Hedge Funds

A hedge is an investment made solely to reduce the risk associated with another investment. The classic example of a hedge is a pairs trade. Let's say that you hear that GM is coming out with three new cars in 2007 and you are convinced that they are going to start making money. (Note: this is hypothetical.) You might feel confident about GM but lack confidence in the auto sector. You may be concerned, for example, about the price of gas or the economy in general. Your confidence is that GM will outperform the rest of the auto sector. What do you do? The easy answer is that you buy GM and you short Ford. You have "hedged" your GM investment.

Hedge Funds are created to use hedging techniques to make money. They are not about risk mitigation. Hedge funds are all about greed. They are geared to achieve a greater return than mutual funds but they do so by taking larger risks than mutuals. This risky activity is attractive at the present time because equities have been flat since 1999 and savings interest rates are modest.

Two-thirds of all hedge funds assets are registered offshore. This even despite the fact that hedge funds are lightly regulated. Hedge funds are not required to register with the SEC.

In general, hedge funds are places where fairly wealthy folks park their money to make some more. Hedge funds, generally speaking, do not own real assets but rather derivative assets. Many of them do what the example cited above suggests. They go long in one stock and short in another. They also may make incredibly complicated derivative trades based of computerized modeling.

Hedge funds tend to be organized as partnerships and steer well clear of SEC regulation. The SEC had ruled that not hedge funds but most hedge funds advisers had to register with them but that rule was recently tossed by a US Appeals Court.

The most notorious example of a hedge funds gone bad is LTCM. LTCM (Long Term Capital Management) had a diversified portfolio and an incredibly sophisticated model. It made one simple mistake. It assumed that markets would behave in the future as they had in the past. Perhaps more accurately it failed to associate a probability with a particular unlikely event. The failure of LTCM was due to various factors but unquestionably it was the fact that In August 1998 Russia defaulted on its bonds. That was an eventuality that the model never foresaw. Four days after the Russian default LTCM lost $500 million in one day.

It's Worse Than That

LTCM was highly leveraged. The amount of money that it had "in play" was vastly larger than its assets. In short, it was losing borrowed money. It had $4.72 billion of equity but leveraged that to $125 billion. Fixed income securities markets (among others) offer much more leverage than equities markets do.

Derivative investments are zero-sum things like poker games. The fact that some fat cats lost money meant that some other fat cats made money. No problem. But when the fat cats lose BORROWED money they are creating systemic risks in both the banking and brokerage industries. LTCM had counterparties: banks and broker/dealers who could have lost vast sums concomitant to LTCM's losses. It LTCM could not meet its obligations then its banking partners, the broker/dealers who executed the transcations for LTCM and the banks of those broker/dealers would suffer the losses.

The Federal Reserve Bank of New York rapidly recognized that the LTCM debacle threatened banks and security brokers and arranged a $3.5 billion infusion of cash to LTCM in exchange for a gigantic dilution of LTCM ownership. Note that the Fed did not bail out LTCM with public money. It helped to arrange financing for the LTCM dilution. LTCM had lost $4.6 billion in 4 months. This company which collapsed in 1998 had on its board of directors 2 guys who won the Nobel Prize in Economics in 1997. The Fed was not bailing out LTCM it was protecting the banks and the broker/dealers. That is of substantial concern to the Fed.

What is This All About?

Good question. I don't see LTCM as anything resembling the Solomon Brothers disasters on the 1980's. Those involved, among other things, phony bids on US Treasuries. LTCM was about a computer model that folks became too enamored with. It was one of those situations where the model was correct 99.9% of the time but that 1 in a thousand thing happened and, essentially, wiped them out.

So What Are the Risks?

The risks generated by hedge funds may in fact be too complex to understand. There may be situations where hedge funds increase market volatility and exacerbate losses. The real dangers created by hedge funds are to the counterparties. The counterparties are the banks that provide financing for their leveraging and the broker/dealers who clear their transactions.

I believe that these risks were well addressed by Bernanke in his speech in Atlanta on May 16, 2006. As an aside it is worth reading this relatively short paper because, unlike his predecessor, Bernanke speaks in comprehensible English.

Bernanke address the issue of regulation of hedge funds by implying that regulation of hedge funds is not practical but risk mitigation is best achieved by getting the counterparties which provide the leverage to hedge funds (banks and securities broker/dealers) to better understand what their customers are doing and to minimize the risks.

Part of the problem is that for a hedge fund to function it must not reveal its entire portfolio or strategy outside its circle of investors. To some extent this is a high stakes poker game and the casino can't ask the players to show their cards.

