Hedge Fund managers in 2007 reaped huge profits by betting on commodities and the crisis in financial markets-John Paulson $3.7Bln., George Soros $2.9Bln. and James Simons $2.9bln. The 50th hedge fund manager’s $210 ml. seems paltry in comparison according to figures compiled by Alpha Magazine
The problem with this goes beyond the injustice and inequality of earning such enormous amounts. These predators financially gained by exasperating rising prices for oil/gas and basic food stuffs-in other words the extra we had to pay for gas and to eat, went right to their bottom line.
Several also profited by betting against the mortgage market and in doing so aggravated the effort to keep those Americans struggling with their mortgage payments stay in their homes. If a handful of traders in the city of London made $2bln from the “meltdown in the subprime market” as the Times of London reported, how much did the thousands of others make? Understand that these figures are a fraction of what their wealthy investors made.
These predators are a major threat to regulators trying to prevent financial calamity and to keep the economy going.
Gaining from Our Misery
As the UK Guardian noted:
“Millions of people are facing foreclosure on their homes, banks are going belly up, tens of thousands are being put out of work, America is on the brink of recession – it’s another fantastic year to make money as a hedge fund manager.”
Paulson is reported to have made his billions by betting against the subprime market that devastated several banks. The NY Times reported that Soros came out of retirement last summer to exploit the banking crisis. Reaping huge profits at the expense of others is nothing new to Soros who profited handsomely from the 1987 stock market crash and the departure of the pound sterling from the ERM in 1992. Some credit Soros for single handily bringing the pound to its knees.
The problem with all the speculators and large pools of capital is that they can make themselves right. In other words they can buy so much of a particular commodity or financial asset price that the sheer volume of their buying or selling, becomes self fulfilling. The huge amounts of Japanese capital roaming the world in the 1980’s was known for its ability to take certain markets to price extremes and keep prices there for a very long time.
Derivatives have given speculators enormous leverage unknown only thirty years ago. Today a speculator has only to put up a fraction of an underlying assets price as collateral to make an investment bet. For example, it might be as low as only a 5% or less; so one could make a $1Bln bet with only putting up $50 mln. With the capital of some of the funds reaching into the tens of billions of dollars the leverage can reach into the hundreds of billions, if not trillions of dollars for one fund only.
It should be pointed out that many feel that margin buying in the 1920’s helped exasperate the great crash.
Ex-Treasury Secretary Robert Rubin recently told PBS in regards to derivatives that:
“I think that most people who deal with these instruments probably do not fully understand all the risks that are embedded in those instruments that can materialize under unusual circumstances.”
We don’t know is an understatement. Worse we have never been here before. Before 1973 when the Floating Exchange Rate Regime began derivatives were almost nonexistent. According to the Bank for International Settlements in 2007 there were $516 trillion in OTC (over the counter) derivatives outstanding; then there are exchange traded derivatives, and,
Thanks to ex Fed Head Alan Greenspan’s advocacy of derivatives there has been little oversight and regulation of them. And as we are beginning to learn, little understanding of them.
Daisy Chain Reaction
The fear with derivatives is that they can start some sort of daisy chain reaction where if one goes sour they all go sour. Bear Stearns was recently bailed out because regulators felt that its collapse could lead to the subsequent failure of other banks. If a bank held a lot of assets backed by Bear Stearns there was a chance that they would go bankrupt if Bear Stearns failed. The collapse of Bear Stearns could also have lead to a panic; similar to the banking panics, or bank runs, of the 1930’s when fearing insolvency depositors ran went from bank to bank pulling out their funds before they became insolvent.
Derivatives also give speculators the opportunity to create their own panic. For example, it was widely rumored that the collapse of the dollar after the stock market crash of 1987 was exasperated if not precipitated by one trader. This trader supposedly bought a large amount of options to sell the dollar at a very low price below the market price of the dollar at the time. To benefit from this trade the dollar had to fall precipitously below the price level (strike price) of the option. The bank selling the option to the trader would hedge (delta hedge) his position by selling a fraction of the face amount of options that he had sold the trader. For example, because the options were so far out of the money the banker might sell $5mln (5% of face) on a $100 mln option.
The trader bought lots and lots of options from banks all over the world. He then began too aggressively sell dollars. As the dollar fell the banks holding the trader’s options would have to sell more dollars to keep their option hedged as the dollar fell. This added to selling pressure. The trader kept selling. As the dollar kept falling banks were forced to sell more dollars to stay hedged. It ultimately became a self-fulfilling prophesy.
There should be no doubt that derivatives and the ability of speculators to bet on the recent crisis in financial and housing markets helped foment the decline.
Too Big To Fail?
Wall Street always reminds us about the risk of investing; that speculators can lose just as easily as they can gain. It is utter nonsense to think that speculators risk all when they speculate. If they are big players in the market history shows that the Federal Reserve or some other central bank will bail them out.
In 1998 Long Term Capital Management a speculative hedge fund made up of the who’s who of financial academia was bailed out when its bets went bad. Similarly Bear Stearns was in some unsavory businesses and evidently took on too much risk. In other words, for large pools of capital their is enormous upside and little downside.
The USA and much of the world is in financial straights. The USA economy that much of the world is dependent upon is slowing. The collapse of housing prices in the USA still has a long way to go and is beginning to reverberate around the world. Rising food and oil prices is creating hardship and famine around the world. The USA, much of the OECD and most of Americans are up to their eyeballs in debt. Hedge fund managers see all of this as a tremendous investment opportunity.
We have entered a new world order where derivatives and deregulation have made hedge fund managers and other predator investors the kings of the world. Central banks as we saw in with the collapse of the ERM in 1992/93 and the Asian contagion in 1997/98 are unable to stop them. We need to remember that the Floating Exchange Rate Regime began and fixed exchange rates ended when central bankers acknowledged that they could no longer tow the line against Eurodollar and Eurobond holders in 1973-let the market set exchange rates. The pools of capital setting exchange rates since then have only gotten larger.
The housing crisis will not end until speculators have wrung every penny of profit from the pockets of Americans unable to make their mortgage payments. Commodities such as oil and wheat will not fall in price until the speculators say so.
The seeds of deregulation and free markets planted decades ago are bearing their malicious fruit.
The end is nigh.
MADIS SENNER is an ex-global money manager turned faith based activist. He is author of Japanese Euroderivatives (Euromoney, 1990). He has written on geopolitical and economic matters for the NY Times, Barrons, IFR and others. To read of his financial musings go to his web page or the Fed Head Blog. He can be reached at madiss(at)verizon.net