Armageddon in Real and Financial Markets

Regulation of Hedge Funds

Driven by Speculation and Leverage

A Market Brief™

by

Steven Kim

MintKit Investing

www.mintkit.com

© 2010 MintKit Investing

 Short Summary

Amid lax regulation, hedge funds large and small played a central role in the
financial crisis of 2008 along with the worst recession since the 1930s. On current
trends, a calamity that destroys the global system of trade and finance is not only
possible but inevitable. On the upside, the impending disaster could be forestalled
by a dollop of proper legislation.

* * *

Extended Summary

Hedge funds entered the public spotlight in 2008 for the dominant role they played
in taking down the financial system and the real economy. The ensuing blowup
was the greatest wipeout of wealth and the worst takedown of the global economy
since the Second World War.

Until the financial crisis burst upon the scene, it was the stuff of sheer fiction to
picture a single outfit or a small crew of actors that could tear apart the fabric of
civilization as we know it. Yet the debacle of 2008, along with its aftershock, was
the shot across the bow for a laid-back populace. On current trends, a calamity that
lays waste to the trappings of modernity is not only possible but inevitable.

On the bright side, though, the outcrop of doomsday could be forestalled by a mere
act of forethought along with the legislation to match. The fitting course of action
would be plain, quick and wholesome.

On the other hand, the feat will be far from easy to pull off due to the mass of
opposition from lobbyist groups. The sensible approach will require the courage of
statesmen along with the backing of their constituents.

The recent crisis has shown that extreme levels of leverage can bring down the
entire system of finance and economics. Thus far, the annihilation of wealth has
amounted “merely” to trillions of dollars and millions of jobs in each of the major
countries of the world.

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Yet the carnage will not always remain so slight in the future. Whether the
assailants happen to be hedge funds or other rabid players, it would make sense to
defang the forces of armageddon before they have a chance to do some serious
damage.

* * *

Keywords: Hedge Funds, Regulation, Speculation, Leverage, Financial Crisis,

2008, Financial Markets, Stock Market, Recession, Armageddon, Trade, Economy,
Legislation, Public Policy, Strategy

* * *

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Wakeup Call

For the starring role they played in tearing down the financial markets and the real
economy, hedge funds lurched into the public limelight in the autumn of 2008. After
a bubble in real estate that had been brewing for years, the inevitable blowout in
the housing sector should have sparked a garden-variety recession like so many
others of the past. Due to the massive buildup of speculation and leverage during
the run-up to the crisis, however, the resulting bombshell turned out to be the worst
smashup in more than half a century.

The fiasco proved in a spectacular way that a house of cards built on leverage can
ignite a chain reaction on an immense scale. The end result was to lay waste to the
capital markets as well as the banking system and the real economy.

In the wake of the fiasco, an outraged populace called on the government to take
concrete measures to thwart such crackups in the future. Sadly, though, the
policymakers have been drawing the wrong conclusions from the debacle and
have ended up for the most part chasing after phantoms.

To begin with, elected officials have failed to grasp the full chain of causality that
led to the catastrophe. Moreover, officialdom has a way of slapping a bunch of
bandages on a creaky structure built atop a pile of sand in the fond hope of
propping up the rig for good. Needless to say, the makeshift response merely sets
the stage for future breakdowns.

If the threat is to be tackled in a trenchant way, the remedy has to root out the
problem at the source. For this purpose, a sweeping program of reform is required
in order to cure the disease rather than just mask the symptoms.

Speculators as Scapegoats

When a nation suffers a financial or economic breakdown, a standard ploy of the

politicos is to finger some nebulous gang of speculators as the source of the
mischief. A glaring example lay in the blowup of the currency in Malaysia during
the Asian crisis of 1997. Another sample was the breakdown of the bond market in
Greece during the European ruckus of 2010.
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In reality, the speculators were of course just the messengers rather than the
ringleaders behind the melee. The local economy was in sad shape, and the
financial markets would have collapsed at some point whether or not any
speculators had been involved.

