Hedge Funds: The Scapegoat or the Solution?

THE LARGE HADRON COLLIDER

(LHC) is the world’s largest and highest-energy particle accelerator. It is located in a tunnel which travels 27 kilometres under the Jura mountains on the Franco-Swiss border.  The LHC can fire opposing beams of protons or lead ions at a speed of 99.9999991% the speed of light.  The collider has been constructed by the European Organisation for Nuclear Research (CERN) with the intention of testing various predictions of high energy physics, including the existence of the Higgs Boson and of the large family of new particles predicted by supersymmetry.

The elusive Higgs Boson is the last unobserved particle predicted by the Standard Model of particle physics.  An experimental observation of the Higgs Boson would help to explain how otherwise massless elementary particles cause matter to have mass.  More specifically, the Higgs Boson would explain the difference between the massless photon and the relatively massive W and Z Bosons. 

If you haven’t a clue what I am talking about, you are not alone; I haven’t a clue what I am talking about either. My ability to discuss, or explain high-energy particle physics has about as much credibility as, say, President Nicholas Sarkozy’s ability to explain the credit crisis. 

The French and current European Union (EU) President could not resist a recent photo opportunity while holding a copy of Das Kapital, to announce the death of capitalism. At the EU summit of 15 October, Mr Sarkozy also stated:

“I would propose a simple principle, that no financial institution should escape regulation and supervision. I am thinking, for example, of the regulation that we must apply to rating agencies and of the necessary supervision of hedge funds…we must also work to eliminate the grey areas that undermine our efforts at co-ordination, in this case the off shore centres.” (Reuters, 15 October 2008)

We obviously all must have missed something over the past few months, when we did not realise that AIG, Freddie Mac, Fannie Mae, Bear Stearns, Merrill Lynch and Lehman Brothers were really hedge funds operating out of the British Virgin Islands, or Cayman, not to mention Northern Rock and Bradford and Bingley, those well-known off shore banks. Well, one of them is based on a rock, which must be close to an off shore tax haven. In Europe, we should also not forget those other ‘off shore devils’: Hypo Real Estate Bank, Dexia Bank and Fortis Bank, all of which have been expensively rescued by the taxpayer in decidedly onshore jurisdictions.

But Mr Sarkozy is not alone in expressing his expert analysis of the villains of the credit crisis. On 11 October the Italian Finance Minister Guilio Tremonti made his views plain to a meeting of G20 countries. As Italy assumes the Presidency of the G7 on 1 January 2009, Mr Tremonti informed the assembled countries that he wants to change the G7, the World Bank and the International Monetary Fund and consider abolishing hedge funds.

He also wants to scrap Basel II, which he has “always said was stupid”. Hedge funds were described as “absolutely crazy bodies, which have nothing to do with capitalism”. (CEP Newswires, 11 October 2008). Of course, Mr Tremonti is not alone among European politicians in his forthright views on a subject he knows absolutely nothing about. He follows in a long line of considered opinions, such as those of the recently resurrected Hans Muntefering of Germany’s Social Democratic Party, who proclaimed in 2005: “Hedge funds are like swarms of locusts that fall on companies, stripping them bare before moving on.”

European politicians continue to attack hedge funds, with absolutely no basis in fact, as the cause of the credit crisis. In doing so, they consistently ignore the considered views of their own Commissioner for EU Internal Markets and Financial Services, Mr Charlie McCreevy, who over 12 months ago spelled out the situation precisely in a speech to the hedge fund-hating European Parliament.

“As much as some people want to demonise hedge funds, they are not the cause of the difficulties in the market. Let us not forget where the present crisis has its roots. Poor quality lending, compounded by securitisation of those loans in off balance sheet vehicles that few understood the risks associated with.”

(EU Commissioner McCreevy, EU Parliament, 5 September 2007)

The Search for the Guilty Parties

For most objective observers, this ‘on the money’ analysis of the causes of the current problems has not changed in the intervening year since it was made. To it must, however, be added the growing realisation of the disastrous effects of the large social engineering project in the United States (US), driven and underwritten by the quasi-governmental Fannie and Freddie at the behest of the federal government, to encourage and indeed force banks to give ’liars’ loans’ to impoverished people with no ability to repay.

The Economist of 18 October 2008 has attempted a primer as to “how we got here?” which considers the initial origin of the current crisis as the floating of international currencies in 1971. This was caused by Richard Nixon’s suspension of the dollar’s convertibility into gold to fund a trade deficit, and the costs of the war in Vietnam. The relaxation of fixed rates of exchange led in turn to the development of currency futures on the Chicago Metal Exchange and later the global abolition of exchange controls, which facilitated the international expansion and movement of cash. Other culprits have been cited, including the development of a method for option pricing by Black and Sholes and the abolition of Glass Steagall in the US, which caused investment and commercial banks to increasingly compete for high margin complex banking business and product.

