Hedge Fund Horse****

[EJ]

Hedge Fund Horseshit

July 2, 2006

Here's the latest on Hedge Fund regulation from the Wall Street Journal:

Hedge Fund Hoopla
July 1, 2006 (WSJ Opinion)

Be unafraid; be very unafraid.

Hedge funds are easy political targets because they aren't sold to the general public and aren't well understood. But the regulators at the Fed and Treasury who are paid to watch the financial system understand that they provide far more benefits than risks. Congress should tread carefully, if it treads at all.

Hedge Funds are not new. They have been around for decades, but as pointed out in "The Modern Depression," the number of hedge funds grew 300% from 3,000 in 2000 to over 9,000 today and manage over a $1 trillion versus $500 billion in 2000. The growth was the result of the Fed pumping liquidity into the markets following the collapse of the stock market bubble. This explosion mirrored the growth of venture capital funds from 1995 to 1999 after the Fed pumped liquidity into the broken banking system that had seized up following its attempt in 1994 to "prick the bubble in the equity markets." As wealthy investors licked their wounds post tech stock bubble collapse and stayed away from VC in droves 2001 to 2003, these new so-called Hedge Funds became the latest means for wealthy individuals and institutions to dip a bucked into the massive river of money that flows through The System every time the Fed bails The System out after the collapse of the previous liquidy fueled asset bubble.

It's intellectually dishonest to call most of these new funds "Hedge Funds." A Hedge Fund hedges, is long one thing and short a correlated other. Most of the new funds that appeared since 2000 are merely long. Long oil. Long Gold. Borrowing yen at 0%, converting to dollars, borrowing dollars at 5%. And so on. So here at iTulip.com we call them what they are, Unregulated Speculative Investment Pools or USIP for short.

Alan Greenspan, as the WSJ piece points out, says these USIPs are perfectly safe. But Greenspan has never met an unregulated investment vehicle he didn't like. As Bill Fleckenstein pointed out, "... in 1984, he (Alan Greenspan) wrote a letter to Edwin Gray, then-chairman of the Federal Home Loan Bank Board, advising the regulator to exempt Charles Keating's Lincoln Savings & Loan, a Greenspan client, from harsh federal regulations about its investments. He told Gray he should "stop worrying so much" about such things as junk bonds, and that 'deregulation (of the savings & loan industry) was working just as planned.'

"Lincoln Savings failed rather spectacularly a few years later. And it’s worth noting that within four years, 15 of the 17 thrifts he mentioned in this letter were broke, costing the old Federal Savings & Loan Insurance Corp. some $3 billion." Actually, Fleckenstein got the size of the tab wrong. It's "$32 billion every year for 30 years."

New York Post columnist Christopher Bryon appears to be single-handedly covering similar risks posed to taxpayers by USIPs. As we mention in "Hedge Funds Still in the Dark":

"The Securities and Exchange Commission has found Michael Lauer in contempt of court for violating an asset freeze order, acting in bad faith by not participating in the discovering process involving his hedge fund Lancer Management Group. To outspoken New York Post columnist Christopher Bryon the latest action is an example of SEC ineptitude, as the agency spends its resources going after small fry while not pursuing what could have been an eye-opening enforcement case against Lancer's administrator, Citco Fund Services. Bryon says the SEC has been sitting on top of the Lancer case since the firm went belly-up in 2003, and two weeks ago, according to the Post, a court ordered the unsealing of some 40 pages of internal e-mail memos and the like from 2002.

"Pursuing a case against Citco, Bryon writes, would have sent 'an unmistakable message to the entire hedge fund industry that those who break the law will go to prison.' Instead, he says, all the SEC can expect to get at the present is an injunction barring Lauer from the industry and relatively small fines. Bryon blames 'revolving-door leadership at the top [the agency has its fourth chairman in five years of the Bush administration], staff defections in the middle ranks and bewilderment at every level' regarding what constitutes 'improper and illegal' hedge fund behavior."

Much like the Savings and Loan industry, USIPs are a not merely unregulated investment pools, they represent an inadvertent Government protected racket, as distinguished from an advertent one like the State Lottery. I'm not a fan of government regulation but am a fan of transparency, of putting big, clear warning labels on risky products. I agree with Martin Mayer, that what USIPs need is not regulation but rules that allow investors and taxpayers, everyone with a stake in how USIPs impact the economy and financial system, to clearly see what USIPs are up to before they turn into S&L disasters.