Another issue with hedge funds is that some of the things which they trade - credit derivatives for example. - are relatively new and we do not have a good collective understanding of what can happen with these. A credit derivative is a type of derivative security whose value at maturity is dependent on some credit event. Private Mortgage Insurance once common to the mortgage industry would be an example.

In essence credit derivatives are vehicles whereby banks can pass the credit risk to someone else at a cost.

There are arguments to be made on both sides as to whether or not credit derivatives are healthy for the economy or potential sources of massive disaster. Warren Buffet referred to credit derivative as "weapons of mass destruction." This was after a company he purchased - Gen Re - suffered substantial losses in credit derivatives. Greenspan said regarding credit derivatives "that benefits have materially exceeded the costs.”

For me the answer is that these derivatives and other hedges have a purpose which well serves the folks who should be using them but that there may well be a large number of relatively ill-informed, greedy folks who misuse these and have the potential of creating disasters which spread beyond merely their own funds but also to the banking system and the security dealers who clear these transactions.

More Potential Trouble

The potential for viral problems to spread from hedge funds collapses is simply unknown but hardly trivial. The problem is that, being highly leveraged, a collapsing hedge fund could create second order market shocks. Hedge funds could be forced to liquidate positions creating fire-sale scenarios. While there are certainly massive opportunities to make a profit by those who are liquid and can buy those assets at low prices there may well be other individuals and funds who because they are moderately leveraged are forced to sell their positions because they have their margins called.

As in 1998 with the default of Russian debt the trigger for such an event could come from many places.

In a nutshell, a hedge fund says: "If you model the economy correctly there is always a play where you can make a buck. It matters little how the market actually moves." Left unsaid is that if you model it incorrectly you can lose your butt with remarkable speed.

The Real Problem

The real problem may be no more than an intellectual one. It is simply hindsight bias. We can construct models which perfectly describe the past and feel confident that they are very likely to describe the future. The true difficulty is ascribing probabilities to events which we might anticipate as being probable but unlikely. There is a scholarly piece on this by Eliezer Yudkowsky. The problem is that it is often difficult or impossible to ascribe a correct probability to a low probability event. In short, if the long-term success of a model depends on one ability to correctly estimate whether the probability of a nation defaulting on its debt in a give year is is 1/1000 or 1/100,000 the process may be intellectually futile.

It is a facet of human nature that we are inclined to be overconfident in estimating that which we do not really know. That little sentence may be the heart of the matter.

Ascribing probabilities to casino games is simple because these involve the activities of sterilized systems. The dice are manufactured with an exactness to assure the predictability to the randomness. Ascribing a probability to an event such as an 8.5 earthquake in a major California city or a category 5 hurricane hitting Miami at least has some data to go on. Ascribing a probability to an outliner event such as 9/11, the Russian debt default or a large comet striking the earth is a more daunting task.

Hedges are important economic tools to mitigate the risk to valid investments. Hedge funds are about nothing other than greed. Their main economic purpose and the reason they are tolerated is that they provide profitable business to the broker/dealer community and also additional participation to the trading of derivative thus mitigation the volatility of those. Volatility is always diminished by additional market participation. Unfortunately the price of that day-to-day mitigation of volatility may be a disaster every couple of decades. It is not hard to imagine that for the sake of keeping what may be one of its best customers a broker/dealer would give less than a thorough inspection of the practices of a hedge fund.

In brief, calculating the correct probability that a hedge fund triggered event causes massive harm to the US economy is, unfortunately, impossible.

Dick Lepre

Sticky Wages & Prices

The Fed must certainly be feeling that its long series of hikes should be starting to have some effect but this is where perception competes with reality. Even if the Fed feels that its actions are sufficient to accommodate economic reality it may still hike to quash concerns about inflation.

This heightens the fact that we are in a new economic age. World currencies used to be tied to commodity prices (e.g. gold). This was called the Bretton Woods system. Bretton Woods was a set of rules whereby each country was obligated to adopt a monetary policy that maintained the exchange rate of its currency within a fixed value—plus or minus one percent—in terms of gold.

The U.S was THE dominant world power when Bretton Woods was created but an interesting thing happened in the late 1960s' which has some striking similarities to the present. The 1960's were dominated by Viet Nam and the Great Society (OK, I left out rock and roll and drugs but let's make that another newsletter). The unwillingness of the Administration to raise taxes in the face of the added expenses of Vietnam an the social programs of the Great Society led to a very serious decline in gold reserves. In essence Bretton Woods collapsed totally in 1972 and the world went on a floating currency system. The US could no longer tolerate or guarantee the conversion of dollars into gold. (BTW, if you have time on your hands Google this topic and you will be surprised at the number of disparate zealot groups who tie all of our troubles to dropping the gold standard.)

