The Weird World Of Economics

Avoid the Craziness and No One Gets Hurt

IT’S ABOUT THE FEES Hedge funds are largely a fraud. A hedge fund is supposed to hedge against market movements by unhedged instruments. In a very simple example, they are supposed to go short when the market is falling and thereby make money to hedge against losses in long positions.

I am sure that some were doing that recently, but from what I’ve seen, many were just highly leveraged bets on long positions. When the market turned sharply against them, they not only lost, but also sometimes had to sell under the compulsion of margin calls and thus hastily and for a loss.

These are not what I could call hedge funds. This is just gambling. Now we see that, at least for many funds, it’s not about investing prowess or sharp insights. It is, as my idol, Warren E. Buffett has said so many times, about “fees, fees, fees.” The model hedge fund is not a means to outperform the market. It is a means to outcharge the investor.

THE RICH AREN’T SO SOPHISTICATED In 2005 and 2006, there was considerable discussion about whether hedge funds needed to be regulated. It was finally decided by the powers that be at the Securities and Exchange Commission that because their investors were often very rich people who were presumably sophisticated investors, the hedge funds needed only the slightest nod toward regulation versus, say, mutual funds.

For anyone at all familiar with rich people, the idea that to be rich is to be sophisticated is almost laughable. Rich people become rich generally in ways that have zero to do with sophistication in investing. I have seen this in spades this week with all of the shrieking from my rich pals about their investment losses. Maybe we need to rethink the notion that the rich do not need regulatory protection.

But more to the point, some of the largest investors in hedge funds are pension and welfare funds for unions and for other groups of employees. These people might well have been stunned if they knew the incredibly risky games that their “2 and 20” managers — charging 2 percent of total asset value and 20 percent of profits — were playing with their money. It is hard to believe a police officer in Los Angeles would really want his pension money tied up in the last slice of subprime, especially with leverage.

If hedge funds are to continue as an entity of some scale, it is high time they are required to display transparency, full disclosure and the kind of fiduciary duty that more sophisticated players in finance always need to show their investors. In other words, we have just seen that we need serious regulation of hedge funds.

FEAR CAN TRUMP FACT Today’s news media will “catastrophize” anything they can. The subprime mess was always much smaller than the media let on. (See my column of two weeks ago.) In a nation of our size, in a world economy on fire with prosperity and liquidity, the losses were not large, but the media endlessly tried to scare us.

When fear can easily outrun fact, some basic education is required from our national stewards of finance. The performance by Ben S. Bernanke, the Federal Reserve chairman, was letter perfect. His injections of liquidity and his resolve to invite banks to the discount window to preserve liquidity were just what the doctor ordered.

Henry M. Paulson Jr., the Treasury secretary, was a slightly different story. He should have been putting things in perspective, assuring us that the government would maintain orderly markets, and that the real problem was fear itself. He did dramatically improve his performance last week, but my feeling is that he still does not realize that he is the financial steward for all Americans, and not just the powers of Wall Street.

INVESTMENTS CAN’T BE ALL THINGS If something seems too good to be true in the world of money, it usually is. The junk bonds that Drexel Burnham Lambert once ginned up were supposed to be loans to less-qualified borrowers that would pay higher rates of interest, but not be subject to default rates that offset those gains. They weren’t (except that once the markets had beaten them to a pulp, Leon Black, of Drexel and then Apollo, made a fortune buying them for a song).

Internet stocks were supposed to offer universal wealth despite paying no dividends and having no earnings. They were supposed to defy the conventional rules. They didn’t. Subprime was supposed to be, in effect, a Milken junk bond, with a low-rated borrower and high interest but defaults low enough to allow a profit to the bond holders. In fact, immense profits were made by the issuers, but when the real default rate appeared, the free lunch vanished.

MARKETS ERR IN THE SHORT TERM After all, they are always changing, so their previous prices must have been a mistake. But they tend toward being right. (Martin Luther King Jr. said, “The arc of the moral universe is long, but it bends towards justice.” Something similar is true of the stock markets.) But in the short run, some drastic overvaluations and undervaluations can occur.

Something like this is happening now with financial stocks, which are at levels that would seem to forecast a second Great Depression. If that does not happen, in 10 years some smart people who bought financial stocks in the late summer of 2007 might be happy they did. It would take staggering mistakes of monetary policy to justify the prices of those stocks now. Unless Mr. Bernanke is replaced by Chuckles the Clown, it won’t happen. More to come.

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posted by UncommonBusiness @ 2:59 AM