In olden days, explorers sailing the world's oceans in search of new profit
opportunities navigated the unknown by means of looking to the heavens and
guiding by the stars. Today, investors still attempt to navigate the dark
waters of turbulent economic times with guidance from the stars, namely the
satellites in the heavens that carry the world's three major international
financial information broadcast networks, General Electric's CNBC, Bloomberg's
Bloomberg TV and News Corp's Fox Business Channel.
Fox Business is under a year old; Bloomberg TV is basically an adjunct of the
company's core data terminal business on every trader's desk in the world;
CNBC, on the air in one form or another for about two decades now, is insanely
profitable; advertisers pay a lot more to reach its audience of millionaires
with money to burn than they do to reach the people at home in the
afternoon
watching the continuing sagas of Jerry Springer's rowdy t-shirt rendering
trailer park lesbians.
CNBC's profit strategy is easy; what works for it are sex and optimism. Gone
are the days when hours of air time would be filled with saggy-jowled,
ashen-faced Wall Street flatulators droning on and on about a stock's
price-to-book ratio. Now it's an unending stream of young nubile brunettes
(they've probably done market research that indicates that their viewership
won't accept serious money news from blondes, as in the old joke that four
blondes were found frozen to death in a car outside a Minnesota drive-in, after
having gone to see Closed for the Winter) flashing their best
come-hither smiles all day long, even through the worst of the current market's
turmoil.
The optimism part of the programming strategy is instantly discernible from
even a few minutes viewing - whatever calamities are befalling the market,
skyrocketing oil prices, credit crisis, war, famine, pestilence, frogs, the
taking of the first-born sons of the discount stockbrokers - it's always a good
time to buy. The rationale for that is obvious: if you own stock you'll keep
tuned in to find out what its worth; if you sell, unless you've got the
steely-eyed discipline of a real trader to wait for your price to buy back in,
you won't.
But among this melange of jumped-up carnival barkers and business school prom
queens was once a real gem named Ron Insana. Beginning in 1984 at CNBC's
ill-fated morally challenged predecessor, the Financial News Network, Insana
was a consistent voice of honesty, judgment and serious analysis who never
seemed to be all that concerned with hewing to the corporate party line.
In 2006, while hewing to the zeitgeist of the time, Insana traded probity for
payout and left CNBC to set up his own hedge fund, Legends, under the umbrella
of his money management firm, Insana Capital Partners. Legends had a very
simple money-management strategy; called a "fund of funds", it would try to
ascertain which hedge fund manager currently had the hot hand, and invest funds
with him. He continued to make the occasional guest appearance on CNBC, a
welcome answering voice to the network's continuing theme that a radiant
sunrise was sure to be soon forthcoming upon the ever-darkening black hole of
the credit crisis current sucking up all of creation.
In August, Insana announced that he was liquidating Legends, and closing up
shop at Insana Capital Partners, to take a job at SAC Capital Partners. His new
position will probably lead to the end of his valuable commentary at CNBC.
Press reports of his failure were all tinged with that unique glee that the
public wants to see when the rich and powerful stumble on their hubris, when
Icarus flies too close to the sun and crashes to Earth. Notable among these was
the heading on the link to the story in the Huffington Post. Attempting to
evocate the type of confusion expressed by a Paris Hilton type when not
understanding just what a driver is supposed to do when faced with a stop sign,
the story had Insana whining "Running a hedge fund is hard!"
No it's not. If you do it at the right time, making untold gazillions upon
gazillions in the hedge fund game is just about the easiest thing one can do in
the markets. The problem is that now is not the right time. That it's not the
right time says a lot about the condition of the markets now, but it says even
more about the condition of the markets just a few years previously.
It was in July, 2006, probably about the time that Ron Insana was reaching for
the gold and going for the gusto, that I wrote about hedge funds in an Asia
Times Online article,
Hedge Funds: Playing dice with the universe.
