice that must be heard now. We need to pick up the phone. We need to pick up the pen. We need to reach out to Governor Quinn and Mayor Emanuel and Speaker Madigan and our legislators and insist that they make the tough choices that will buy our state another day.

And day by day, we will secure ourselves a future. And let me be clear, the city of Chicago is counting on us. Before us, a generation of leaders made Chicago what it is today. And it falls to us to carry their work forward. Who else can do this? We have the relationships, the expertise, the experience, and yes, we have the means to do what is required to save Chicago from decline. And not just to save Chicago, but to make Chicago better. We must be the ones who do this work. We must fight for the ideals and principles which are at the heart of this great city and our great state. It is our duty and it shall be our legacy. Thank you.

That's a pretty thunderous applause. I'm going to get on that. That was spectacular. And I know you don't speak often. As you said to me, never. So I want to thank our own Michael Ferro for talking you into doing this. And as you can see, as soon as we announced it, we sold out the whole place. And I don't think anybody's unhappy that they came here tonight. So thank you very much, Ken.

John, thank you. Thank you so much. And I do think in preparation for tonight's speech, I learned a very valuable lesson. For all the parents in this room who have young children, save those artifacts. Mom, I greatly, my mom's here. Would you mind saying it, Mom? Yay. Yay. It was a fantastic trip through memory lane to just appreciate how far back my passion in finance goes. Thank you for saving all those memories of our lives. Thank you, Mom.

Well, after doing us such a great favor, I want to in advance apologize to your mom for this first question. No, I'm getting scared. What is your response to the claim about compensation in your industry and that hedge fund managers make too much money? That's an interesting question.

So I'll be succinct in my answer. Most of the income that you see reported in the newspapers for hedge fund managers relates to the return on their own invested capital in their funds. That, for almost all the managers, is the vast majority of their income. Now, let me be clear. The top firms that are wildly successful for their investors have created some vast fortunes in our country. And it's the nature of the inherent alignment of interests that when we are successful in creating wealth for the endowments and foundations that entrust us with their capital, we're well rewarded for doing that.

Hey, I'm on your side here. Do you have a view on the taxation of carried interest? For those who may not know, carried interest is the percentage that fund managers receive on the gains of money they manage for limited partners. In some cases, it's taxed as capital gains, not ordinary income. The current administration would like to get those of us who toil hard for that capital gains treatment to pay ordinary income. Do you have a view?

I have a pretty straightforward view. So first of all, almost all the income that we generate is short-term in nature. So my tax rate's pretty much the highest federal marginal rate. So I don't have a lot of skin in the game on this issue from my personal vantage point. But I have an interest in this from a matter of principle. In our country, our tax code favors the creation of wealth. It favors the creation of long-term capital gains. And so long as that is the basis of our tax code, the nature of the income that is created should flow through to those who create it. And so in your business, in which you buy and sell companies that you spend years working to make better, when you create long-term capital gains, I don't see why your long-term capital gains should be treated differently than anybody else.

It's populist, it makes for some really good rhetoric, but it doesn't make for fairness.

You were right on the money there.

Now I'll get easier questions for the next 20 minutes.

Yeah, now I'm going to soften up. Citadel has a robust energy business. What is your view on the U.S. energy policy and energy independence? And should we be exporting natural gas around the world? That's a great question.

And we do trade a tremendous amount of natural gas and oil around the world. For all of us in this room, the revolution of fracking is a near miracle. It means that the United States has an opportunity to be free of dependency on the rest of the world for energy, which, as a matter of national security, is priceless. Now, having said that, there's quite a bit of debate as to whether or not we should export our natural gas to the rest of the world, where it trades at about three times the price. And the answer to that, if we believe in free markets, is we absolutely should. Our country should do everything it can possibly do to maximize the value of its resources. And if we build a larger industrial base on the back of an artificially depressed price of input, we will find that industrial base stranded at that point in time in the future when markets do equilibrate.

And markets, in the long run, do equilibrate.

