News2008NovemberArticle03

http://www.nytimes.com/2008/09/21/weekinreview/21leonhardt.html?_r=1&ref=weekinreview&oref=slogin Another graphic from same NYT story titled "Bubblenomics - Understanding the Shrinking Economy":

http://www.nytimes.com/2008/09/21/weekinreview/21leonhardt.html?_r=1&ref=weekinreview&oref=slogin Graphic showing Greenspan's loose monetary policy post the tech crash:

("Fed Considers Rate Cut as Recession Fears Mount," By SUDEEP REDDY, JON HILSENRATH and TIMOTHY AEPPEL, WSJ, October 2, 2008): Graphic from a Paul Krugman blog post titled "Greenspan's bubbles":

http://krugman.blogs.nytimes.com/2008/10/11/greenspans-bubbles/ House price to rent ratios going back to 1975:

http://krugman.blogs.nytimes.com/2007/12/28/housing-how-far-is-down/ NYU economist Nouriel Roubini (NYT profile of Roubini titled "Dr. Doom") describing the causes of the current crisis:

The crisis was caused by the largest leveraged asset bubble and credit bubble in history. Leveraging and bubbles were not limited to America's housing market, but also characterized housing markets in other countries. Moreover, beyond the housing market, excessive borrowing by financial institutions and some segments of the corporate and public sectors occurred in many economies. As a result, a housing bubble, a mortgage bubble, an equity bubble, a bond bubble, a credit bubble, a commodity bubble, a private equity bubble, and a hedge funds bubble are all now bursting simultaneously.

http://www.project-syndicate.org/commentary/roubini8 FT op-ed by former Chief Economist at the IMF on hedge funds phony Alpha returns ("Bankers' pay is deeply flawed"):

Indeed, compensation practices in the financial sector are deeply flawed and probably contributed to the ongoing crisis. The typical manager of financial assets generates returns based on the systematic risk he takes - the so-called beta risk - and the value his abilities contribute to the investment process - his so-called alpha. Shareholders in asset management firms, such as commercial banks, investment banks and private equity or insurance companies are unlikely to pay the manager much for returns from beta risk. For example, if the shareholder wants exposure to large traded US stocks she can get the returns associated with that risk simply by investing in the Vanguard S&P 500 index fund, for which she pays a fraction of a per cent in fees. What the shareholder will really pay for is if the manager beats the S&P 500 index regularly, that is, generates excess returns while not taking more risks. Hence they will pay for alpha.

In reality, there are only a few sources of alpha for investment managers. One of them comes from having truly special abilities in identifying undervalued financial assets. Warren Buffett, the US billionaire investor, certainly has it, yet this special ability is, by definition, rare.

A second source of alpha is from what one might call activism. This means using financial resources to create, or obtain control over, real assets and to use that control to change the payout obtained on the financial investment. A venture capitalist who transforms an inventor, a garage and an idea into a fully fledged, profitable and professionally managed corporation creates alpha.

A third source of alpha is financial entrepreneurship or engineering - creating securities or cash flow streams that appeal to particular investors or tastes. As long as the investment manager does not create securities that exploit investor weaknesses or ignorance (and there is unfortunately too much of that), this sort of alpha is also beneficial, but it requires constant innovation.

Alpha is quite hard to generate since most ways of doing so depend on the investment manager possessing unique abilities - to pick stocks, identify weaknesses in management and remedy them, or undertake financial innovation. Such abilities are rare. How then can untalented investment managers justify their pay? Unfortunately, all too often it is by creating fake alpha - appearing to create excess returns but in fact taking on hidden tail risks, which produce a steady positive return most of the time as compensation for a rare, very negative, return.

http://www.ft.com/cms/s/0/18895dea-be06-11dc-8bc9-0000779fd2ac.html WP op-ed by Oxford economist and Wharton statistician on phony hedge fund Alpha returns ("Hedge Fund Wizards"):

Scarcely a day goes by without another story of some large hedge fund blowing up due to bad bets. While many of the latest hedge fund casualties are linked to the subprime mortgage crisis, investors should not be lulled into thinking that the problem will be solved once the mortgage mess is mopped up.

Hedge funds are risky for another reason. It is extremely difficult to tell, based on past performance, whether a fund is being run by true financial wizards, by no-talent managers who happen to get lucky or by outright scam artists.

To illustrate how easy it is to set up a hedge fund scam, consider the following example. An enterprising man named Oz sets up a new fund with the stated aim of earning 10 percent in excess of some benchmark rate of return, say 4 percent. The fund will run for five years, and investors can cash out at the end of each year if they wish. The fee is the standard '2 and 20': 2 percent annually for funds under management, and a 20 percent incentive fee for returns that exceed the benchmark.