The only vestiges remaining are the near pegging of the Chinese currency to the dollar but in essence we have one big floating exchange for world currencies.

Of course the underlying problem is that these are all fiat currencies - money printed by the central banks with less than clearly defined standards of accountability.

What we now have is a system in which not only commodity backing (gold standard) but even control over the money supply has given way to a system in which control over one thing - interest rate policy - is supposed to be able to keep not only the economy of the US but everyone else's economies functioning.

A Sticky Issue

An issue which economists like to discuss which never seems to make it to the mainstream media is the stickiness of prices and wages. The idea here is that both wages and prices are sticky. "Sticky" means that wages and prices do not instantly or even quickly adjust to changes in money supply, demand or supply. If there were a completely "free market economy" out there economists would believe that wages and prices should adjust more often than they in fact do. Except for the price of gasoline and perhaps fresh produce almost nothing adjusts rapidly.

Economists need to know just how sticky wages and prices are to properly model interest rate policy. Stickiness increases the length of time that it takes for policy changes to have an effect. Consequently, it is important to always know how sticky prices and wages are. It is very easy to get a handle on prices. A gigantic number of electronic transactions captured by computers every second. Some where out there the retail price of beef correct to 5 decimal places and update every one minute is known.

Wages are tougher. The week to week changes in wages are simply not known. Perhaps an entity such as ADP has the data but it would be nice if the Federal Reserve had better access to the current cost of wages. Wage inflation is a significant contributor to inflation and the Fed must have better access to this data.

But Why so Sticky?

Economists seem to be struck by the fact that wages and prices are as sticky as they are. In a theoretical economy prices and wages would be changing much more quickly but the fact is that these are real things tied to real people. While it might make theoretical sense for a plant manger possessed of absolutely perfect data to have a meeting with his employees at the start of the third quarter and say, "Folks, you all need to take a 1.734% cut in wages this quarter if you all want to be working here at the start of the 4th quarter." There are considerations. He might be instantly murdered by an employee. Employees might have such resentment to his request that their productivity falls off dramatically. Employees might say, "Screw it. Keep my wages where they are because I bet that I am not one of the folks who will not be here in the 4th quarter."

Prices are also sticky. There are considerations here. A restaurant cannot print new menus just because the prices of beef changes for week-to-week. Poker game like considerations regarding market share are also important. Both wholesalers and retailers are resistant to marking up prices if it will cost them market share. The power of a mega-retailer such as Wal-Mart gives them a certain amount of insulation against price shocks. Their suppliers may well be willing to forego all of most of their profit for the ability to sell to them next year. Folks who shop at Wal-Mart do not have a lot of discretionary spending to do. Contrast that with Neiman-Marcus or Whole Foods which have clientele seeking something other than a bargain.

Maybe stickiness is a consequence of having such a low domestic savings rate. If the average family had 12 months of expenses cushioned in their checking account they might have a different attitude about the effect of less than sticky wages and prices. Stickiness might be a consequence of our profligacy.

These discussions have a purpose. Making correct decisions about monetary and fiscal policy necessitates the ability of the Fed to estimate the stickiness of wages and prices. This gets into the arcane space of economics. See, for example, Optimal Fiscal and Monetary Policy with Sticky Wages and Sticky Prices by Sanjay Chugh.

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Dick Lepre

Equity Pimps

Interest Rates

Short-term Treasury techs are bullish so we believe that we will see modestly lower yield in the coming weeks. This coming week has CPI and anything greater that +0.2% core will not be tolerated by the Treasury markets.

Import prices were +1.6% in May. Core Import Prices were +0.7%. This is of concern for inflation abatement. The question remains: to what extent are higher energy prices responsible for higher prices of other goods? The big issue here is that there is little that the Fed can do about the price of crude. The choice to consume less gasoline, for example, takes place on the individual or family level and we are paying the price for many years of bad choices of vehicles which use too much fuel. Add in 30 years of disregard for things such as nuclear power and there is little mystery.

Equities

With little market action and little to talk about regarding Treasuries I will attempt some comments on equities. I know that I know little about equities. From my perspective, it is easy to understand the forces that drive fixed-income securities and especially Treasury rates. They are all about inflation and they are the most secure investment in the world. Equities are strange because they are driven to a large extent by greed, herd mentality and other quasi-rational forces not to mention funky accounting. Equities seem to be suffering at present from the effects of two forces: 1) the belief that corporate profits will diminish and 2) concern about inflation. The corporate profits thing is indeed strange. Equities have been flat for something like 7 years. They seem to be only loosely correlated to profits. It used to be that case that a company's value was correlated to its profits and the dividends disbursed to the shareholders but times have changed.

