Pride Cometh Before the Sell

What Julian Delasantellis says:

...Starting with the tax cuts by US president Ronald Reagan of 1981, and especially after the near-worldwide evaporation of socialism in 1989, the regulatory, budgetary, and especially tax policies of the major capitalist democracies began unequivocally to favor the rich. This meant that greater and greater pools of free capital, once spread more or less evenly in smallish amounts among the broad middle classes, began to be concentrated in fewer and fewer hands of those at the very top of the income pyramid. This process barely slowed with the election of center/left-wing governments in the US in 1992, Australia in 1993, Britain in 1997, and Germany in 1998, and it continued after the US victory of George W Bush in 2000, and the passage and implementation of tax cuts heavily skewed to the rich by his administration in 2000-01.

This overabundance of capital presented a problem for the rich. What were they supposed to do with all the new money? Much of it went into mindless consumption of luxury goods...

But even the elite can only spend so much, and that left a lot of unused cash left over that had to be put to work, had to be invested. It was then that hedge funds came on the scene.

Just because the rich had earned or inherited the money didn't necessarily mean they had the investment skills to grow it. They wanted a surer thing than just buying and holding GM or some other common stock, and they also wanted something a lot more aggressive than the average tightly regulated mutual fund.

"Hedge fund" is simply a fancy name for a high-initial-investment limited partnership. In contrast to mutual funds, where an account can be opened with as little as $500, starting investments in hedge funds are frequently in the $1-million-to-$10 million range; thus their status as investment vehicles to the very upper classes (when pressed to defend their social utility as institutions that make the very rich even richer, the funds say that university endowments or public pension funds are also their customers, although these are but a small minority of the industry's customer base).

Also very much in contrast to mutual funds, hedge funds are for the most part unregulated as to the investment or, more accurately, speculation choices they can make. Mutual-fund managers are usually highly constrained as to their possible investment options. The mutual fund may be restricted by charter to invest only in large capitalization stocks, Treasury bills, or corporate bonds, but the hedge-fund manager has unlimited license to invest in stocks, bonds, countries, commodities, parcels of real estate, or anything else. The hedge-fund manager also has unlimited license either to buy the investment, in hopes that he/she will be able to sell it later at a higher price, or "short" the investment, hoping to profit from a decline in price.

In today's financial world, hedge funds are all the rage. Although there are no real statistics (a big appeal of hedge funds is their reticence; although most operate out of such places as Greenwich, almost all are registered offshore, about half in tax-friendly havens such as the Cayman Islands) detailing the actual or aggregate size or the world's hedge funds, Institutional Investor magazine estimates the worldwide total of hedge-fund assets under management (AUM) at more than $1 trillion.

To illustrate the magnitude of the industry, if hedge funds were a country and the AUM represented a nation's gross domestic product (GDP), it would rank eighth in the world, according to the World Bank, just behind Italy and ahead of Spain. Since most hedge-fund strategies involve substantial borrowing, using AUM as, say, 5% collateral for positions up to 20 times the actual cash on hand, multiplying the AUM times 20 gives you a potential hedge-fund-market impact just about the same size as the United States' GDP.

Hedge-fund managers, mostly recruited from concerns such as brokerages and investment banks, are far and away the most generously paid players in the money-management game. This is because, on top of the standard base "salary" hedge-fund mangers earn, usually comprising up to 5% of total AUM (meaning that on the day the hedge-fund investor hands his money over, he starts 5% in the hole), the hedge-fund charters usually include managers taking home substantial portions, usually around 20-50%, of the yearly total profits the manager earns for the clients. Thus, since successful hedge-fund strategies almost always include substantial borrowing to produce huge returns, it is not surprising that Institutional Investor reported in 2005 that the average salary for top hedge-fund managers was $363 million; the reputed top earner, James Simons, of Renaissance Technologies Corp, is reported to have taken home $1.5 billion in 2005...

Through painful experience, armies know that you can't march soldiers across a bridge in formation, for the force of all those feet striking the bridge deck simultaneously can reinforce the natural vibrations of the bridge with each step, causing the bridge to collapse. It's the same with investing. Get a lot of players all doing the same thing, putting in huge orders to buy or sell the same instrument at about the same time, and you can move the price of that instrument tremendously in a short time. Those fat bonuses rise along with the inflated asset paper values, and as long as there are always new buyers, as long as nobody sells, everybody's happy.

Then May 11 of this year came along. People started selling.

During the first days of heavy market decline, Fox News attributed the selling to what it called "traitors" who leaked the news of the National Security Agency's latest phone-surveillance scheme to the media. Those who still had some connection to the reality-based community had another explanation.

With hedge funds needing to borrow huge amounts of money to finance their trades, the hedge-fund managers discovered a neat trick. Why borrow in US dollars and pay high US rates (the current US prime rate is 8%), when you can borrow in Japanese yen and convert the proceeds to dollars, or any currency you want? Ever since 1999 yen interest rates have hovered around 0%, as the Bank of Japan desperately tried to pull the economy out of a seemingly unending recession that started with the crash of the Japanese stock market in 1989.

