Blame the Hedge Funds

The catalyst for the worldwide collapse in credit markets was the plunge in housing prices in the United States.

However, the decline in stock prices represents the economic power and inherent weaknesses of the hedge funds and mutual funds.

Black Thursday’s plunge in the Dow Jones in 1929 was exacerbated by margin calls. Too many purchased stock on credit, often with no money down. A rising stock market, as with the recent housing bubble, hid many sins. When share prices dropped, margin calls went out. Fail to cover meant the brokers sold the stock at whatever price they could, setting up cascading declines.

Margin calls aren’t as great a problem today because of the large amount of capital that has to be posted to buy on margin. In other words, the stock would have to drop precipitously today, as has happened, before the calls go out. Some margin calls have gone out recently, including to Summer Redstone, who is now only three quarters of a billionaire he once was.

However, the modern versions of margin calls are the hedge and mutual funds. When the market started dropping, they were inundated by clients and customers who wished to redeem their investments. After exhausting their cash on hand, the funds had to sell, blindly sell, securities to meet the demands to cash out.

More declines resulted in more panicked calls to cash out.

As it is, the unregulated hedge funds add tremendously to the volatility in the Market, especially in the last ½ to 1 hour of trading. That’s when they assess their portfolios in light of trading earlier in the day, and decide how to profit accordingly, driven by computer programs.

Hedge funds profited greatly in recent years, adding to the net worth of their clients, including university endowment funds and other institutional investors.

The universities will survive. Many, if not most, hedge funds will be history once the markets settle down.

Ten years ago, Long Term Capital, a multi-billion dollar hedge fund essentially failed and was bailed out by a consortium of banks and investment bankers (ironically not including Bear Stearns). Long Term Capital had two Nobel Prize winners in Economics and the most complex computer mathematical models. Like the Titanic, it could not fail. It listed capital of $4.72 billion, assets of $129 billion, and borrowings of $124.5 billion, which did not include off-balance sheet derivatives of $1.25 trillion. It was too highly leveraged with poor assets. It could not survive a drop in its investments.

The lessons went unheeded.

More recently, the collapse of Bear Stearns set off the crisis in the credit markets. Bear Stearns demise started with the failure of two of its hedge funds last June. The funds were heavily invested in collateralized debt instruments tied to the sub-prime mortgage market. On November 30, 2007 Bear Stearns listed $395 billion in assets and capital of $11.1 billion, a 35.5 to 1 ratio. Not included in these figures were $13.4 billion in derivatives. Just like déjà vu with Long term Capital.

No one at the time predicted the subsequent Wall Street plunge and drying up of credit.

Long Term Capital and Bear Stearns were the warnings, but like Cassandra, no one listened.

One of the greatest societal and economic failures of the hedge funds is that they do not add to the capital of America. They don’t invest in new companies and new technologies, unlike traditional investment bankers. Rather they use computer programs to squeeze profits out of trades and in sophisticated arbitrage. They play the futures market, not to hedge their fuel costs such as with Southwest, but simply to profit by the rise or fall in prices. This practice is certainly not new, but was at a scale never conceived of before, aided by computers and the web.

The early, high profit returns, ignoring Long Term Capital, seemingly attracted everyone and their uncle into establishing hedge funds without doing a proper risk-analysis study. Warren Buffet did such a study and avoided derivatives. Now he’s buying into Goldman Sachs and General Electric on the cheap.

Fear not, for on Monday the market will rise. Bottom feeders will jump in. But rather it will be the start of a sustained rally, or just the bounce of a dead cat, remains to be seen.