The Hedge Fund Headache
The Hedge Fund Headache By William Cate
Hedge Funds are dangerous. They play with the D-bomb and Hedge Fund managers don't know what they are doing. They are like children playing with a landmine in a sandbox. It's fun and exciting until the darn thing goes off. A D-bomb explosion would have the same impact on the global financial market, as an H-bomb would have denoted over Salt Lake City. The result would be a multi-century wasteland after the explosion. A D-bomb explosion means that our Civilization will be facing a new multi-century Dark Age.
The D-bomb is the Derivatives Market. In theory, derivatives are balanced risk investments that allow Hedge Funds, banks, insurance companies and others to profit from the spread created by the bet. The three design problems with D-bombs are that the risk is usually an either or option that doesn't factor in a third alternative. Many bundled derivatives have components that don't represent outside financial instruments that might have value after a D-bomb explosion. The Derivatives Market represents about forty times the total value of all world currencies combined. If the D-bomb goes off, all world currencies would be worthless about forty times over. There simply isn't enough money to cover a D-bomb meltdown.
In simple terms, a derivative is merely a bet. And it can be a bet on anything: interest rates, exchange rates, stocks, commodities, etc.Find a counter-party willing to wager against you, and you havecreated a derivative. And to make the bet you usually only have to put downa small fraction of the bet amount. However, if their bet explodes, the Hedge Fund must cover the leveraged amount of their bets. It's this coverage requirement for dangerous bets that puts the global financial market at risk. The D-bomb risk/reward ratio doesn't make sense to anyone who understands it.
Consider Long Term Capital Management. In 1998, it was the largest Hedge Fund in the world. It's derivatives shenanigans almost triggered the collapse of the entire global financial system. It careened to the brink of failure and would have gone under if the U.S. Government had not organized an emergency bailout. That bailout took the taxpayers of twenty countries to cut the timer to D-bomb denotation. And, Long Term Capital Management wasn't even an American Hedge Fund.
The global derivatives market is around $272 trillion, according to the recent figures from the Bank of International Settlements. And three big American banks' JP Morgan Chase, Bank of America and Citicorp - account for $77.6 trillion of the money being bet.
European banks are at risk for over $100 trillion and are the global center for D-bomb development. However, America is racing to close the D-bomb gap. Because they aren't regulated like banks, U.S. Hedge Funds are on the cutting edge of D-bomb development. American Hedge Funds manage over one trillion dollars, up from thirty nine billion in 1990. In the first quarter of 2005, wealthy investors added twenty seven billion dollars to the capital of Hedge Funds. These Funds are borrowing billions of dollars from major brokerage firms and others. With the help of Hedge Funds, America is closing the D- bomb development gap. A small bad bet can easily bring down the largest financial institution. Hedge Fund trading may account for up to 50% of the trading volume on the NYSE. A few bad bets would collapse the Dow Industrial Average. Because there are no reporting requirements, nobody knows how well or badly Hedge Funds are doing. However, I've never met a Hedge Fund manager who wasn't seeking new blood for their operations. If they were doing so well, they wouldn't need a constant influx of new capital.
GM is in financial trouble. The company is planning to layoff 25,000 U.S. employees. The troubles were evident to the investment community for over a year. Hedge Fund managers made a simple bet on GM. Funds bought GM's corporate bonds and hedged the risk of default by shorting GM stock. The plan was to hold the bonds and the Hedge Funds would lock in the interest rate spread between the coupon on the debt and the dividend on the common stock. This was a simple either or bet. If GM defaulted on the bonds, the shorted GM stock would cover the bond loss and allow for a profit. If the Company strengthened its financial position, the interest on the bonds would cover any losses sustained by the short position. As with many D-bombs, it appeared the Hedge Funds couldn't lose.
The D bomb exploded when GM debt was downgraded (causing its bonds to go down) and Kirk Kerkorian made a tender offer for 3% of GM's stock, causing GM shares to rise. Hedge funds got shredded in this little D-bomb explosion. A similar thing happened with Ford stock and debt. And, it happens often with no one the wiser.
The fact is those betting on Derivatives are betting on the future of Civilization. At some turning point in the economic situation, whether it be a recession or double-digit inflation, the Hedge Funds will lose sufficient bets to create a cascading explosion that will destroy Civilization. The sad fact is most people don't see that the D-bomb is in play and will eventually explode.
About the author: He has been the Managing Director of Beowulf Investments [http://home.earthlink.net/~beowulfinvestments/] since 1981 and is the Executive Director of the Global Village Investment Club [http://home.earthlink.net/~beowulfinvestments/globalvillageinves tmentclubwelcome/]