The Hedges Need Trimming

It seems as if only yesterday we were discussing in these pages the existence of the Working Group in the Capital Markets. Many an establishment observer has disputed the idea that the government engages in market manipulations. However, just as former president Bill Clinton backpedaled on the idea of a conspiracy lurking within the hallowed halls of government, so too must we confront and accept this “benevolent conspiracy” in the wake of the Bear Stearns Companies Hedge Fund bailout.

In case you missed it, Bear Stearns, the Wall Street Broker/Dealer, gathered $600 million dollars through the Federal Reserve System and started a Hedge Fund. The Hedge Fund pledged the $600 million as a down payment on $6 billion worth of subprime mortgages. Bear Stearns and a few of its executives had only ever fronted $40 million for the funds.

We all saw what happened next. As the quality of these subprime loans deteriorated, Bear Stearns found itself with a Hedge Fund that was now worth a negative $3 billion. Great investment; put up $40 million and lose $3 Billion. That should have been the end of it:  Pay up.

But wait, not so fast. To hell with the Americans who lost their homes in this debacle, we can’t allow Bear Stearns to fail! Hence the bailout. At least the whole disgusting affair may finally provoke the regulators to act. It seems that buying derivatives is like stoking a campfire in a gunpowder factory. How does one assign values to complex derivatives? In many cases the value is just “arbitrarily assigned” in the technical maneuver referred to as “make it up as you go along.”

As soon as someone asks the accountants, a new price emerges. If you have ever applied for a mortgage you may recall the mountain of paperwork involved. Most regular borrowers are typically required to obtain an independent appraisal of the property. The bank involved certainly would not take your word for the value of the asset. Yet in the high finance world of Hedge Funds – that is exactly what they did. The typical homeowner can’t so much as add a room onto their house without a permit “for their own protection.” One can’t drive their car without a seatbelt, again for their own protection, and if one ventures into the glitzy world of Las Vegas, every single game of chance is regulated.

Apparently the government thinks the activities of Bear Stearns and others of their ilk do not warrant any such regulations. These entities have grown in size and quantity. The amount of money under management with Hedge Funds has increased four fold between 1996 and 2004 and is expected to triple between now and 2010 to over $2.7 trillion. These powerful entities make colossal bets, designed to generate corresponding returns. Returns which the participants get to keep. Occasionally a bet gone bad results in huge losses. Recently however, as in the Bear Stearns debacle, the losses exceed the assets of the fund by many times. This essentially forces the sponsor to assume responsibility for paying out more money than they have. Unlike those Vegas gamblers, if these bets go against them, they are apparently assured of a Government induced bailout to prevent financial ruin.

I say induced because it is interesting to note that the money does not come directly from the Treasury. Instead, it is coerced from institutions within the system with the plunge protection team acting as the cop. But there are no effective regulations on the operation of these funds.

How can a “trillion dollar” anything not require some regulation? The drivel that is propagated by the Federal Reserve is that derivatives are important financial vehicles that allow risk to be efficiently distributed. Observers might be excused for asking, “What risk exactly?” The risk that if they lose money the taxpayer will bail them out? Not much of a risk there. The majority of these Hedge Funds use derivatives to purchase positions in products which they have no intention to use. These are mostly speculative endeavors. Derivatives can allow one to profit from interest rates going up, or the price of oil going up, or bonds going down. These are not infrequent events.  They will all eventually happen at some point. Yet, instead of regulating this insane game of chance masquerading as a vehicle of investment, the authorities and all of the major financial institutions around the world have heralded these funds as the best thing since the cell phone; even in the face of another credit crunch.

The same authorities who see the need to regulate our rights into oblivion see no hypocrisy here. Regulate the people but allow these financial behemoths to plunder the markets? That makes no sense. The existing financial entities are all complicit. They are in many cases sponsoring these entities only to distance themselves in the event of a meltdown. This latest bailout represents the biggest rescue of a Hedge Fund since 1998. That, you may recall, was when more than a dozen lenders provided $3.6 billion to rescue Long-Term Capital Management. Meanwhile, defaults on subprime loans continue to accelerate. Pension Funds which hold these dubious investments could be left with hundreds of billions of dollars worth of securities backed by loans that are effectively worthless.

In this particular instance Bear Stearns decided to buy out the Wall Street banks that had lent their Hedge Fund the bulk of the money. They presumed that this would prevent a more broad based panic sale in the market for collateralized securities. If the lenders had repossessed the assets of these funds and then sold them for whatever the market would allow, Bear Stearns would have been forced to take substantial losses. The fund that began in 2004, the Bear Stearns High-Grade Structured Credit Fund, had a pretty decent performance rate prior to the crunch – posting better than 40 percent gains over three years.

But that was not enough for the high flying world of Hedge Funds. Call it greed or something less honest, but someone decided that higher returns could be achieved with more borrowed money. So borrow they did. And you know what they say:

When you owe the bank $6 million and can not pay up, you are in trouble.  When you owe the bank $6 billion and can not pay up, the bank is in trouble.

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