The Great Deformation (91 page)

Even as the momentum traders heralded its 100 percent sales growth in the year ending December 2007, it was plainly evident that the auto companies were scrambling to install navigation systems as original equipment and that demand for Garmin's portable “aftermarket” product would dry up rapidly. In the event, its sales growth rate fell to 20 percent by June 2008 and turned negative by year end.

The fact that Garmin's sales today are actually 40 percent lower than their 2007 peak level was predictable at the time, since the new model cars carrying their own navigation systems were already in the well-advertised automotive pipeline. As the second Greenspan bubble approached its peak, therefore, it is evident that the stock market was not discounting future corporate sales, earnings, or much of anything else except the expectation of more juice from the Eccles Building.

By the time of the 2008 bubble peak, the great financial deformation reduced the stock market to a momentum-driven gambling hall. Indeed, the senseless overvaluation that punters affixed to the likes of Crocs and Garmin was cut from the same cloth as the implausibly high valuations which had been assigned to the home builders, the mortgage brokers, Fannie and Freddie, and the Wall Street investment banks themselves.

Yet as hundreds of other highflyers like the solar energy stocks, the teen retailers, and the casino stocks took their turn in this malignant pattern of chase and crash, apologists for the status quo always had the same answer. On the occasion of these crashes they advised onlookers to move along, insisting there was nothing to see except some minor breakage attendant to animal spirits that occasionally get too rambunctious.

HEDGE FUNDS AND THE RULE OF RIPS AND WRECKS

The Wall Street–hedge fund casino is all the more volatile because it deploys massive leverage in many forms. The tamest form of this leverage, funding obtained in the wholesale money and repo markets, is potent enough. As has been seen, most of the time the resulting carry trade produces handsome spreads and funds a steady bid leading to higher asset prices.

But at junctures of extreme financial stress, the high level of carry trade funding, which builds up during the bubble expansion, results in violent market reversals. In these circumstances, wholesale funding evaporates and involuntary asset sales cascade into a bidless abyss. The devastating broad market collapse of 2000–2003 (45 percent) and 2008–2009 (55 percent) was dramatic proof.

The most potent amplifier of volatility in the hedge fund arena, however, is the embedded leverage of options and OTC derivative concoctions. Exchange traded options require regulatory margin, of course, but in the case of momentum trades the margin factor actually turbocharges volatility.

Options are an accelerator on the way up, since no extra margin deposit is required as the underlying asset price rises, while on the way down, they become a widow maker: any price drop requires the posting of additional margin on a dollar-for-dollar basis. Needless to say, when momentum trades start cratering, the margin clerks become purveyors of pole grease.

Compared to exchange traded options, the OTC derivatives fashioned by Wall Street dealers are even more combustible. In these unregulated bilateral trades, margin requirements are not standard, regulated, or continuous, meaning that margin calls are often lumpy and precipitate; they tend to exacerbate losing positions as the dramatic, margin call–driven demise of Lehman, AIG, and MF Global demonstrated. Such OTC positions are
also festooned with fillips like knock-out and knock-in triggers which produce drastic value changes when these defined trigger points are hit. In effect, these “weapons of financial mass destruction,” as Warren Buffett once called them, can simulate leverage ratios so extreme and opaque that they cannot even be meaningfully quantified.

THE MYTH THAT SPECULATORS ARE LIQUIDITY PROVIDERS

The Wall Street fast money casino is thus land-mined with potent agents of volatility. Yet these huge and financially metastasized secondary markets are, paradoxically, portrayed by apologists as agents of economic advance. Hedge funds and Wall Street trading desks are held to be doing God's work; that is, providing trading liquidity in return for a tiny slice of the turnover.

What looks like churn and hit-and-run speculation, they contend, is actually a sideshow. The real function of these rollicking secondary markets is enabling corporate issuers to sell new securities efficiently and permitting savings suppliers such as pension funds, insurance companies, and 401(k) investors to smoothly enter and exit investment positions.

Like the case of Bernanke's Great Moderation, however, the truth is more nearly the opposite. The Fed's prosperity management régime has actually fostered a vast increase in capital market volatility, not a gain in liquidity. The proof is in the pudding. If these vast trading venues were meaningfully enhancing liquidity, then volatility would be abating over time, not reaching increasingly violent amplitudes and frequencies. In fact, the highly leveraged carry trades, the financial elixir of the Greenspan era, actually evaporate abruptly under stress and therefore amount to anti-liquidity.

True market makers, by contrast, minimize leverage in order to maximize their market-making capacity during periods of stress. By thus keeping their powder dry, they can take advantage of that part of the cycle where the bid-ask spread is the widest and dealers can earn above-average returns on their working inventory.

For these reasons, the liquidity function conducted by genuine dealers on the free market bears no resemblance to the leveraged, momentum-chasing prop traders. Beyond that, the free market seeks out efficient solutions to resource allocation, but having trillions of hedge fund capital absorbed in the “dealer” function does not meet that test by a long shot.

It can be correctly assumed, therefore, that the $6 trillion of hedge funds domiciled in Greenwich partnerships and Wall Street banks do not toil in the service of the Financial Almighty. They exist not to bring liquidity to asset markets, but to extract rents from them.

Needless to say, today's hedge funds do not operate on the free market, and they are neither dealers nor investors. Their business of hit-and-run
speculation generates no economic value added but nonetheless attracts trillions of capital because the state and its central banking branch make it profitable.

Cheap cost of carry and the Greenspan-Bernanke Put are the foundation of this hothouse profitability. They mitigate what would otherwise be the substantial costs of funding portfolios at normalized interest rates and of reserving for asset price risk on the free market. Without these artificial economic boosts, the high-churn style of hedge fund speculation would be far less rewarding, if profitable at all.