Although he has no investment track record, Oz has a smooth manner, a doctorate in physics and many rich acquaintances. He raises $100 million and opens shop. He then studies the derivatives market and finds an event on which the market places fairly long odds, say 9:1. In other words, it costs $.10 to buy an option that pays $1 if the event occurs and $0 otherwise. The nature of the event is unimportant: it might be a large fall in the stock market, Florida getting hit by a Category 5 hurricane or Russian President Vladimir Putin dying before the end of the year.

Next Oz writes some covered options on this event and sells 110 million of them in the derivatives market. This obligates him to pay the option holders $110 million if the event does occur and nothing if it does not. He collects $11 million on the options. To cover his obligations in case the 'bad' event occurs, he uses the investors' money plus the proceeds from the options to buy $110 million in one-year Treasury bills yielding 4 percent, which he deposits in escrow. This leaves $1 million in "pocket money," which he uses to lease some computer terminals and hire a few geeks to sit in front of them, just in case his investors drop by.

The probability is ninety percent that the bad event does not occur and Oz owes nothing to the option holders. With a gross return (before expenses) of $15,400,000, the investors are thrilled, and so is Oz. He collects $2 million in management fees (of which he has only spent $1 million), plus a performance bonus equal to 20 percent of the 'excess return', namely, 20 percent of $11,400,000. All in all, Oz nets over $3 million for doing absolutely nothing.

Oz can then repeat the same gambit next year. When the fund terminates after five years, the chances are nearly 60 percent that the unlucky event will never have occurred. Oz looks like a genius and gets paid like a genius.

While most hedge funds probably don't operate in such a nakedly self-serving way, the underlying logic of Oz's strategy is quite common: take a position that yields high returns with high probability and extremely poor returns with low probability, and keep your fingers crossed. Credit default swaps are one example, so are bets on interest rate spreads. Such strategies are risky but not fraudulent; the manager can always argue that his opinion about the odds differed from the market odds (he was simply engaging in arbitrage).

http://www.washingtonpost.com/wp-dyn/content/article/2007/12/18/AR2007121801642_pf.html NYT story titled "Hedge Fund Glory Days Fading Fast":

While big hedge funds have blown up in the past, and many small ones fail every year, the current problems are more far-reaching than in the past.

Fund after fund is warning investors that the markets have become increasingly difficult to predict. They are having a tougher time making money now that Wall Street banks likeLehman Brothers, which is in an all-out fight for survival, have reduced the amount of money they are willing to lend to the funds in order to safeguard themselves.

It is now 5 to 10 percent more expensive for hedge funds to borrow from banks than it was a year ago, and banks are increasingly hesitant to lend to hedge funds for long periods.

In recent weeks, several funds have closed, most notably a fund run by Ospraie Management. Rumors about troubled hedge funds like Atticus Capital have unsettled the broader markets.

"I think we're seeing what these hedge fund managers really, truly are," said Robert Discolo, head of hedge fund strategies for A.I.G. Investments, an asset manager within the insurance giant A.I.G. "And some of them really can't make money in a difficult environment."

Already, hedge funds are planning for harder times ahead. Fund managers are planning to slash employee bonuses in December, according to study to be released this week by Glocap, a hedge fund recruiting firm.

"This is probably one of the worst years for performance of hedge funds - it's been a bloodbath," said Adam Zoia, chief executive of Glocap, which began tracking hedge fund compensation in 2001 and has never recorded a down year until now.

http://www.nytimes.com/2008/09/12/business/12hedge.html?partner=rssnyt&emc=rss WSJ story titled "Credit Crunch Rocks Bain, as Funds Fall Up to 50%":

Some high-profile Bain Capital credit-investment funds are choking on losses of as much as 50%, said people familiar with the matter, the latest revelation in a day of shake-ups across the hedge-fund business.

The private-equity firm's credit affiliate, Sankaty Advisors LLC, has lost between 40% and 50% across two funds that bought up highly secured corporate loans, these people said. The two vehicles had roughly $4 billion in assets just a few weeks ago, and used a relatively low amount of borrowed money to fund their investments.

Steep losses have also hit London hedge fund Centaurus Capital LP, which Wednesday offered its investors a chance to cut their fees. And, at Tudor Investment Corp., one of the oldest and best-regarded hedge funds, fund manager James Pallotta finalized a plan to run his own firm separate from longtime colleague Paul Tudor Jones.