Now, there's been a lot of discussion about too-big-to-fail and regulations in our banking system. What are the implications, and how is this impacting our market, your business, and investors overall?

Regrettably, one of the outcomes of the financial crisis of 2008 was a dramatic consolidation within our banking industry—firms like Wachovia acquired by Wells Fargo—and it has greatly reduced the competition amongst our banks. And we all know that when markets are less competitive, consumers lose. It's just that simple. Now, how can I sit here and talk about why we should break up our too-big-to-fail banks? I'm a free-market advocate. Banks are not free-market institutions. Every bank has a seal on its front door that says, 'FDIC-insured.' It's a huge subsidy from our government. A huge subsidy. And because our banking system relies upon the faith and credit of our government, we have an obligation as a society to make sure that we maintain that part of our—of our commercial realm, a competitive, vibrant commercial realm. We need to break up our banks that are too big to fail. No company in America

deserves the privilege of being too big to fail. None. So, how do we do it? We limit the size of the deposit base as a percentage of total national deposits.

And do we also limit the activities that you can use with those insured deposits?

In my opinion, and we refer to this as 'narrow banking' in the industry, the answer is yes. I find it, for example, absolutely ludicrous that Goldman Sachs is viewed as a bank. Nothing against my friends and colleagues at Goldman Sachs, but you don't deserve the taxpayer support in running your business. You run a trading firm, a trading firm of highly paid, highly gifted professionals. You shouldn't be entitled to a taxpayer safety net. It's not fair to the taxpayers, and it's not fair to their competitors who don't have that safety net.

You referred to this a little in your speech, that basically, I think you take the position that every bank could have failed, and that's why Goldman became a bank over that weekend. Do you think it was a mistake to let Lehman Brothers fail?

It was not a mistake to let Lehman Brothers fail. It wasn't. It was a complete catastrophe at Lehman Brothers. It would have required endless amounts of taxpayer dollars to make the creditors Lehman whole. And what we have lost sight of is market discipline is a really important function. When companies are poorly managed, they fail. And that releases the resources that are trapped in poorly running businesses to explore and undertake new opportunities. We need to embrace that dynamicism of capitalism. You see it in the industrial base. We need to see it in our financial services base, where companies that out-compete their competition win, and companies that fail to do so lose. And regrettably, in business, we know that losing means bankruptcy.

Let me switch gears a little bit. You know, I'm just a private equity guy trying to get through the day. What the hell is high-frequency trading? And what impact does it have on the markets?

You know, high-frequency trading is like the favorite buzzword du jour of the journalists. It's the cause of all problems on a day where the market goes down. In English, it's electronic market making. Firms such as Citadel make markets in thousands of stocks on the back of very specialized computer systems that transmit the information across all assets in the market to all other assets. Let me put that in English. That means that when you trade IBM, you see a bid-ask spread today of about two cents. When I used to trade out of my dorm room, the bid-ask spread in IBM was between 25 cents and 50 cents. And when you went to do that trade with a specialist in the New York Stock Exchange, you had to wait a few minutes to get a response back.

Today, if you jump onto Ameritrade's website and trade IBM, you get a response back in about one second. Now, I'm going to talk about the good old days of trading, the early days of Citadel. We used to keep replacement phones. Why? Because people would lose their minds when taken advantage of by floor traders in the New York Stock Exchange and break phones. I can't actually own up to having broken a phone myself, but I've tried. Now, since the advent of electronic markets, not a single phone's been broken at Citadel. Not one. We trade 100 million shares a day in our primary asset management business. No raised voices, no high blood pressure, no anger over a specialist taking advantage of you for a quarter or an eighth.

But nonetheless, every time the market has a bad day, it must be these electronic market makers that the press doesn't really understand but loves to blame for all the problems.

So you referred to the fact that you had a satellite link installed in your dorm room in order to access market data on a real-time basis. Just to be clear, I installed that. You installed it. I installed it.

This is the one time in my life I actually used tools.

I didn't mean to imply that you hired someone.

No, I want to own this because I really can't make anything work. If you need something fixed in your house, don't call me. But I did make the satellite dish work. That's impressive. Not particularly, but I want to own this moment.