In fact, the flight of capital from the local economy could be ascribed in large part to
the jitters of regular participants in the marketplace, along with their haste to find
safe havens on foreign shores. The players of this breed include long-term
investors located abroad as well as wealthy citizens residing within the country.

In line with the foregoing vignettes, speculation by itself has scant power to trash a
financial market or the real economy. In fact, many observers have argued – with
some justification – that speculators improve the efficiency of the marketplace by
providing liquidity for commercial firms. In that case, the end result is to bolster
rather than reduce the health of the financial forum and the real economy.

For these reasons, speculation in itself is not the cause of the problem. Rather, the
source of the menace lies in an excess of leverage.

Once again, a levered position is not in itself a dastardly scheme. Rather, it’s an
overdose of leverage that causes the mayhem. When the market takes a turn for
the worse, the reckless schemes end up whacking the punters in the ring as well
as others standing by the sidelines.

We should note that a modicum of leverage can be useful for the conduct of
routine commerce. A case in point is a carmaker that wants to safeguard its
earnings from fluctuations in the exchange rate for a foreign currency. For an outfit
of this sort, there is no sensible way to obtain adequate protection without the use
of a levered position against its cash reserves.

The problem comes up, though, when leverage is puffed up far beyond the bounds
of reason. All too often, the pileup of levered positions is so massive that the
punters themselves go bust en masse when the tide in the marketplace turns for
the worse, as it always does sooner or later.

Unfortunately, a plunger can easily take up loony levels of leverage by using

financial tools of mass destruction. Even in the absence of fancy tools, manic
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players can jack up their bets by scrounging up funds from wealthy investors or
taking on loans from commercial banks.

To make matters worse, the mountain of leverage creates an artificial demand for
the underlying assets, whose surge in price attracts even more gamesters. The
impact is to pump up the demand for the runaway goods. In a bubble of this sort,
the bloated assets may take the form of stocks, houses, commodities, or any other
type of widget.

A prime example lay in the ravenous demand for mortgage-based securities during
the run-up to the financial flap of 2008. The craving for high-yield debt in the
financial forum sustained a binge of risky loans in real estate. So reckless was the
spree of lending by the bankers that borrowers of all stripes, including the jobless
and the destitute, could take out multiple mortgages on houses that stood vacant
or were yet to be built.

The tidal wave of demand for properties could not help but lead to soaring prices in
the housing sector. The froth in real estate in turn brought forth a deluge of houses
that had no use other than serving as vehicles for speculation.

This sorry example illustrates the fact that massive speculation propped up by
external funds leads to swollen prices, which in turn twists the market out of shape.
For this reason, the glut of speculation during the run-up to the blowout is the real
source of the problem. Furthermore, the smashup in the aftermath is merely a
byproduct of the distortion caused by the binge of leverage.

Given this backdrop, the way to cure the malady is to put a lid on rampant
speculation in the first place. The proper course of action is to root out the source
of the disease rather than paper over the symptoms.

Scant Leverage Causes Slight Hangover

The remarks above are not meant to suggest that leverage is the only way to
cause a bubble. Clearly, a horde of independent investors acting on their own are
perfectly capable of creating a bubble in the stock market, real estate, or any other
domain.

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A showcase lay in the Internet frenzy of the late 1990s. In this case, the mania
stemmed largely from the hype whipped up by gold diggers, zealous promoters,
and private investors rather than the leverage scrounged up by hedge funds,
commercial banks, and the like.

On the other hand, lonesome players acting on their own are prone to hurt only
themselves along with their nearby neighbors. The plungers can only muster so
much money out of their own pocket and dump it onto the bonfire before the well of
cash runs dry.

In that case, the resulting blowup will be restricted for the most part to the
participants within the niche. For instance, a crackup of the stock market will whack
only investors while a breakdown of the housing sector will bash only homeowners.