The developments at Bain, meanwhile, are a blow to a group of top-tier institutions that long have been investors with the Boston-based firm. Harvard University, the Massachusetts Institute of Technology and the University of Notre Dame all have some money invested in Bain's loss-making credit funds. Two of the problem funds include Sankaty's Special Situations and Prospect Harbor.

As market conditions have deteriorated, Sankaty has had to seek new, but more expensive, financing for some of its key borrowing facilities. It recently obtained longer-dated terms to stave off margin calls, which typically kick in if asset values fall below a certain price. The funds have not seen significant redemptions, according to a spokesman.

The market for leveraged loans -- senior loans issued by banks largely to fund buyout deals -- has plummeted in the last month. A Standard & Poor's index of leveraged loans now trades at 70 cents on the dollar, down from 88 cents one month ago. Until last summer, these senior loans rarely traded below par, or 100 cents on the dollar. In recent weeks numerous "bid lists" have flooded the market, creating overwhelming supply and further damping prices.

http://sec.online.wsj.com/article/SB122472657432961253.html NYT story titled "High-Flying Hedge Fund Falls Back to Earth":

Only 10 months ago, Remy Trafelet was so flush that he treated about 100 employees at his hedge fund to a getaway in Venice. He and his crew spent a long, luxurious weekend at the five-star Hotel Bauer, which has Murano glass chandeliers, private gondoliers and a splendid view of a 17th-century basilica.

But now, a bit like Venice, Mr. Trafelet's hedge fund seems to be sinking. His flagship fund has fallen about 26 percent this year, and Mr. Trafelet is struggling to hold on to anxious employees, as well as some investors.

Perhaps the most remarkable thing about Mr. Trafelet is that he is not so remarkable at all. Thousands of hedge fund managers like him - mostly young, mostly male and virtually all unknown outside financial circles - confront a sober reality: for now, the days of easy money are over.

The economics of the hedge fund industry, so lucrative on the way up, are trying even the most seasoned managers on the way down. Hotshots who amassed millions or even billions of dollars from deep-pocketed investors are struggling to persuade those backers to stick with them. For the $2 trillion hedge fund industry, a long-feared shakeout is at hand. Some analysts say one out of every 10 funds could fold.

http://www.nytimes.com/2008/10/14/business/14hedge.html?_r=1&pagewanted=print&oref=slogin

Finally, Wolf had a column titled "Risks and rewards of today's unshackled global finance" where he ended with this chilling thought:

We will have to live with today's financial markets, since policymakers would seek to curtail them only after a disaster. Even their critics should fear such a disaster. The task is, instead, to exploit the many benefits, while managing the risks. This will never be done perfectly. But it can be done at least tolerably well. The alternative is too awful to consider.

http://us.ft.com/ftgateway/superpage.ft?news_id=fto062620071342241825

Unfettered finance is fast reshaping the global economy Martin Wolf Published: June 18 2007 Financial Times

"In Rome everything is for sale." - Prince Jugurtha in Sallust's Bellum Jugurthinum

"Yes to market economy, no to market society." - Lionel Jospin, French Socialist ex-prime minister

It is capitalism, not communism, that generates what the communist Leon Trotsky once called "permanent revolution". It is the only economic system of which that is true. Joseph Schumpeter called it "creative destruction". Now, after the fall of its adversary, has come another revolutionary period. Capitalism is mutating once again.

Much of the institutional scenery of two decades ago - distinct national business elites, stable managerial control over companies and long-term relationships with financial institutions - is disappearing into economic history. We have instead the triumph of the global over the local, of the speculator over the manager and of the financier over the producer. We are witnessing the transformation of mid-20th century managerial capitalism into global financial capitalism.

Above all, the financial sector, which was placed in chains after the Depression of the 1930s, is once again unbound. Many of the new developments emanated from the US. But they are ever more global. With them come not just new economic activities and new wealth but also a new social and political landscape.

First, finance has exploded. According to the McKinsey Global Institute, the ratio of global financial assets to annual world output has soared from 109 per cent in 1980 to 316 per cent in 2005. In 2005, the global stock of core financial assets had reached $140,000bn (£70,660bn, ¤104,490bn: see chart).

This increase in financial depth has been particularly marked in the eurozone: the ratio of financial assets to gross domestic product there jumped from 180 per cent in 1995 to 303 per cent in 2005. Over the same period it grew from 278 per cent to 359 per cent in the UK and from 303 per cent to 405 per cent in the US.

Second, finance has become far more transactions-oriented. In 1980, bank deposits made up 42 per cent of all financial securities. By 2005, this had fallen to 27 per cent. The capital markets increasingly perform the intermediation functions of the banking system. The latter, in turn, has shifted from commercial banking, with its long-term lending to clients and durable relations with customers, towards investment banking.