On the real-estate
pages of the New York Times, any story about the latest outrageous selling
price of some co-op on the Upper West Side, or on the beach in St Barts, or the
slopes of Vail is bound to have some reference to a hot hedge-fund manager as
the purchaser. A new off-Broadway play, Burleigh Grime$, celebrates the wild
ways of the title character, a hedge-fund manager who, in one of his more
legitimate profit-making schemes, has dead fish dumped on the beaches of
California to try to profit from an El Nino market panic.
So
what has happened in two years? What happened to the billions and billions that
seemed to be then as easily reachable as low hanging fruit? Why is Insana now
standing in line like the rest of us, time card in hand, waiting to punch in
before the factory whistle blows?
Hedge funds employ a wide variety of trading strategies, but, once you strip
out all the math and gobbledygook that they snow their prospective investors
with, at the most basic level, what they're doing is trading stocks. At its
very core, trading in stocks is just that - a trade. Just like children trading
marbles or collector cards, the process of buying a stock involves a swap of
your money for something that is not your money, in this case, for a stock
ownership certificate.
It may seem like this process is just a trade of one piece of paper for
another, but it's slightly more complex than that. A stock certificate is more
than just a piece of paper, it's an actual slice of ownership in an operating
(well, usually) enterprise. To put it simply, if a company whose only asset is
a 1,000 square-meter building has 1,000 shares outstanding, your purchase of
one share in the company means you own 1 square meter of that building. You
can't come in and saw it off because a majority of the other shareholders have
hired a management team that decides how the assets of the enterprise are to be
allocated.
What did the person who sold you the stock get for his share? Paper money.
On the surface, it might seem that the guy who got the money got the worst of
the deal. After all, he sold something real and tangible; who knows, maybe
there was a photocopier or a cappuccino machine on the square meter he once
owned. The paper money, in the case of the US dollar and all others, in no way
guarantees you a share of anything at all, not since US president Richard Nixon
"closed the gold window", by suspending the government's accepting of dollars
for exchange into gold, in 1971.
In the small print on the dollar bill can be found the source of the dollar's,
or any other paper money's, attraction. "This note is legal tender for all
debts public and private," it says. Paper money is, in economic jargon
"fungible"; it is easily and readily accepted as a store of wealth. It is a lot
easier buying a candy bar in a convenience store with a dollar bill than with
that piece of office floor you owned with that stock certificate. The tension
of paper money's fungibility versus everything else's tangibility is, and has
been since the first appearance of paper money in China in the 7th century, the
core dynamic of change in a market economy.
It's one thing if the balance, like the weights on an apothecary scale, is
stable, if the quantities on both brass platforms don't change much. When they
do, things get a lot more interesting.
In this analysis, it's the value of the items on the scale, not the absolute
quantities of money and goods, that are being measured. Thus, as happened in
the United States this decade up to early last year, if homebuilders embark on
a wild spree and go absolutely crazy building houses, then the weight of all
those houses pushes that scale beam down, and the value of the money on the
opposite scale beam goes up. In places like California, you can buy about 30%
more house with the same amount of money than you could 18 months ago; in other
words, that money is worth 30% more when you trade it for a house.
If you increase the weight, the quantity on the money beam, the absolute
opposite happens - the value of the "stuff" beam rises up in the air. Thus,
real estate, factories, fine art, collectibles, commodities, and, most of all
stocks based on companies that own all of the above, rise in value.
In these circumstances, being a successful hedge manager is about as easy as
taking a trip by train. You buy a ticket, sit down, enjoy the ride.
So where did all that extra money that bid up stock prices and make hedge fund
managers the avatars of the new millennium come from?
Part of it was undoubtedly from the massive popularity of the so called "carry
trade", where money was created out of thin air by borrowing in
low-interest-rate currencies, usually the Japanese yen, which had short-term
interest rates under 0.25% for most of this decade, converting the proceeds
into US dollars, and then buying stocks with it. There is substantial economic
research that correlates day-to-day falls in the yen, making the carry trade
even more profitable, with rises in world, particularly US, stock prices, and
vice versa.