Granted, the carnage could spread to some extent beyond its home turf. A plain
example lay in the onset of recession in the real economy after the Internet bubble
popped in 2000. Even so, the scope of collateral damage is apt to be limited.

By contrast, punters that use other people’s money have practically boundless
power to pump up a bubble. By driving up the price to ditsy heights, the plungers
bring forth a flood of pointless widgets when the frenzy is in full swing.

An exemplar lay in the gush of worthless ventures on the stock market during the
Internet craze. Another showcase was the torrent of vacant homes amid the
housing frenzy at the dawn of the millennium.

In short, the problem in using other people’s money for speculation stems from the
enthrallment of the external creditors and passive investors. When – rather than if
– the bet goes wrong and the plunger goes bust, their thralls on the sidelines suffer
the brunt of the blowup.

In fact, the perverse matchup of gain and pain in the hedge fund game ensures
that only the outsiders take the fall. Remarkably, the principals who caused the
blowout get off scotfree.

The debacle of 2008 proved without a shadow of doubt that a chain reaction
sparked by zealous punters can bring down a legion of healthy firms as well.
Worse yet, the carnage can be so severe as to knock down the capital markets,
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banking system, and the global economy to boot.

To sum up, the use of outside funds gives rabid speculators unlimited power to
feed on wanton assets and twist around market prices. The outcome of the warped
prices is to make a mockery of resource allocation in the financial forum as well as
the real economy.

On the other hand, an upsurge in price cannot keep soaring forever. The inevitable
result is a bombshell that has to burst sooner or later.

The greater the crank-up, the bigger is the bang when it finally does occur. If the
blowup is large enough, the entire system of finance and economics comes
tumbling down in tandem.

New Beginnings

It may sound like an exaggeration to say that a single outfit or a small crew of
actors could tear apart the fabric of civilization as we know it. Yet the debacle of
2008, along with its aftermath, has served up a bitter foretaste of what lies in store.
On current trends, a catastrophe that lays waste to the trappings of modernity is
not only possible but inevitable.

In the popular imagination, the destruction of our way of life will come about – if it
does at all – through an act of god from the heavens above. A case in point is a
killer asteroid that upends the planet and throws humanity back to the Stone Age.

As it happens, though, we are quite capable of wreaking carnage of similar scale

on our own. Moreover, a calamity of such magnitude is more likely to result from
arms of financial leverage rather than weapons of physical mayhem. If we leave
things the way they are, we will surely meet the ghastly fate sooner or later.

On the bright side, though, we could stave off the outcrop of doomsday by a mere
act of forethought along with the legislation to match. The fitting course of action
would be plain, quick and wholesome.

On the other hand, the feat of regulation will be far from easy to pull off due to the
mass of opposition from lobbyist groups. The sensible approach will require the
7
courage of statesmen along with the backing of their constituents.

On a positive note, it would take only a small fraction of the voting public,
numbering in the millions, to see the project through. The stalwarts would be acting
on behalf of the entire population of consumers and producers that count in the
billions throughout the globe.

Securing the Future

It’s a truism that many things in life are knotty and complex. Yet, here is one issue
for which the proper tack is straightforward and free from any nasty byproducts. All
that is needed is the willpower to do the right thing.

The blowup of 2008 has shown that extreme levels of leverage can bring down the
entire system of finance and economics. Whether the assailants happen to be
hedge funds or other wildcats bulked up by leverage, it would make sense to
defang the agents of Armageddon before the bell tolls for everyone in the financial
forum as well as the real economy.

Additional Information on Hedge Funds

A suite of articles titled Hedge Funds delves into the past, present and future of
wildcat pools in the financial forum. The resource is available at the following
location.

Hedge Funds. Knol Collection. http://knol.google.com/k/steven-kim/hedge-

funds/30p6914355voj/9 – tapped 2010/4/23.