Third, a host of complex new financial products have been derived from traditional bonds, equities, commodities and foreign exchange. Thus were born "derivatives", of which options, futures and swaps are the best known. According to the International Swaps and Derivatives Association, by the end of 2006 the outstanding value of interest rate swaps, currency swaps and interest rate options had reached $286,000bn (about six times global gross product), up from a mere $3,450bn in 1990. These derivatives have transformed the opportunities for managing risk.

Fourth, new players have emerged, notably the hedge funds and private equity funds. The number of hedge funds is estimated to have grown from a mere 610 in 1990 to 9,575 in the first quarter of 2007, with a value of about $1,600bn under management. Hedge funds perform the classic functions of speculators and arbitrageurs in contrast to traditional "long-only" funds, such as mutual funds, which are invested in equities or bonds. Private equity fundraising reached record levels in 2006: data from Private Equity Intelligence show that 684 funds raised an aggregate $432bn in commitments.

Fifth, the new capitalism is ever more global. The sum of the international financial assets and liabilities owned (and owed) by residents of high-income countries jumped from 50 per cent of aggregate GDP in 1970 to 100 per cent in the mid-1980s and about 330 per cent in 2004.

The globalisation of financial capitalism is seen in the players as well as in the nature of the holdings. The big banks operate globally. So increasingly do hedge funds and private equity funds. In 2005, for example, North America accounted for 40 per cent of global private equity investments (down from 68 per cent in 2000) and 52 per cent of funds raised (down from 69 per cent). Meanwhile, between 2000 and 2005, Europe increased its share of investments from 17 per cent to 43 per cent and funds raised from 17 per cent to 38 per cent. The Asia-Pacific region's share of private equity investment rose from 6 per cent to 11 per cent during this period.

What explains the growth in financial intermediation and the activity of the financial sector? The answers are much the same as for the globalisation of economic activity: liberalisation and technological advance.

By the mid-20th century the financial sector was highly regulated everywhere. In the US, the Glass-Steagall Act separated commercial banking from investment banking. Almost all countries operated tight controls on the ownership of foreign exchange by their residents and so, automatically, ownership of foreign assets. Ceilings on interest rates that lenders could charge were common. The most famous of these, "Regulation Q" in the US, which forbade the payment of interest on demand deposits, promoted the development of the first significant postwar offshore financial market: the eurodollar market in London.

Over the past quarter-century, however, almost all of these regulations have been swept away. Barriers between commercial and investment banking have vanished. Foreign exchange controls have disappeared from the high-income countries and have been substantially, or sometimes even completely, liberalised in many emerging market economies as well. The creation of the euro in 1999 accelerated the integration of financial markets in the eurozone, the world's second largest economy. Today, much of the global financial sector is as liberalised as it was a century ago, just before the first world war.

No less important has been the revolution in computing and communications. This has permitted the generation and pricing of a host of complex transactions, particularly derivatives. It has also permitted 24-hour trading of vast volumes of financial assets. New computer-based risk management models have been employed across the financial sector. Today's financial sector is a particularly vigorous child of the computer revolution.

Two further long-term developments help explain what has happened. The first is the revolution in financial economics, notably the discovery of options pricing by Myron Scholes and Fischer Black in the early 1970s, which provided the technical underpinning of today's vast options markets. The second is the success of central banks in creating a stable monetary background for the world economy and so also for the global financial system. "Fiat" (or government-created) money has now worked well for a quarter of a century, providing the monetary stability on which complex financial systems have always depended.

Yet there is also a shorter-term explanation for the explosive recent growth in finance: today's global savings and liquidity gluts. Low interest rates and the accumulation of liquid assets, not least by central banks around the world, has fuelled financial engineering and leverage. How much of the recent growth of the financial system is due to these relatively short-term developments and how much to longer-term structural features will be known only when the easy conditions end, as they will.

What then have been the consequences of this vast expansion in financial activity, much of it across international borders?

Among the results are that households can hold a wider array of assets and also borrow more easily, so smoothing out their consumption over lifetimes. Between 1994 and 2005, for example, the liabilities of UK households jumped from 108 per cent of GDP to 159 per cent. In the US, they soared from 92 per cent to 135 per cent. Even in conservative Italy, liabilities rose from 32 per cent to 59 per cent of GDP.

Similarly, it is ever easier for companies to be taken over by, or merge with, other companies. The total value of global mergers and acquisitions in 2006 was $3,861bn, the highest figure on record, with 33,141 individual transactions. As recently as 1995, in contrast, the value of mergers and acquisitions was a mere $850bn, with just 9,251 deals.