Sincerely,

Eric Janszen

July 03, 2006 - Hedge fund exec accused in Ponzi scheme
July 3, 2006 - Refco Unit Reaches Pact With Customers

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[jk]

how are hedge funds gov' protected?

the sec hasn't done much policing, and i think there are likely major systemic risks buried in various hedge funds, but i don't see why you call them gov't protected like the s&l's.

the fslic commitment required bailing out the depositors up to 100k. [i don't recall if in fact they bailed out deposits over the 100k limit as i believe the fdic has done on occasion.] i don't recall whether neil bush was ever called to account on silverado. keating and some others were prosecuted.

the fed stepped in and made the major banks and brokers liquify ltcm so it could be unwound in an orderly way, but i don't think the invesors came out whole, did they? if by protection you mean a neglect of oversight, ok, but you seem to imply more.

[EJ]

the sec hasn't done much policing, and i think there are likely major systemic risks buried in various hedge funds, but i don't see why you call them gov't protected like the s&l's.

the fslic commitment required bailing out the depositors up to 100k. [i don't recall if in fact they bailed out deposits over the 100k limit as i believe the fdic has done on occasion.] i don't recall whether neil bush was ever called to account on silverado. keating and some others were prosecuted.

the fed stepped in and made the major banks and brokers liquify ltcm so it could be unwound in an orderly way, but i don't think the invesors came out whole, did they? if by protection you mean a neglect of oversight, ok, but you seem to imply more.

Here's the algorithm as simply as I can state it:
Step 1: Stumble on a way to make scads of money off the lastest liquidity bloom that follows the collapse of the previous asset bubble (e.g., re-cycling of tech venture capital through the public markets 1996 - 2000, yen carry trade 2003 - 2006, etc.)
Step 2: Create a plausible mythology that explains why the latest game of extracting money from The System is actually something new, unique and clever.
Step 3: Make sure you spread enough of the resulting money around that it pays a bunch of consultants' salaries, produces scads of capital gains tax revenue, buys a lot of advertising, and generally makes good copy. The mythology gets repeated ad nausem until even its inventors come to believe it (e.g., "Public Venture Capital" during the top of the tech bubble.)
Step 4: Something, or several things at once, go wrong and the game ends.
Step 5: Bubble collapses, the Fed pumps away, but as Martin Mayer explains, "The truth is that liquidity, the only significant weapon remaining in the central bank's arsenal as decision making moves to the markets, will not necessarily go where you want it to go when you need it to go there."
Step 6: Go to Step 1.

[Spartacus]

well we ever know what happened at REFCO?

Hedge Fund Horseshit

July 2, 2006" I'm not a fan of government regulation but am a fan of transparency, of putting big, clear warning labels on risky products. I agree with Martin Mayer, that what USIPs need is not regulation but rules that allow investors and taxpayers, everyone with a stake in how USIPs impact the economy and financial system, to clearly see what USIPs are up to before they turn into S&L disasters.

Speaking of transparency (or total lack thereof), just how was REFCO's derivatives mess cleaned up?

Could it possibly be that their whole derivatives book netted out to zero?

But if there was intervention required, was it a practice run for "sooooper seeeekrit" FED plans, in development since LTCM, for dealing with these blowups?

[jk]

refco

Speaking of transparency (or total lack thereof), just how was REFCO's derivatives mess cleaned up?

Could it possibly be that their whole derivatives book netted out to zero?

But if there was intervention required, was it a practice run for "sooooper seeeekrit" FED plans, in development since LTCM, for dealing with these blowups?

the refco mess is being played out in the courts. jimmy rogers' fund is a case in point. rogers moved the account to refco shortly before refco blew up. turns out that rogers' fund's money and positions were not in a segregated account as was supposed to happen [this was, i imagine, illegal, and certainly fraudulent]. so the fund ends up just an unsecured creditor, get in line at the liquidation.

i had an account at refco. it had been at lind-waldock, which had a relationship with schwab. lind was then absorbed by refco. after the news came out i called and discovered, happily, that my own rather minor funds were indeed where they were supposed to be- in my own account, which i promptly drained.

the question you raise though is about the counterparties. if rogers' fund, for example, was long cotton futures, then someone else was short. but i would imagine that since these are all listed futures the clearing corporation would be guaranteeing settlement. that is, unlike otc derivative contracts, there is no SPECIFIC counterparty associated with the contracts rogers' fund was holding.