This maneuver, called the "carry trade", works great - unless either Japanese interest rates or the yen rise in value, for that would eat up the trades' profits for the hedge funds. When the yen did rise to 110 to the US dollar, and fears of rising Japanese interest rates spread through the market, hedge funds acted to protect their profits by selling massive amounts of gold, oil, steel, and developing-country equities - all the stuff that had risen so strongly before as they purchased it.

On June 1 the European Central Bank (ECB) warned of the risks to market stability from what it called the "correlation of hedge-fund returns". If all the hedge funds are doing the same thing - such as placing huge leveraged bets on the Indian stock market, a major casualty of the post-May 11 global selloff - then all their returns will be "correlated" or, in non-economist terms, similar. ECB vice president Lucas Papademos stated: "The increasingly similar positioning of individual hedge funds ... is another major risk for financial stability..."

...with the proportion of income in the developed capitalist democracies remaining heavily skewed toward the upper classes, the concomitant amount of global wealth controlled by hedge funds has grown tremendously. With all of them investing similarly, the risks of the market turning against their positions, resulting in a tremendous destruction of global capital liquidity, have also grown apace.

The result? We are all like hapless ancients, trembling before the gods playing dice on Mount Olympus, knowing that we are powerless to affect the results that will so greatly affect our lives and destinies. As they might have said at Hedgestock:"Bummer!"

Like the technocrats of the 90s, the New Gods have run right into the Old. Like in the 90s, the Elder Gods of finance are in a position to make plenty of money off the churning of the New. But the Ancient Ones are also jealous deities, because their old ways of reckoning aren't precisely those of the young.

...hedge fund managers and central bankers — call them hedgies and bankies for short — do not think alike. The grand panjandrum of the Federal Reserve, Chairman Ben S. Bernanke, has been learning the hard way that sometimes words can speak louder than actions. Having said on April 27 that he and his colleagues might "decide to take no action … in the interest of allowing more time to receive information relevant to the outlook" (translation: "Don't assume we're going to raise interest rates again"), Bernanke realized that the hedgies had taken this as just another signal to borrow and buy.

SUDDENLY, Chairman Ben was struck by a horrible thought. Perhaps he'd been too soft. Perhaps the combination of surging commodity prices and credit growth might transport the world back to the inflationary 1970s. So, on May 23, he changed his tune. There were, in fact, "upside inflation risks," he said. Less than two weeks later, he was pledging anti-inflation "vigilance." Translation: "Sorry, what I meant was that we really are going to raise rates."

Now, you might think "core" consumer price inflation of 2.4% (the latest U.S. rate) isn't much to worry about. Inflation rose six times higher than that in the 1970s. But any rate that's higher than the Fed's not-very-explicit-but-low target makes the bankies nervous. In a booming globalized world, they now tell us, their monetary policy may have been "too accommodative" — hence the recent bubbles in equity, property and commodity markets. The Bank of Japan started saying this kind of thing some time ago. So did the European Central Bank and the Bank of England.

This apparently uncoordinated global tightening of monetary policy effectively shears the hedgies. For years they have been making stupid money by borrowing from central banks at near-zero rates and taking long positions in any market with momentum. "Too accommodative" central banks meant one-way bets and low volatility. Now it costs to borrow, and volatility is back.

The key point, however, is that many hedgies fear the bankies are over-tightening. They fear a sharp slowdown, if not a recession, in the United States and therefore in the rest of the world. If they're right, the bankies will turn out to have been like generals fighting the last war. It will be deflation, not inflation, they'll soon need to worry about.

Unlike Bernanke, who got his doctorate in 1979, the hedgies don't remember the '70s. Most of them were still in short trousers then. Yet they may turn out to be nearer the mark than the inflation-targeting bankies. For one thing, there is little evidence yet that higher rates are reducing credit growth.

The Fed's latest "flow of funds" report showed that in the first quarter of this year, household borrowing in the U.S. was up 32% compared with last year. That's huge. It means that higher rates haven't yet translated into retrenchment by American families.

Growing U.S. household debt has been the single biggest driver of global growth in the last five years. When Americans do finally stop borrowing and start saving, the effects could be bigger than the bankies anticipate. (Fact: 29% of borrowers who took out mortgages in the U.S. last year have no equity in their homes or owe more than their house is worth.)

My guess is that belts are already being tightened. Certainly, consumer confidence has fallen to levels we've seen only twice in the last 10 years.

The question I'm asking myself is what kind of festival the central bankers will throw to celebrate the recession of 2007-08. Anyone for Sellstock?

The other parameter no one seems to talk about is how the stagflation of the 80s might have been brought under control by raising interest rates- but the inflation seen now isn't due to wage/ price increment cycles.

It's due to skyrocketing energy costs rising as we ride down the peak oil curve.

A funny thing happens when markets crash in a big way. Look at what happened at the onset of the Great Depression. Look at what happened in the big market crash of 1987. The very, very rich get very much richer in a big way. The Old Ones, the real bluebloods like the Bu$h crime family, profit while almost everyone else loses.

You might even say it's their modus operandii.