Short Selling

As part of the ill-informed attack on hedge funds in the current context, the issue of short selling is usually mentioned. It is important to address this matter. It is clear that short selling is, by definition, an activity by which hedge funds fund their long purchases of assets. In a short sale, a hedge fund will sell securities it doesn’t have, but has borrowed, in order to fund the purchase of another security in the hope that the subsequent relative movements of the long and short legs will yield a profit before the trade is closed out. In order to close the trade, the fund must purchase and deliver the shorted security at the end.

It is important to distinguish this activity from so-called ‘naked shorting’, the often illegal activity which involves selling stock which hasn’t been borrowed, in a one-way down only bet. The New York Stock Exchange (NYSE) and other federal authorities in the US have been investigating the possibility that naked shorting impacted on the demise of Lehman Brothers. It is interesting to note that the only entity to have been fined by the NYSE in relation to ’unmatched shorts’ on Lehman was in fact another bank and not a hedge fund.

In an open letter to the Financial Times of 3 October 2008, Simon Ruddick, the Managing Director of hedge fund consulting firm, Albourne, (the creators of the charity ‘Hedgestock’ event in 2006) has taken the politicians and other commentators to task on the populist spinning of the role of hedge funds in the current crisis. It is worth considering what Mr Ruddick has to say on this matter:

“The global binge was neither created nor fuelled by hedge funds. They are now being vilified for having played a role in bringing this madness to an end. Those investment banks with 29 times leverage, or building societies lending out radically more money than they had received in deposits were all fully regulated entities. Did the regulators blow the whistle; or the management or shareholders of those banks, or the journalists, or politicians?”

On the subject of shorting, Mr Ruddick is illuminating:

“There needs to be a dark word beyond irony to describe why the FSA has initiated multiple enquiries about short selling without having initiated a single enquiry at the firms that have actually failed. Even the Archbishop of Canterbury is against short selling, as if it were an ecumenical issue. Presumably, he is also against wasps, rain, MMR jabs and a whole host of other things that appear irritating to those who have absolutely no concept of how equilibrium within complex systems has to work.”

It is important to consider, in particular, the role of hedge funds in short selling of financial institutions. Their overall impact on the performance of bank shares is highly debatable. In the case of HBOS, during the week leading up to the rescue of the bank by Lloyds TSB, the level of short interest in its shares remained small and only rose fractionally from 2.8% to 3.05%. It should also be noted that the worst performing global stock market this year has been Shanghai, where the Chinese ‘A’ market is down 57%. This is one of the only markets in the world where short selling has been prohibited. Ironically, China announced in September that short selling was to be permitted for the first time. (Antonio Borges, Chairman of the Hedge Fund Standards Board in the Daily Telegraph, 28 September 2008)

It has also been noticeable that since the various bans on short selling, which were introduced across the world, bank shares have continued, in some cases precipitously, to fall. To some extent this has to have been caused by the removal of the liquidity and ameliorating effects that hedge funds previously had on the market. As William Brodsky, the Chairman of the World Federation of Exchanges (WFE) has recently stated:

“We must be very careful not to demonise short selling. It is a very important part of a complicated market structure.” (Lipper Hedgeworld, 14 October 2008)

The WFE represents 97% of the world stock market capitalisation.

The Solution

If hedge funds are not part of the problem, can they be a part of the solution? The moves by many governments across the world to recapitalise the banking system can only be part of the answer. Investors and taxpayers should be careful of a state managed and civil service-led banking and financial system where the rules can always be ‘gamed’ and corruption is a possible consequence. However, if the bail-outs are handled properly and in a timely manner, taxpayers could benefit from a temporary holding in bank shares. Equally regulators can and should learn from their many mistakes. Governments should also be more cautious in the future at attempting to socially engineer unfunded projects to increase home ownership. To conclude, who better than Simon Ruddick again:

“For the avoidance of doubt, not a single dollar of taxpayers’ money has, or ever will be needed to bail out a hedge fund. Indeed, there is already a pool of$700 billion waiting to rescue the world’s financial markets. It’s called the hedge fund industry. Quite simply, it works because of an alignment of interests. Hedge fund managers put their money alongside that of their clients, exactly where their mouth is.”

Peter O'Dwyer
Peter J. O’Dwyer is a business and financial consultant with a number of interests. He primarily specialises in providing bespoke advice to cross-frontier businesses, in particular to those involved in international investment funds, holding company structures and structured finance and to Governments and regulatory authorities. He is Managing Director and proprietor of Hainault Capital Limited, based in Ireland. He is a non-executive director of several private and public companies, including investment companies, mutual funds, energy, property and hedge funds domiciled in Ireland and the Cayman Islands for amongst others; HBOS, Barclays Capital, Citigroup and BNP Paribas. He is a former director of a Shari’a hedge fund and has lectured widely on the subject of Shari’a investment funds.