THE “KEYNESIAN” FOUNDATION OF HEDGE FUNDS

What really makes hit-and-run speculation remunerative, however, is financial engineering in the corporate sector. It catalyzes momentum trades, a venue where the peculiar type of inside information which percolates through the Wall Street–hedge fund complex is concentrated. Indeed, financial engineering is what puts the “Keynesian beauty contest” principle of investment, as once described by John Maynard Keynes, at the front and center of the hedge fund trade.

In his famous 1936 treatise on macroeconomics, the learned professor prescribed how to compete in a theoretical newspaper contest to pick from among six pictures the girl the public would judge to be the prettiest. Keynes, who had been an inveterate speculator of some renown, advised not to pick the girl who appears to be the prettiest, or even the one that average opinion might select.

Parse the matter still further, he urged: “We have reached the third degree where we devote our intelligence to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practice the fourth, fifth and higher degrees.”

Needless to say, there is much more snake oil of this tenor in the general theory of employment, interest, and money. But what Keynes wrote about the art of speculation in 1936 could not have been more apropos to the behavior of hedge funds in the deformed financial markets that his theories brought to full flower seventy-five years later.

Mr. Market has seen fit to deliver to the hedge fund complex $6 trillion of capital, which is to say, a wholly insensible amount. This anomaly is explainable, however, by the fact that hedge funds operate in a financial setting ideally suited to the great thinker's methodology.

Thanks to the Fed, momentum trading is cheap and reasonably safe from unforeseen general market declines. Yet individual stocks are volatile enough to enable traders to profitably practice the “Keynesian” method; that is, to trade what they judge other traders will be buying based on
whatever pictures of the corporate contestants come their way from legal sources, or perhaps not.

Furthermore, the hedge fund industry ensures that only the astute judges in the Keynesian beauty contest thrive, or even survive. Capital is continuously reallocated and concentrated in hedge funds that get the momentum trades right; that is, hedge funds which buy stocks that others decide to buy.

At the same time, funds which are persistently wrong shrink rapidly or are completely liquidated. Quarterly withdrawal rights for investors are the key tool of this winnowing process, but the quite improbable mechanism of the “fund of funds” also plays a major role.

It is not immediately evident how much value-added fund of funds provide in return for their 5 percent share of investment profits plus fixed management fees, but it consists of advice to punters on where to punt based on the latest punting results from the universe of hedge fund punters. Stated differently, they perform a dispatching function, continuously reallocating capital based on short-term results—sometimes even daily and weekly—to the best-performing beauty contest judges.

This constant reallocation is vitally important owing to the heavy fee burden; that is, 20 percent to the hedge fund, 5 percent on top to the fund of funds, and the 2 percent management fee spread all around. It goes without saying that momentum trading has to be unusually successful in order to absorb such heavy fees, meaning that investors must quickly exit funds that are failing or treading water and scramble into partnerships that at the moment are surfing on winning waves.

So the fund of funds is essentially momentum traders of momentum traders. They function as financial concierges, scheduling and slotting their high-net-worth customers and other large investors into the right mix of hedge fund styles and short-term performance metrics.

Taken together, these allocation mechanisms are a potent financial laxative; they unclog immobile money and cause it to flow to the winning trades with a vengeance. The resulting uplift to any particular flavor-of-the-moment trade, in turn, begets more momentum chasing and further replication by new players who pile onto the rising tide.

PRIME BROKERS AND THE WHIRLIGIG OF WALL STREET FINANCE

Until winning trades finally finish their run and reverse direction, copycat replication is low risk because it is facilitated by the prime brokerage desks of the Wall Street banks. These desks keep their hedge fund clients posted
on “what's working” for the hottest funds and, mirabile dictu, the flavor-of-the-moment bandwagon rapidly gains riders.

To be sure, Wall Street prime brokerage operations perform valid services such as margin lending, consolidated reporting, trade execution, and clearing and settlement. Indeed, it is the independent clearing functions of the prime brokers which safeguard against the Bernie Madoff style of self-cleared “trades” that were actually not all that.

In this independent trading and clearing function, however, Wall Street banking houses take in each other's laundry, unlike Madoff's in-house method. This means that the hedge funds embedded in each of the big banks—operations which are otherwise pleased to characterize themselves with meaningless distinctions such as “prop,” “flow,” and “hedge” traders—use one of the other banks as their prime broker.

JPMorgan's now infamous “London Whale” trading operation, for example, used Goldman Sachs as its prime broker. It would require a heavy dose of naïveté to believe that the invisible Chinese walls maintained by these two banking behemoths actually stop any useful trading and position information from circulating throughout the hedge fund complex.

Besides a steady diet of tips about hot trades, the hedge fund complex also needs incremental cash, preferably from low cost loans, in order to pile into rising trades. This, too, the prime brokers provide in abundance through what amounts to a variation of fractional reserve banking. The mechanism here is “rehypothecation,” and it amounts to a miracle of modern finance.

Prime brokers are essentially in the business of selling used cars twice, or even multiple times. When they execute trades for a hot hand among their hedge fund customers, for example, they retain custody of the securities purchased on behalf of the customer. But under typical arrangements, the prime broker promptly posts these securities as collateral for its own borrowings; that is, it hocks its customer's property and uses the cash proceeds for its own benefit.

The precise benefit is that the prime broker relends the proceeds to another client who is advised to jump on the same trade with the new money. The resulting purchase of securities by the second customer begets even more collateral, which triggers another round of rehypothecation. Needless to say, this enables the prime broker to lend and whisper yet a third time, imparting even more momentum into the original trade. In this manner, financial rocket ships are born.