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I'm certainly no expert on hedge funds, but I've read everything I could get
my hands on over the past few days about them, and I now feel both better
and worse about the whole situation.
The good news is I think the meltdown scenario a lot of people are claiming
will happen as the derivitives owned by failing hedge funds are unwound is
greatly exaggerated. People are wondering which fund after Long Term
Capital Management (LTCM) will need a bailout next. It appears LTCM really
was the "worst of the worse," simply because they invest almost exclusively
in bonds. Unlike most other assets, there is apparently no legal limit on
the amount of leverage one can obtain on bond holdings. If you have a bond
portfolio with a face value of $1,000, a bank can loan you $1,000,000+ with
only those bonds as collateral (incredibly stupid, but legal). LCTM
therefore was employing a much larger amount of leverage than most hedge
funds.
The other thing to remember is that most of these derivatives employed by
hedge funds were hedged, therefore losses on one side should have been
offset by gains on the other. What has cost the funds so dearly is that in
certain cases the party or institution on the other side of the hedge is not
honoring their agreement (Russian banks...). Somebody on the list already
pointed out very accurately that these funds shouldn't have even been
entering hedge agreements with entities that were on very shaky financial
grounds to begin with (Russian banks...), and therefore posed a serious risk
of default. The good news is that the defaults seem to be fairly limited
to just a few areas (as of right now...) , primarily in Russia and Malaysia,
where currency trading has effectively been shut down.
The last piece of good news is I think the quick intervention we saw this
week by large financial institutions on behalf of LTCM was a smart move.
Recent history has clearly showed that indecisive, half-hearted responses to
global financial problems only end up making them much worse. I would
rather see the parties involved overreacte now than do nothing.
The bad news is in how this situation was ever allowed to happen, and what
will stop it in the future. This part of the story really has me pissed
off. Tim Morge is absolutely correct in saying one of the appeals of hedge
funds is that there is very little regulatory control over them (especially
those based offshore). However, there is supposedly PLENTY of regulatory
oversight of the financial institutions that lent LTCM the money to go on
their leveraged bond spree to begin with. How in God's name did these
lenders not see this coming, and where the hell were the banking authorities
and accounting firms that watch these lenders?
Let's not forget that the Asian meltdown began over 1 1/2 years ago. You
would think these people would have started pouring over the books of their
borrowers to see what their overseas exposure was. Call me crazy, but I'd
like to think that a hedge fund with only $4 billion in hard assets but over
$90 billion worth of financial commitments would have raised some red flags.
People shouldn't just be fired over this, they should be shot.
I find it even more reprehensible that Greenspan and the Fed had to get
involved to begin with. Some people take this as a sign of how the serious
the problem is. I have a different view. I take it to mean that John
Merriwhether of LTCM first went to these banks to bail him out, and they
told him to go take a long walk off a short pier. He would've never gotten
Greenspan involved unless he had been totally rebuffed on his own. A lot of
people are speculating there was some kind of quid-pro-quo involved, like a
promise from Greenspan to lower interest rates. Nobody knows the truth
except for Alan, but I sure hope he didn't promise to overlook their past
sins. Remember, most of the lenders who ended up giving LTCM money ALREADY
had large amounts of outstanding loans to LTCM. An audit of their books may
have sent a few people to jail (and should).
It's bad enough that probably no one will ever get held responsible for
this, but now Congress is going to hold hearings on hedge funds. Great, the
same people who can't balance their own checkbooks with the House Bank are
going to solve the hedge fund problem.
The good news is I think the solution is pretty simple- TOTALLY BAN all
leveraged investments in emerging markets. Want to short the dollar? Use
all the leverage you want. Want to short the Thai Baht? Put up 100% of the
money. Any lending institution providing leverage for a third world trade
should be dissolved. These markets are simply incapable of dealing with the
massive flow of money (both in and out) that hedge funds throw at them.
They may grow at a slower rate because of this, but they'll be better off in
the long run. Hedge funds should also have to report within 24 hours any
leveraged investment they've made. If a hedge fund has a large leveraged
position in a stock I own, I want to know about it so I can reach the exits
first if I read their Brazilian bond trade has gone bad. They might have to
sell the stock just to meet a margin call.
Comments welcome.
Bruce
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