HEDGE FUND FOLLIES
National Investor
July 2006
We have often written about how a wide variety of topics that are debated in media and/or public policy circles truly are not debated at all. Instead, two essentially scripted “sides” or premises are devised; the “debate” then centers on arguing these points while real issues and solutions are left almost untouched. More often than not, the subjects are more political in nature than economic, though the two can overlap. Where trade is concerned, for instance (a subject we’ll get to later in this issue) you either believe in what passes for free trade, or you’re an “isolationist”. Such is the left vs. right Potomac Parlor Game that masquerades as serious discussion among politicians and pundits every bit as dumbed down as their constituents.
Today’s example concerns recent news relating to the hedge fund industry. It recently scored a major victory over the Securities and Exchange Commission when the U.S. Court of Appeals in Washington nixed an S.E.C. rule requiring hedge funds to merely register with the agency and be subjected to some of the same kind of inspection and disclosure requirements, as are mutual funds and similar products. Some are understandable up in arms over this; among them are members of the U.S. Senate. They recently heard from former S.E.C. enforcement officer Gary Aguirre, who contends that he was canned by the agency for going too far in investigating a potential insider-trading scheme involving Morgan Stanley C.E.O. John Mack and Art Samberg, head of the hedge fund Pequot Capital. While Aguirre’s initially earth-shaking claim lost some of its punch under closer scrutiny, the combinations of this and the court decision have reignited the debate over the need for some regulation of the industry. The commonly expressed reason: to fight fraud and insider trading.
The real issue is seldom mentioned. It is, as Berkshire Hathaway founder and now-record-setting philanthropist Warren Buffett once said, that hedge funds are “financial weapons of mass destruction” which will one day accomplish the equivalent of detonating a nuclear device on Wall Street.
The operation of many of these funds can be characterized as fractional reserves banking on Steroids. That’s right, BANKING. Many of these funds, due to the obscene leverage they are able to employ, have created tens of trillions of dollars on their books and within the financial markets out of nothing. An estimated $1.5 trillion has actually been invested in hedge funds. Yet-are you ready for this? - The total “notional value” that exists in the derivatives markets (of which the leverage employed by hedge funds is a key driver) is in the neighborhood of $300 TRILLION!! “The Game” is of necessity past the more sedate credit creation involved in everyday banking/lending activities. It’s even got about all the mileage it can out of creating “wealth” on which more lending and spending can take place by creating bubbles on Wall Street and in real estate. Now the last hurrah is for the hedge fund industry to do what even the Fed can’t; this is why former Chairman Alan Greenspan was a relentless foe of any regulation of derivatives, and a cheerleader for the hedge fund industry.
Making matters worse for the markets on a regular basis – apart from the nuclear systemic risk inherent in their activities and leverage – is what hedge funds can do on a moment’s notice even if it doesn’t involve Armageddon. Investors recently got a taste of this when, in a matter of weeks, previously hot assets ranging from copper to Saudi Arabian stocks lost 20%, 30%, or 40% of their “values”. Increasingly, hedge funds have gone from what they industry used to consider as hedging to more of their investing being done in currently-hot assets, but with the “kick” of their leverage. Think of a 300-pound man jumping into a kiddie wading pool; or maybe half a dozen people in a little rowboat who all decide they want to sit on the same side. Whatever the analogy, hedge funds trying to “keep up with the Joneses” by chasing one another into and out of markets can clearly exacerbate volatility and as it recently did give a nasty roller coaster ride to average investors on Main Street.
**(NOTE: Just6 before heading off to the Federal Prison Camp in Duluth, Minnesota, Chris updated his “signature” essay on our system, entitled “Understanding the Game”. Though some of the information is a bit dated it remains one of the most useful tools you’ll ever have enabling you to truly understand our economic system and investment markets. You can read it HERE. We hope to shortly have an updated/revised edition, too!)
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