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Hedge-fund con artists

By
August 22, 2007

The recent market meltdown had much less to do with bad subprime loans than advertised. It was caused more fundamentally by excesses at hedge and private equity funds. Those contraptions, invented by the sinfully wealthy barons of Wall Street, have lied to themselves and their investors about the efficacy of their schemes. Now they are quiet in their sins as bad home loans take the rap for a global meltdown that the U.S. housing market is not large enough to cause.

Essentially, hedge funds have been pairing put and call options with borrowed money from banks. Derivatives may have fancy drapings but most of what goes on boils down to complicated buy-sell pairing. Those pairings are based on computer models that establish patterns of stocks moving in opposite directions.

That can work for one or a few investors, with a very small share of market capitalization, betting against the market. But when hedge funds multiply, they essentially bet against one another and require one another to validate their bets. So betting on borrowed money endangers commercial banks stupid enough to believe the Brahmins who peddle their paper.

It’s akin to a Las Vegas bookie taking only bets on the Washington Redskins and none on their opponents, while financing the book on money borrowed from a New York bank. An Ivy League Ponzi scheme!

In this environment of complex financial derivative operations, private-equity firms like Cerberus have been pushing paper that is not backed by sound business plans. For example, Chrysler is merely a grand subprime scheme. Chrysler may be redeemable, but John Snow, chairman of Cerberus, which has bought Chrysler, has not explained how. He doesn’t have the skills for that.

The European Central Bank was correct to shore up banks’ balance sheets by providing more liquidity. But its high-profile tender offer did more to scare markets than calm them. Banks are calling in notes from hedge funds and denying private-equity funds new loans for questionable investments.

It’s a modern-day run on the bank, where the banks become the depositors and the hedge and equity funds are the banks. Unfortunately, the ECB behaved as if it were Franklin Roosevelt and is in out of its depth. Roosevelt did more than provide liquidity, he closed the banks in 1933 so that depositors could not withdraw their savings and stopped the banks from foreclosing on farm and home loans until sanity resumed.

The ECB and the Fed need to get between the banks and the hedge and private-equity funds, much as New York Federal Reserve Bank President William McDonough did in the Long-Term Capital crisis in the late ’90s, or they need to simply provide liquidity and take a lower profile. In the end, the ECB and Fed need to reassure markets through steady, calm action and not behave as the ECB did, like a frightened child.

(Peter Morici is a professor at the University of Maryland School of Business and former chief economist at the U.S. International Trade Commission.)

3 Responses to Hedge-fund con artists

  1. Steve Horn

    August 22, 2007 at 3:26 pm

    I’ve been trying to isolate the “cause” of the sub-prime meltdown – and I don’t believe it was hedge funds, nor the home owners with the loans. I believe it was greed on the part of those who made the loans.

    Allow me to explain.

    Joe Sixpack wants to buy a house, his credit isn’t perfect but he’s a hardworking guy and pays his bills. He gets a loan and buys his house.

    For a couple years he’s making his $2500.00 a month payments – on time – every month. The company that initiated or bought the loan is making a nice 4-6% return on their investment. The builder made his money, everyone is somewhat happy.

    But hey – if we can make a nice buck at 4% to 6% – we can make a BIGGER buck at 8% – so let’s jack Joes rates up.

    Able to eke by at $2500/month, Joe is unable to make it at $4000/month. He tries – builds up increasing credit card debt as his house consumes more and more of his available cash – maybe misses a payment – his credit card goes into 30% “penalty” mode and he goes straight down the shitter. Broke, homeless, unable to secure credit, Joe has just been shoved out the ass of the American dream.

    It wasn’t hedge funds that screwed over Joe, it was greed, plain and simple. If they hadn’t “adjusted” his rates he’d still be making his payments, every month and there would be no meltdown.

    I’m no financial wiz kid – but the basic rules of micro and macro economics I remember from my Samuelsons Economics textbook 24 years ago still apply.

    If the government wanted to stop the carnage they’d have frozen the rates on the sub primes and allowed the home owners to continue to pay at a reasonable rate – of course – that would build up the population in the “haves” column and perhaps not allow those well established there to continue to amass ever greater fortunes.

    Now we’ll bail out the lenders – but poor Joe Sixpack gets to try and rebuld his own life – with no assistance what so ever.

    Peace

    Steve

  2. www.nazilieskill.us

    August 22, 2007 at 7:27 pm

    It’s not really greed that motivates crooks. They always use their money to steal some more. They are basically practical jokers who feel superior to all of those they gull.

    4 trillion from the market. 2.5 trillion from the pentagon. That will buy a lot of mischieve. Just like a James Bond thriller with satellites used to extort even more from the world.

    John Hanks, Laramie, Wyoming

  3. bryan mcclellan

    August 22, 2007 at 8:51 pm

    Steve, your hammer must be smokin from nailin that one.Well said..