With the vast size of the new private equity funds and the scale of the bond financing arranged by the big banks, even the largest and most established companies are potentially for sale and break-up, unless they enjoy special protection. The market in control of companies, to which private equity is an active contributor, has greatly increased the power of owners (shareholders) over that of incumbent management.

The new financial capitalism represents the triumph of the trader in assets over the long-term producer. Hedge funds are perfect examples of the speculative trader and arbitrageur. Private equity funds are conglomerates that trade in companies, with a view to financial gain.

In the same way, the new banking system is dominated by institutions that trade in assets rather than hold them for long periods on their own books. With the orientation towards trading come explicit, rather than implicit, contracts and arms-length dealing rather than long-term relationships. So-called "relational contracts" are no longer worth the paper they are not written on. They are subject to the solvent of new opportunities for profit. It is no surprise, therefore, that the cross-holdings of postwar capitalism in Japan and the bank-dominated equity ownership of postwar Germany have both evaporated.

Moreover, the presence on share registers of large numbers of foreigners, who are fully prepared to exercise their rights of ownership and are unconstrained by national social and political bonds, has transformed the way companies operate: the successful shareholder revolt against the plans of Deutsche Börse's management for a takeover of the London Stock Exchange is an excellent example. Thus is global financial capital eroding the autonomy of national capital.

Another consequence has been the emergence of two dominant international financial centres: London and New York. It is no accident that these are located in English-speaking countries with a long history of financial capitalism. It is no accident either that Hong Kong, not Tokyo, is generally viewed as the leading international financial centre in Asia, even though Japan is the world's biggest creditor country. Hong Kong's legacy is British. The legal tradition and attitudes of English-speaking countries appear to be big assets in the development of financial centres.

How then should one evaluate this latest transformation of capitalism? Is it a "good thing"?

Powerful arguments can be made in its favour: active financial investors swiftly identify and attack pockets of inefficiency; in doing so, they improve the efficiency of capital everywhere; they impose the disciplines of the market on incumbent management; they finance new activities and put inefficient old activities into the hands of those who can exploit them better; they create a better global ability to cope with risk; they put their capital where it will work best anywhere in the world; and, in the process, they give quite ordinary people the ability to manage their finances more successfully.

Yet it is equally obvious that the emergence of the new financial capitalism creates vast new regulatory, social and political challenges.

Optimists would argue that the new financial system combines efficiency with stability to an unprecedented degree. Publicly insured banks not only take fewer risks than before but manage the ones they do take far better. Optimists can (and do) also point to the ease with which the global financial system coped with the collapse of the global stock market bubble in 2000 and the terrorist attacks of 2001 - in particular, the absence of any large bank failures at that time. They would point, too, to a diminution in the frequency of global financial crises this decade. Pessimists would argue that monetary conditions have been so benign for so long that huge risks are being built up, unidentified and uncontrolled, within the system. They would also argue that the new global financial capitalism remains untested.

Regulating a system that is this complex and global is a novel task for what are still predominantly national regulators. Co-operation has improved. Reports, such as the International Monetary Fund's Global Financial Stability Report and its national equivalents, provide useful assessments of the risks. New groups, notably the Financial Stability Forum founded in 1999, bring regulators together. But only severe pressures can give a good test of the system.

The regulatory challenges are big enough. But they are far from the only ones. Lionel Jospin's hostility to what he called a "market society" is widely shared. Powerful political coalitions are forming to curb the impact of the new players and new markets: trade unions, incumbent managers, national politicians and hundreds of millions of ordinary people feel threatened by a profit-seeking machine viewed as remote and inhuman, if not inhumane.

Last but not least are the challenges to politics itself. Across the globe there has been a sizeable shift in income from labour to capital. Newly "incentivised" managers, free from inhibitions, feel entitled to earn vast multiples of their employees' wages. Financial speculators earn billions of dollars, not over a lifetime but in a single year. Such outcomes raise political questions in most societies. In the US they seem to be tolerable. Elsewhere, however, they are less so. Democratic politics, which gives power to the majority, is sure to react against the new concentrations of wealth and income.

Many countries will continue to resist the free play of financial capitalism. Others will allow it to operate only in close conjunction with powerful domestic interests. Most countries will look for ways to tame its consequences. All will remain concerned about the possibility for serious instability.

Our brave new capitalist world has many similarities to that of the early 1900s. But, in many ways, it has gone far beyond it. It brings exciting opportunities. But it is also largely untested. It is creating new elites. This modern mutation of capitalism has loyal friends and fierce foes. But both can agree that its emergence is among the most significant events or our time.