[slackful]

The threat is massive naked short selling of volatility

To the extent that "hedge funds" (USIPs) are long volatility, they represent no threat. The problem is that everyone in the system, hedge funds included, have managed, on average, to get themselves short volatility. Everyone is an unregulated, unhedged, uncalculated insurance seller. Floating rate mortgages are a form of being short volatility. Credit default swaps create massive short volatility positions. The extended bear market in the VIX index is a coinciding indicator of the massive unhedged, unregulated short volatility positions extent in the system. (And the recent May "volatility storm", which raised that index to a 3 year high, is a warning shot across the bow.)

I guess my point is that USIPs being unhedged naked long or unhedged naked short their positions is not necessarily a problem. It's when their long (or short) positions translate to effective short volatility positions (as in the Japanese Yen "carry trade"), that the system is put at risk. Mayer's article (that you linked) says it all. Remarkably, that article was written back in 1999.

[jk]

who exactly is short volatility?

To the extent that "hedge funds" (USIPs) are long volatility, they represent no threat. The problem is that everyone in the system, hedge funds included, have managed, on average, to get themselves short volatility. Everyone is an unregulated, unhedged, uncalculated insurance seller. Floating rate mortgages are a form of being short volatility. Credit default swaps create massive short volatility positions. The extended bear market in the VIX index is a coinciding indicator of the massive unhedged, unregulated short volatility positions extent in the system. (And the recent May "volatility storm", which raised that index to a 3 year high, is a warning shot across the bow.)

I guess my point is that USIPs being unhedged naked long or unhedged naked short their positions is not necessarily a problem. It's when their long (or short) positions translate to effective short volatility positions (as in the Japanese Yen "carry trade"), that the system is put at risk. Mayer's article (that you linked) says it all. Remarkably, that article was written back in 1999.

i agree that the risk lies with those who are short volatility. for each derivative, though, there is also a counterparty who is long volatility. e.g. someone buys that credit default swap. the seller is short volatility, the buyer long. the question is who is short, and who is long. but, as mayer states: "Nature obeys Mayer's Third Law, which holds that risk-shifting instruments will tend to shift risks onto those less able to bear them, because them as got want to keep and hedge while them as ain't got want to get and speculate."

[slackful]

Re: who exactly is short volatility?

i agree that the risk lies with those who are short volatility. for each derivative, though, there is also a counterparty who is long volatility. e.g. someone buys that credit default swap. the seller is short volatility, the buyer long. the question is who is short, and who is long. but, as mayer states: "Nature obeys Mayer's Third Law, which holds that risk-shifting instruments will tend to shift risks onto those less able to bear them, because them as got want to keep and hedge while them as ain't got want to get and speculate."

You ask a good question. I don't really know exactly who is short volatility, in a magnitude that has driven, e.g., the VIX to such extended low levels. But I believe that their has been a huge increase in the amount of "volatility insurance" (in the most catholic sense of the phrase) that has been sold. I believe that those who are selling this insurance have priced it, on average across the portfolio, as if the recent extended calm period is the norm. I believe that when we have the next 15-sigma event in the financial markets, that many of the insured will encounter defaults from their counterparties, who were never sophisticated professionals in the insurance business, merely portfolio managers seeking yield, silently conspiring with intermediaries seeking yield. Slowly but surely, we've managed to boil the frog, who never jumped out of the water. Now, someone is going to find out they are cooked.

In the end, it will all get marked to market, or reality, or whatever you want to call it. The actual amount of risk that all these insurance sellers are taking will be revealed. The insurance buyers will not benefit from the fact that they are equally long what the sellers are short. They will be paid only a fraction of their coverage. And the markets will give us their version of the interplay between the big insurance companies and those on the Gulf Coast who thought the combination of their fire, flood, and other casualty insurance was worth anything when something real happened.