But an even more powerful firehose that drenched the markets was a result of
the world's central banks sanctioning the essential privatization of money
creation. This happened when they allowed private financial institutions, such
as commercial and investment banks, virtually unlimited license to use their
existing collateral to engage in ever and ever larger successive rounds of
lending and borrowing that, when the liquidity reached the equity markets, with
their relatively fixed amount of stock, were the afterburners that rocketed
markets ever upward until this year.
The key to the massive returns achieved by the hedge fund traders was leverage;
they soon learned that it was a gross mistake to borrow $10 million to buy
stocks and get a nice return, when they just as easily could have borrowed $1
billion for a truly astronomical return.
As Tobias Adrian and Hyun Song Shin wrote in the January-February edition of
the New York Federal Reserve Bank's "Current Issues in Economics and Finance":
Increased
demand for the asset tends to put upward pressure on its price, there is the
potential for a feedback effect: the stronger balance sheets lead to greater
demand for the asset, and this outcome in turn raises the asset's price and
further strengthens the balance sheets. Having come full circle, the feedback
process goes through another turn.
But this year we have
learned that all the hedge fund managers' outsize performance was due not, as
we were told in the good times, to their superior ability to find a new
investment opportunity at the bottom of a haystack 300 kilometers away, but on
all the money creation based on rising US real estate prices. Now that the
money is not so easily available, neither are those hedge funds' easy millions.
According to Adrian and Shin, the mechanism on the downside is just about the
same as that on the upside - just a lot less fun.
During downturns, the
mechanism works in reverse. Consider a scenario in which asset prices decline.
Then, the net worth of institutions will fall faster than the rate at which
their assets decrease in value. As the institutions' balance sheets weaken,
their leverage will increase. Since these institutions are targeting
pro-cyclical leverage, however, they must attempt to reduce leverage in some
way - in some cases, quite drastically. How do these institutions reduce
leverage? One way is to sell some assets, then use the proceeds to pay down
debt. Thus, a fall in the price of the asset can lead to an increase in the
supply of the asset, overturning the normal supply response to a drop in asset
price.
And that's what to tell the Maserati dealer when he
wonders why all his leases are coming back. He, too, much like Insana, is a
victim of the current imperative to "sell some assets, then use the proceeds to
pay down debt".
The first six months of the year saw the hedge-fund industry suffer its worst
aggregate total return since specific statistics on this sector started to be
kept in 1990. That was even before the gruesome month of July, when the long
commodity stock/short financial stock strategy that many funds had been loading
up on suffered a spectacular reversal after the government rescue of Fannie Mae
and Freddie Mac in the middle of the month.
Many other hedge funds besides Legends are now closing their doors. Atticus
Capital took a $5 billion pasting in July, Ospraie Management is shuttering its
commodities fund, which has lost 40% in 2008 alone. In the interconnected
working oligopoly that is modern finance, Ospraie's trials are casting a long
shadow; with 20% of the firm owned by Lehman Brothers. It is the small domino
of Ospraie leaning onto the big one of Lehman that has the market's focus
fixing on Lehman to see if it is the next great house of money to place a phone
call to the office furnishings auctioneer.
In the Frank Herbert science fiction series Dune, a class of humans
called "Mentat" were specifically bred to be able to serve rulers with awesome
and breathtaking feats of mental agility. Reading the financial press up to
about a year ago, you might have thought that a spaceship full of Mentats had
landed in hedge-fund central in Greenwich, Connecticut, to rule that business
as a first step towards the conquest of the world.
We now know that nothing of the sort was happening. What we saw in the rise and
current fall of the hedge-fund empires was just another example of Gresham's
Law, that bad money drives out good. By allowing paper money to be debased
through unregulated structured finance, the world's central bankers drove out
the good money, stock certificates, and the actual physical goods represented
by such, driving up their prices.
Gresham's Law is named after 16th century English financier Sir Thomas Gresham.
In 1551, in the service of King Edward VI, Gresham stabilized the value of the
pound, for which he received an annual grant of royal lands worth about 400
pounds. Hedge-fund managers received much much more, for delivering much much
less.
Julian Delasantellis is a management consultant, private investor and
educator in international business in the US state of Washington. He can be
reached at juliandelasantellis@yahoo.com.
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