The inflation thing is strange. Read what I wrote in last Friday's newsletter: "Morning brain-dead radio spin says that the Fed may stop hiking but I do not think so. The problem with media news about the economy is that it is geared to equities. It expresses what equity dealers want not for the economy but for their own gain. They equate a lower Fed Funds rate with higher equity prices." Wall Street (the equity business) tries to "wag the Fed." When it does not work as Monday’s Bernanke speech they have a hissy-fit.

Wall Street equity traders are hilarious. Their pitch is, "Hey, if the Fed does not do what WE want we will throw ourselves under a subway train. Really, we will. If you keep talking about hiking we really are going to keep selling and kill ourselves. We really, really, really mean it this time. We are not kidding." The Fed pays no attention. Markets sell and then recover. The reality is that the economy is in good health and corporate economy is in better shape than the average Joe.

What happened is that the equities folks made a case for "no more hikes" based on the BLS Employment Situation Report of last Friday and the Fed did not buy it. What is most noticeable here is that the Fed does not cater to Wall Street or any political party. It is looking our for the general health of the American economy. The economy consists of much more than equities and the day-to-day trading thereof. The media fails in its attempt to convey the complexities of the economy because it chooses to dumb things down. To the media high equity prices are good, low equity prices are bad.

We're coming up on one of those times when the Fed will be done hiking but we have not yet seen the effects of 16 (or however many) hikes. What is needed is a conspicuous display of the lack of inflation.

Mr. Greenspan - you remember Mr. Greenspan - spoke on Wednesday to the Senate Foreign Relations Committee and expressed concern that the US economy might finally suffer from the impact of higher oil prices. He noted that the buffer between balance of supply and demand is so thin that any abatement in supply or production causes price shock. In short there is too little global refining capacity. Also this enables speculators to push on the margin and drive the price up even further. With all respect, while Greenspan's comments certainly matter his observation has as much value as "the sun will rise in the east tomorrow."

I have talked about this extensively before but we need the following: in the short term - more crude supply and more refineries, and in the longer term more alternative sources of energy - nuclear, solar, wind and whatever. We also need folks to make sensible decisions about their choice of motor vehicles. In the meanwhile we need more refinery capacity for gasoline. We do not need Congress passing inane tax credits for SUV's. (Actually I don't think we need Congress but let's make that another newsletter.) The discussing is silly. The answers to the energy problems are all right here. This is not like finding a cure for cancer.

This past Tuesday was, for me a statement about the massive stupidity and lack of vision on the part of media. It was June 6 - D-day as in Normandy but we seemed to hear more comedy about 6/6/06 and its satanic implications than about D-day. Something is wrong. I have the notion that young folks know practically zero about the history of World War II. If they know more about satanic cults than about D-day I would be troubled. But, hey, I live in San Francisco a place where the Board of Stupidvisors decided to change the name of Army Street to Cesar Chavez Way. Thankfully, this was before they knew about Hugo Chavez.

Also in California we had a primary election. Two guys fought over who would face Arnold in November and each one campaigned on a "the other guy is a bigger scumbag than me" platform. This was confusing because all the ads for "A" mentioned only "B" and all the adds for "B" mentioned only "A." There was an election in San Diego to replace the crooked Republican Congressman and the Democrat's "Culture of Corruption" message seemed not to hold sway. Maybe folks are actually getting sick of negative campaigning. I am. I have found the "Culture of Corruption" message strange. To me, there really are several places where there is a genuine corruption of political culture: Louisiana and New Jersey. And I am not referring to the dude with the cash in his freezer. He is a chump change wannabe. Corruption in Louisiana was raised to an art form by Huey Long - one on the most truly interesting people in the history of American politics. Huey would never have put cash in his freezer. He would have invested it.

I think that Newt Gingrich - a guy with a lot of political savvy - may indeed have the message for politicians: for whatever reason the main issue seems to be immigration or illegal immigration or immigration reform or whatever you want to call it. A Democrat winning an election in conservative San Diego County would have created a different political calculus. The issue in that election seemed to be immigration. Gingrich, a more conservative guy than even the average Republican voter is clearly sending a message to Senators and Congressmen and it is a "Don't give these folks amnesty" hard-line message.

I did read one line this week which I thought strange, "an attorney with the Mexican American Legal Defense and Educational Fund, warned that the cameras [installed on the S. border of the US] could lead to racial profiling." Uhh, right.

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Dick Lepre