A Bad Trade

Every mother wanted her babies to grow up and work on Wall Street or the City. Why? Because the money was so good. No sector was more profitable; no employees were better paid. But that was the basic problem too. Bill Bonner explains…

The present period in financial history favors ducks and undertakers. On the banks of the Thames and the Hudson, every day they fish a couple more cadavers out of the water. And then the medical examiner opens them up so we get to see what caused them to go under. What a sight! It is amazing that any sane investor ever had anything to do with them in the first place.

We are speaking about the entire financial industry, in general, and hedge funds in particular. Picking at the innards of the deceased, we find their plumbing so twisted, it’s a wonder they lived as long as they did.

Of course, every mother wanted her babies to grow up and work on Wall Street or the City. Why? Because the money was so good. No sector was more profitable; no employees were better paid. But that was the basic problem too. People who worked in the financial industry were encouraged to take outsize gambles in the hopes of outsized bonuses. And as long as the credit cycle was on the upswing, the wagers paid off.

"Until the recent tempest," says Fortune magazine, "Wall Street firms looked like just about the world’s best businesses. Year after year they boasted sumptuous profitability, ever-rising share prices, and, if you believed their claims, a new generation of chief executives who had mastered the art and science of risk management."

In the period, 2002 to 2006, the sun never shined more brightly for the five big independent firms – Goldman Sachs, Merrill Lynch, Morgan Stanley, Lehman Bros., and Bear Stearns. Their earnings rose 200%, to more than $30 billion, with an average return on equity of 22%. Too bad they didn’t hold onto the money. But when the money was on the counter, the clerks at financial firms didn’t put it in the till. They took it home.

Fortune continues with the numbers: In 2006, the top six employees at Lehman pocketed $150 million, and James Cayne, who was at the time Bear Stearns’s CEO, paid himself $40 million. Employee compensation at Wall Street’s big five investment banks included restricted stock and options equal to 26% of the companies’ outstanding shares.

As long as the weather was good, no one complained. But in 2007, the monsoons began. Since the middle of the year, just three firms alone – Bear, Merrill Lynch and Morgan Stanley – have taken more than $40 billion in writedowns. Bear drowned…while managers at other firms looked for ways to stay afloat. Shareholders, meanwhile, raced to the cupboard to look for the companies’ rainy-day reserves. Alas, employees had stripped the company of capital.

As for hedge funds, we have nothing against them. Au contraire, we value them as we value influenza and Russian roulette….they help carry off the weak and eliminate the stupid.

It was a bad week for hedge funds. Poor John Meriwether, for example, was back in the news; we get to laugh at him twice. He was the captain of LongTerm Capital Management which sailed along beautifully – thanks to the aid and comfort provided by two Nobel Prize-winning economists, Myron Scholes and Robert Merton – until it hit a reef in 1998. After the LTCM sinking, Meriwether swam ashore, dried himself off, and went back to doing what he did best – taking a big piece of investors’ money. But in 2008, his flagship fund is down 28%. And he’s not the only one. It was the worst quarter ever for the hedge funds. And March was almost as bad for hedge fund managers as it was for Julius Caesar; the average fund was down 2.4% in the month alone. Some of the big, well-known funds fell much more. Endeavor Capital dropped 34%. London Diversified Fund Management’s flagship fund lost 10%. And in New York, Pardus Capital Management, which seems to specialize in airline stocks, refused redemptions on its $2 billion fund.

Alert readers will already be asking questions. Isn’t the whole idea of a ‘hedge’ fund to hedge against market disasters, by taking countervailing positions in different asset classes? We assume that was a rhetorical question, since everyone knows hedge funds ceased to hedge a long time ago. Instead, they are some of the biggest go-for-broke gamblers in the financial world.

It is the old principal/agent problem – a traditional bugaboo among economists – says a colleague. You hire someone to do a job for you and you assume he’s on your team. And then you discover than your doctor operates a funeral parlor on the side. It’s a problem in business and politics as well as the investment world. Turn your back for just a moment and your CEO is awarding himself stock options and your kids are wearing your socks; your local politicians are hiring their girlfriends, and your hedge fund manager is taking extraordinary risks with your money.

In the world of hedge funds, the problem was particularly acute. Because the managers have such lopsided incentives. If they make money, they take 20% of it off the table and put it in their own pockets. If they lose it, you, the investor, get to keep the whole loss. Heads I win, tails you lose. This is why Warren Buffett calls hedge funds a "compensation system," not an asset class. Over time, the hedge fund manager is practically guaranteed to end up with more of your money than you have. John Kay, writing in the Financial Times last month, demonstrated that if Buffett had charged like a hedge fund, he would have ended up with 90% of his client’s money in the 42 years he’s been investing.

But in the recent stormy weather, 50 hedge funds have washed up. Only about 7,950 left to go.