So how much of your brain do you devote to information technology, and how it can deliver a competitive advantage now in your business?

What's interesting is over the 20-some-year history of Citadel, technology has gone from a huge competitive advantage across a variety of things that we've done to a source of competitive advantage in a far narrower range of activities. Because much of the technology that we built in the early days has now become commoditized. It's available to all participants. And that's great. That's the march of progress forward. And in areas where our technology provides a competitive advantage, it provides a really important competitive advantage that we place great value on. So technology in our business, like in every business run by people in this room, is really important. And I think what's really important is to understand what do you need to build yourself and what can you buy from third parties?

And making good decisions around those trade-offs is a key success driver in using technology. So do you consider yourself a technology company? The 400 people that work for me in software engineering would really want me to say yes. But I think we are like every other business in existence today. We're not a technology business, but technology is core to our business.

You know, in your talk, you made a big emphasis about people, and I'm a big Jim Collins fan, so I agree 100% with that—right people in right seats on the bus. What do you look for in people? I mean, you obviously base your business around picking good people. What do you look for?

We really seek out passion. That's the one thing we really seek out. Because I'll tell you what, determination and persistence almost always wins the day. The world's awash in really gifted people who have never really accomplished that much. Because just being gifted isn't enough. You've got to be passionate about applying that gift. So we really look for passion amongst the people that we hire. And we do receive about 25,000 resumes a year, so we're in a pretty good position to pick out passionate people from that group. That, hands down, is what we look for. Beyond that, there's a couple things that we really look for. We look for people that play well in teams. Finance today is a team sport.

The days of a single person going through 10-Ks and 10-Qs and picking stocks are well over. They're well over. Our equities team, for example, they do 10,000 management meetings a year. There's a lot of time on airplanes, a lot of time in conferences, and a lot of time coordinating between members of a team to come to the right decision. So we look for people who are team players. We look for people who really enjoy getting the details right, because in our business, the details are what drive the outcome.

It doesn't matter if we're close.

There's lots of people who are close. To win in finance, you've got to be closer than everybody else. Teamwork, detail orientation, passion are the three things that we really look for across the team members that we hire. It's a good moment there. Now that you mention it, what about the people you fire? Oh, we fire some people too. No, look, I'm really proud of all the talent that we've brought to Citadel. I'm also proud of all the people who've left Citadel. GE placed a great, great emphasis on talent development. They realized that in doing so, a lot of people would leave GE because they had other opportunities elsewhere. You know, I have a bit of a reputation for being a hard guy to work for.

I am. I expect excellence. I'm not shy about that. And the guys around me, they've delivered excellence for 23 years. And I'm proud of that. But everyone who's been at Citadel has had a great learning experience. They've learned from some of the best and brightest in the industry. Some people who leave go off to pursue other careers or to work for our competitors. I always worry about our competitors who don't have a heritage of developing great people. Why would you want to work there? I don't know. I'd want to work at the shop that produces the real stars in the industry.

So you started, obviously, as a trader, building models, doing all the stuff where you roll up your sleeves, and now you've got a gigantic company and you've got to be a manager. How do you make that transition? How do you spend your day? What do you do?

I still spend an enormous amount of my time on the nuts and bolts of our investment process. That's what drives our business. You know, succinctly put, what do we do at Citadel? We try to understand what's going to move the prices of assets. What factors are relevant? And of those factors, which can we predict better than the next guy? 10 years ago in the energy business, it was about forecasting the weather. Could you forecast the weather better than the next guy? And if you could, you could buy or sell natural gas appropriately. We had a whole meteorology team. And there were a whole bunch of third-party commercial providers of meteorology forecasts. Well, then the game became, could you forecast the third-party forecast?

See, everyone was doing weather forecasting. The trick was, could you forecast the forecast? And of course, that of course disappeared with time. So our job is to understand what's going to move prices and what can we gain a competitive advantage on doing. Trading is how we monetize our research. So when we have a differentiated view as compared to the market, that's when we trade, that's when we monetize our research. And I spend a lot of time thinking about and work with my team members trying to understand where can we have a competitive advantage in this research undertaking and in how we trade to monetize our research.

