EYE ON AMERICA Hedge funds need trimming
By Peter Morici
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 the US housing market is not large enough to cause.
In essence, 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 and the like, which 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 in essence 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 Brahmans
that peddle their paper.
It's akin to a Las Vegas bookie taking only bets on the Washington Redskins
football team and none on its opponents, while financing the book on money
borrowed from a New York bank. An Ivy League Ponzi (pyramid) scheme!
In this environment of complex financial derivatives operations, private-equity
firms such as 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 Cerberus head John Snow has not explained how.
He doesn't have the skills for that.
The European Central Bank (ECB) was correct to shore up banks' balance sheets
by providing more liquidity. But its high-profile tender offer did more to
scare markets than to 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 the late US president Franklin
Roosevelt during the Great Depression, and it is in out of its depth. Roosevelt
did more than provide liquidity, he closed the banks 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 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 Management crisis in 1998 when he organized a bailout of
US$3.625 billion by the major creditors to avoid a wider collapse in the
financial markets. Or the ECB and Fed need simply to 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 US International Trade Commission.
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