Until next week,

Bill BonnerThe Daily Reckoning
April 4, 2008 — London, England

Bill Bonner is the founder and editor of The Daily Reckoning. He is also the author, with Addison Wiggin, of the national best sellers Financial Reckoning Day: Surviving the Soft Depression of the 21st Century and Empire of Debt: The Rise of an Epic Financial Crisis.

Bill’s latest book, Mobs, Messiahs and Markets: Surviving the Public Spectacle in Finance and Politics, written with co-author Lila Rajiva, is available now.

Bottoms…bottoms…and more bottoms…

Today, we have to open our collar and loosen our tie; we see more bottoms than at the Folies Bergeres.

"What do you call it when the stock of the country’s fifth-largest investment bank trades at $50 on a Thursday and at $3 the following Monday?" asks Jim Cramer. "I call it a bottom."

Of course, everyone says he saw the bottom in the U.S. stock market in January…and the bottom in the financials when Bear Stearns owners panicked and agreed to sell the firm for $2 a share…subsequently amended upwards.

And look at the U.S. builders – they seem to have bottomed out too. "It can’t get worse than this," say industry spokesmen. The index has now turned up.

Meanwhile, look at the Chinese stock market. As predicted in this space – remember, lines of people in Shanghai waiting to open up brokerage accounts? Thousands of new accounts being opened every day? Share prices up 500% in two years? Now, the Chinese stock market has collapsed. The FXI – a kind of Dow Jones Industrial average for the Shanghai market – fell from 220 to 120, a loss of 45%.

It wasn’t the only one. Both Japan and India fell 31%. And Vietnam must have felt as though it had been hit by another Tet Offensive – stocks are down 53% since October. (Colleague Manraaj Singh swears this is a buying opportunity for the Vietnam Fund…more about that some other time.)

But now…all these markets seem to be going back up. Have we seen the bottoms?

And what’s this – gold, our favorite metal went down to $887 or thereabouts, then bounced back over $900. And yesterday, gold added another $9. Have we seen the bottom in the gold market correction too? A lot of people are betting on it…

Look around you; you’ll see bottoms everywhere. Yesterday, prices on just about everything were rebounding. The euro (EUR) rebounded against the dollar. Asian markets rose. Wheat, soy, rice prices – all on the way back up. The CRB index rose too.

(Even base metals have gotten so precious that a front page report in today’s International Herald Tribune tells us that thieves are stripping the lead off of church roofs in the UK.)

About the only thing that didn’t bounce yesterday was oil – which was off a bit, but still holding over $100. Yes, dear reader, it looks to us as if oil found its bottom at around $100, which is a remarkable thing.

Even in volatility, it looks like a kind of bottom has been found – meaning, volatility is decreasing…markets are calming. As they say on Wall Street…the bottoms are in…

…or are they?

George Soros wonders:

"We had a good bottom," Soros said yesterday in an interview in New York, referring to the rally in stocks and the dollar after JP Morgan Chase & Co. agreed to buy Bear Stearns Cos. on March 17. "This will probably not prove to be the final bottom," he said, adding the rebound may last six weeks to three months as the U.S. moves closer to a recession.

*** Soros had a new book released online yesterday: The New Paradigm for Financial Markets (Public Affairs, 2008). He explains the causes of the current meltdown, which he traces to the big turnaround in 1980…when U.S. President Ronald Reagan and U.K. Prime Minister Margaret Thatcher came to power and borrowing ballooned.

Hmmm…sounds familiar. That is what we have been saying too – that people got the wrong idea about the free market. They thought it was a panacea. As long as you reduced taxes and regulation, they believed, you could get away with murder…or at least leverage.

Not so. Capitalism is not a system that makes people rich. It’s a moral system…not really a financial system at all. And like any moral system, it’s fuzzy at the edges and difficult to master. Where does the Atlantic stop and the Jersey shore begin? No one can tell you exactly. And no one can tell you where, exactly, one person’s rights begin and another’s stop. Does a landowner really have an unencumbered right to enjoy the usufructs of his property…knowing that his ancestor stole the land, even fair and square, from the local natives? Does an airline have the right to fly its jumbo jets into an airport…regardless of the noise pollution it causes to the local householders? Would motorists have the right to drive gas-guzzlers if the planet really were headed for a global climatic disaster? Who knows? All you can do is do your best…trying to respect other peoples’ property…and other peoples’ freedom to do what they want…and trying to hold people to their agreements and obligations. Some people get rich; some people get poor. Some people lose; some win. But mostly, grosso modo, the free market gives people what they’ve got coming.

*** While George Soros believes the advanced markets of the West will begin heading down again in a few months, he thinks that some emerging markets will continue going up. He’s heavily invested in India, for example, where he believes "the fundamentals remain good."

In other words, capitalism still works. But the winners in this capitalistic world are not necessarily those who blather on about freedom and market economies.