Now, you hire a lot of engineers. Do you have trouble attracting them to Illinois and to Chicago?

We do. We do. And some reasons have nothing to do with Chicago, and some reasons do. All right? What are the reasons that have nothing to do with Chicago? This isn't the home to Facebook and Google. And if I'm trying to hire somebody out of college, it is almost always us versus a Google or Facebook. We're just not Silicon Valley. And we are not going to be able to attract the people that want to go to the Valley yet. We don't have a deep enough technology presence in Chicago to really successfully make those hires. Now, having said that, a lot of people want to come to the state because of the great quality of life we have here. And we do. We have a spectacular quality of life in Chicago.

And it's the basis of my speech. This is a city worth fighting for. We have offices all over the world. I couldn't think of a better place to live than where we live here today in Chicago.

You know, we became famous for dominating the financial futures and options businesses, but it seems that Connecticut and New York are kind of the home to the larger hedge funds. You're a big exception to that. You're the largest one, certainly in Illinois and probably between the coasts. Why is that? I mean, is there something wrong here?

No, there's network effects in talent. So talent tends to aggregate in communities of specialty: Silicon Valley's technology, Boston's medical research, New York's finance, Hollywood's actors and actresses. Talent tends to drive itself towards where the depth of talent exists. And that's one of the challenges that we face in Chicago, is that with respect to some of the newer lines in our economy where there's more growth, we just have less of a base to leverage.

So let me switch tracks here. Can you explain what QE3 is and its benefits and implications? And by the way, do you think these Fed policies are healthy, unhealthy?

So I'll give you first the flip remark, which is QE3 denotes the lack of innovation by our Fed in naming policies. QE1, QE2, QE3. I think there's that old saying, the third time you're out. So let's talk about what quantitative easing is. The Fed is not printing money. So when you take your wallet out tonight and you look at your dollar bill, you should just have some peace of mind. They're not printing more bills in quantitative easing. What they're doing is what we call liquidity transformation. They are borrowing money from our banking system to buy seven-year, 10-year bonds and Treasuries. They borrow money from our banks to buy longer-dated Treasuries and mortgage-backed securities. And what does that do?

That pulls longer-term interest rates down. And their hope is that in doing so, they will increase inflationary pressure and they will accelerate the creation of jobs. Now, Ben Bernanke has to walk a very fine line, a line between two dynamics. First of all, inflation is not the path to prosperity. I mean, we're all familiar with the hyperinflation of Germany. If inflation were the path to prosperity, Germany would rule the entire world. It's not the path to prosperity. On the flip side, we live in a debt-ridden society. Off-the-charts consumer debt, and until this last financial crisis, significant corporate debt. And when the borrowers borrowed money from lenders, everyone assumed some level of inflation in those negotiations.

And no one contemplated deflation. You see, deflation erodes the value of the collateral against which you borrow or erodes your earnings power, making it difficult to service debt. So I give Ben Bernanke credit for understanding this. He needs to try to pull the U.S. economy towards positive inflation so as to reduce the unexpected burden on borrowers, but if he creates too much inflation, we will spiral into a different set of problems. That's the economic problem that we face today that the Fed's trying to navigate through. Now, having said this, I think QE3 is a terrible idea because we are now reaching the point where the Fed is becoming captive to our political institutions. You see, with the Fed owning several trillion dollars of U.S. Treasuries, it's easy to imagine that at the next confirmation hearing, the questions posed by politicians will be of the nature, “Will you continue to help subsidize the cost of the U.S. federal government's borrowings?”

Even at the ensuing risk of potentially creating uncontrollable inflation. That last part won't be asked, but that'll be the risk. And I think there's going to be real pressure on picking people to the Federal Reserve Board who will appease our politicians and continue to try to drive interest rates to an artificially low level. I'm very worried about that, very worried about that. The other problem that the Fed has is it's not clear that their policy is actually achieving their goals given the fiscal and regulatory policies out of Washington. Let's go back to basic economics. When the cost of an input goes up, you use less of it. What have we done to the cost of labor during the last four years in America?

We've taken it straight up, and Obamacare is taking it even higher. Here we have a country struggling with job creation, and in particular, job creation for our lower-skilled workers, and we're driving up the cost of hiring them. What is a company logically supposed to do? They build their factories abroad. And by the way, build them abroad with money you borrow cheaply domestically, right? We've driven down the cost of capital. We've driven up the cost of labor. What do you do? You substitute capital for labor. Every chance you get to automate a process or build something in a lower-cost jurisdiction, you take advantage of with these current policies.

Do you see much of an issue about unwinding QE3?

I'm not worried about the unwind. The Fed can run off. A lot of people want to make this big scare story that they're going to try to sell these assets and it's going to cause this great chaotic disruption in the marketplace. I don't worry about that. That's not the primary worry. The primary worry is our Federal Reserve Bank, our central bank, losing its political independence.

Now, with interest rates on U.S. Treasuries at historic lows, maybe since World War II, maybe forever lows, do you think there's a bond bubble building or existent, and are there dangers inherent to that? I think there's a couple problems that are associated with these very low-level rates.

And first of all, I think it's important we all take a step back, right? We're all savers in this room, by and large. So we look at these low interest rates and we go, God, they're punishing us. Because let's face it, savers are the ones being punished. Now, we should also be intellectually honest. We've been huge beneficiaries of these policies because most people in this room have a lot of assets. And those assets have inflated in value because of the Fed's policies. Who's really being punished is the 30-year-old family that has neither assets nor savings. That's who's really being punished. Who else is being punished? Those amongst us who are less fortunate, who have to get by on a meager paycheck, who have seen great inflation in the price of food and energy fueled by the Fed's policies.

You know, it's really ironic, in an administration that so prides itself on being populist, the primary policy of our central bank has made the rich richer and the poor poorer. It's a great human tragedy, one that never gets written about by our liberal press.

U.S. government debt over 16 trillion. It's more than our annual GDP. How big a problem is this in your view?

Well, compared to our entitlement problem, it's not a problem at all.

So tell us a little bit about the entitlement problem.

Well, the entitlement problem is pretty straightforward. 10 years from today, we will spend, under current tax regimes, we will spend every single dollar that we pay in federal income taxes on Medicaid, Medicare, Social Security, and interest on our debt. Every function of the federal government that we think of as government, there's no money for, not a penny. So do I worry about our debt? I do. But I'm terrified by our entitlements. And I'm terrified because no one is being honest with the American public. The American public would get the joke. We're gonna have to work a few more years. We are all going to live far longer than ever anticipated when they designed Social Security. It's a great triumph of modern medicine.

But with those longer lives, there's going to come a requirement to work a few more years so we can pay for our retirement. And no one wants to confront this. And rising medical costs, you know, I really applaud Paul Ryan for having the fortitude to go out there and propose that we push more of these programs down to the states. And why is that important? One of the great things our Founding Fathers did is they put in place 50 states to compete with one another on the principles of how they would govern. And we would see if we pushed more of the medical costs down to the states, we would see a lot more innovation and thoughtfulness on where to take medicine in America. Because the monolithic central government of our country isn't going to deal with the tough moral issues

that go with modern medicine. But we've definitely seen signs that the states are willing to take that issue on. And we need one of our states to shine a light on where we should go forward with respect to health care in America.

I know you're a student of state finances, and you pay a lot of attention to it. And the Civic Committee of the Commercial Club recently said that Illinois' pension problem is unsolvable. Do you have a view on Illinois itself being the state in the worst financial shape of any state and its pension issues?