Soro’s former sidekick, and our old friend, Jim Rogers, says he wouldn’t put a dime in India. He sold all his emerging markets, except China. The Middle Kingdom has very little political freedom. According to the theorists of the Reagan/Thatcher era…China as it is today couldn’t exist. Political freedom was thought to be inseparable from economic freedom. And economic freedom was considered essential to growth and prosperity. But there it is – China! What to make of it?

Jim is so sure that China will be the world’s next super-power, perhaps replacing America as the leading hegemon of the planet, that he has insisted that his daughter learn to speak Mandarin. Practically from the day she was born she’s had a Chinese nanny.

So colleague Manraaj Singh is good company. He has faith in the emerging markets too. His favorite Asian market is Vietnam, also a communist country…the one that booted out U.S. troops 40 years ago and imprisoned America’s candidate for president, John McCain.

But yesterday, Manraaj was not talking about Vietnam. Instead, he had this to say about U.S. Treasury Secretary Paulson’s visit to China:

"In a press conference in Beijing, he said that he emphasised to the Chinese government the benefits of more efficient capital markets as a device that could ensure ordinary citizens received an "adequate" return on their savings…and that’s when I burst out laughing!

"Since the beginning of the decade, the S&P 500 Index has actually fallen by five percent. In China, the benchmark Shanghai A-shares Index is up by 124 per cent – and that’s after falling 43 per cent from its peak in October. They were up 296 per cent at their peak. I think that Chinese investors have seen an "adequate" return on their savings. U.S. investors, on the other hand, probably wouldn’t think so…and neither would the average British investor… the FTSE is down 11 per cent over the same period."

Interestingly, Asian markets have been hit hard… not by anything they did wrong, but by the sub-prime crisis, which was 100% made in America. The emerging markets have their troubles and weaknesses, Manraaj concedes, but they are fundamentally in better positions than the US, because they have less debt and cheaper operating costs.

*** We mentioned Icelandic bonds the other day. They’re an intriguing investment because yields are exceptionally high. Obviously, wherever you get high rewards, it is a good idea to look around to find out why; there’s bound to be a reason. Mr. Market never gives our favors without strings attached. The cord attached to this particular yield leads right to the krona (ISK) – which fell 22% last year. Even if you can get an inflation adjusted, or real, yield of 5% on Icelandic bonds, another drop like that in the currency would leave you deep in the hole.

We put the question to a team of investment managers from HSBC. Here is their reply:

"There is obviously a chance that all the pessimism over debt and default is over done and that the bonds are a good buy at these prices. HSBC PB (Private Bank) wouldn’t recommend it as a strategy. The main reason is that our view is that the bust in credit will take a long time to correct and has significantly further to go. The market has to come to a point that it is willing to lend to Icelandic banks again. This is unlikely for the foreseeable future. As I am sure you know the mainstays of the economy are fishing (70% of exports!), aluminum (the country has a developed a large amount of geothermal electricity) and to a small extent tourism – not particularly inspiring given the scale of the problem.

"Rather than re-visiting an old bull market story, such as Iceland, we would prefer to look to the future. That would mean that we would be looking at different sectors which will grow or protect investors money because they are working in high-demand areas. Because the developing economies of Russia, China, Latin America and the Middle East are cash-rich on the back of the commodities boom, we prefer to invest, generally, in those economies."

*** Finally, speaking of Latin America. We got an update from colleague Horacio Pozzo on what is happening in Argentina (for which we are bound this afternoon):

"Today in Argentina, it’s a holiday, the anniversary of the beginning of the Malvinas War (known in the UK as the Falklands War). But yesterday, I thought for a moment that the holiday had been moved forward. Because my neighborhood bakery and butcher were both closed. The crisis of the countryside has arrived in the city…shortages are beginning to appear."

The crisis of the country is simple enough to explain: reacting to record grain prices, Argentina’s farmers planted as much as they could. Now, it is autumn in South America…and the crops are being sold. But along comes the government with a tax on grain exports of up to half the proceeds. Naturally, the farmers were hacked off. And then President Cristina Fernandez de Kirchner made an aggressive speech, which made them even madder. Soon, they had mounted a siege operation against Buenos Aires, blocking 400 roads into the capital, hoping to starve the city into submission."

It was a showdown that threatened violence and disruption. Too bad for the Argentines, who have been enjoying an economic growth rate only slightly behind that of the Chinese. But no day is ever so sunny that politicians can’t find a way to make it rain. We’ve seen that all over the world…and throughout all history. And now in Argentina.

We called our son in Buenos Aires on Friday.

"What’s going on…what’s the latest…if I come down there this weekend, will I be able to get something to eat?"

"Dad, don’t worry about it. This is Argentina. The Argentines are a bit theatrical. But life goes on – at least in this part of the city. Besides, they’ve called off the blockades and both sides have agreed to a 30-day cooling down period. That ought to give them time to figure out a way out of this mess without losing face."

And so…we’re off…catching a cab…then a plane…trains and automobiles, too!

The Daily Reckoning