You know, I have to commend Jim Farrell, who worked on this a lot. He really brought this issue to my attention first years ago, in the context of the Economic Club. And Jim was so right, so right about how this problem was going to engulf our state. And he was so right years ago. And you know what? That problem has now engulfed our state. We have, using any reasonable set of assumptions, a hundred and some billion dollars of unfunded commitments to our retirees. What is unbelievable to me is the idea that we are going to guarantee our pension benefits above all else in our state, above the interests of our children, above our safety and security. You know, when a company goes broke and you end up in the hands of the Pension Benefit Guaranty Corporation, when you get a U.S. government guarantee,

you take a huge, a huge hit on what you're entitled to as compared to the plan that you had in place. Now, let me be clear. I'm not advocating that we impose a huge hit on our current state employees, but we have to have a grown-up conversation about how they're gonna have to work more years to get the benefits that they thought they're gonna get. And we're to be very thoughtful about, after they retire, what are the appropriate cost-of-living adjustments? And here I'll say something you might find surprising. The idea that we will not provide catch-up on COLA over the retirement of a pensioner is a problem. You see, when people retire, and they should retire in the state government at 67 like those of us here in this room will, you generally have enough of your own resources to make it through the first few years without much worry.

But if you live to 100, you've long since depleted your personal savings. And if we don't provide some catch-up on the cost of living as you live longer, those who are fortunate to live a long life will be unfortunate in that they will be poor. And that's not right. So we need to think about a cost-of-living adjustment that is lower in the first years of retirement and that increases if you manage to be in the fortunate group that live a long and prosperous life.

I can't let the evening end without seeing if I can ask you about your political views and possibly, possibly, how you determine what candidates you'll support. Well, so first of all, I'm on the right of you. Yes, definitely.

You were definitely, definitely on the right of you. Let me, let me tell you where I am on my political views. I'm a Republican, and I'm a Republican because I haven't seen the Democrats willing to make the tough choices they need to make. You know, I was with a very senior member of our political body talking about Chicago Public Schools, a person who had great influence in the area of topic. And we all know our schools are broken. They're really broken. It should be criminal what happens in Chicago Public Schools. It should be criminal. You can't have the greatest nation on this planet and have only a few percent of your kids able to finish high school and go on to college. It's disgraceful. And you know what this person said?

They said, to make the changes we need to make, it's politically really tough. And I'll skip the profanity that I used, but I'll tell you what I pointed out. Every alderman in our city is a Democrat. Our mayor is a Democrat. Our governor is a Democrat. Our House is a supermajority of Democrats. The Senate is controlled by the Democrats. And the President of the United States is a Democrat. What is so politically hard when you control the entire political process from front to back? What is politically hard is that the Democratic Party is captive to the unions and not captive to the children. Now let me be very direct on answering your question. I supported Rahm for mayor. He was the best man for the job.

He intellectually understands the issues and we will see in his next two years, does he have the strength of will and the moral fortitude to do what must be done. The early returns are lackluster. And I'll say it as it is. I'm good friends with our mayor. I think the world of him. He is as bright as they come. But he's gotta step up and really deal with the problems that we have in our city. You know, we're fighting this. We're gonna close 50 schools. The number should have been 125. And in the teacher strike, yeah, we got the longer school day at a cost in additional salaries for teachers that we just can't afford. That can't be the negotiating position that we're gonna have with the police and fire departments as we negotiate their contracts in the months ahead.

We're gonna have to step up and make some tough calls. Rahm understands the issues better than anyone, and I hope he finds it in himself to fight for each of us in this room, to educate our children, to make our city a safe city to live in, and to secure for all of us a brighter future. At the federal level, I've gone from supporting who I think is the best candidate on either side to supporting the Republican candidates. I think we're on the wrong course on the federal level. There's 47 million Americans on food stamps. 47 million Americans dependent on our government. I won't have the quote quite right from Thomas Jefferson. It doesn't really matter. But a government that is big enough to provide for all the needs of its citizens is also big enough to take away all the freedom of its citizens.

And we've seen in the last few weeks the IRS scandal, the Associated Press scandal. I think we are seeing the knife's edge of a government that is too big, that is taking away the freedoms and rights of each of us in this room.

By the way, you're sitting on my right, but you are not to the right of me. I want to thank you for one of the best evenings we've had at the Economic Club. This meeting is adjourned.