Magic Formula + High Rollers = Hedge Funds

They preached to the rich that they had the answers – philosophically-driven investment vehicles for the rich. Some crawled and leaped into emerging markets (high-growth but unstable developing countries), a few financed movies while others created and plied the infamous derivative trade – many packaging subprime mortgages, rating them in tranches and either holding them or selling them as high-yield instruments to institutions like Bear Stearns, AIG and Lehman Bros. A lot of billionaires were born and made in those deals.

Today, even the federal bailout has excluded investing in these funds, as hedge funds are pulling their investments out of emerging markets as fast as they can, tanking the local currencies against a rising dollar and yen. Investors are pulling their money, when they can, out of hedge funds themselves (literally dumping their investments in the already volatile marketplace), and that is a big shoe rapidly slipping off the foot ready to drop. The New York Times today: “Hedge funds lost an estimated $180 billion during the last three months and some are near collapse. Investors are demanding their money back, and Wall Street is bracing for a shake-out in the $1.7 trillion industry.”

Since many of these funds still carry the subprime mortgage derivative bundles, any attempt by banks to lower interest rates or reassess principal necessarily makes the subprime mortgages that remain in those funds worth even less. So what are the funds holding such toxic derivatives doing about this potential further dilution in their retained subprime derivative packages? What every other red-blooded American company would do under the circumstances. Sue the banks to stop them from fixing bad mortgages with realistic interest rates!!!

Today’s New York Times also reports that: “At least two funds, Greenwich Financial Services and Braddock Financial, have told banks that they may take legal action if loans are renegotiated in a way that hurts the funds’ financial interests.” Ooh baby! Calling all lemmings! There are some hedge fund guys out here beginning a new suicidal march to the sea! Okay hedgey guys , bring it on, and then let’s RICO (Racketeer Influenced and Corrupt Organizations Act) them into some free room and board and regulate them out of existence!

I’m Peter Dekom, and I’m feelin’ it!

America: Addicted to Debt

It’s un-American not to be in debt over your eyeballs! We, as individual consumers, borrow more than we earn! For four years in a row, an event that has not occurred since the Great Depression. That alone is an alarming fact. People believed that real estate could only rise. Everyone seemed to borrow more than was prudent, even beyond the sub-prime market. As the January 23, 2008 New York Times noted: “Everyone from first-time home buyers to Wall Street chief executives made bets they did not fully understand, and then spent money as if those bets couldn't go bad. For the past 16 years, American consumers have increased their overall spending every single quarter, which is almost twice as long as any previous streak.”

We all follow the lead of our government that borrowed 100% of the cost of the Iraq War. The United States currently owes $9.5+ trillion of “national debt” (the aggregation of unpaid deficit-borrowings), which in turn generates a massive $350-$400 billion dollars in annual interest payments, mostly to other countries that have politely funded our deficits. Put another way, the national debt currently grows by $1 million a minute or $1.4 billion a day!

We Americans have another form of debt; we call it a “trade deficit” – it runs about $60-$70 billion a month – what happens when you import much more than you export. The November 30, 2006 Business Week predicted that “[f]or the first time in recent memory, the cost of imported goods and services will exceed federal revenues. In other words, Americans will soon pay more to foreigners than they do to their national government.” That happened this year. Even with the slowdown from the recession/depression (whatever you want to call this total meltdown). With massive amounts of our national debt in foreign hands, with global competition accelerating at the expense of U.S. workers and with oil reserves predominantly in antagonistic foreign hands, the future of our economy is decreasingly within our own control. We live based upon the “kindness” of strangers.

So enter Wall Street. Not only did they encourage all the above consumer borrowing, they repacked the debt and sold “derivatives” (including aggregations of risky mortgage loans), making fees creating, buying and selling these “derivatives,” but they fell so much in love with debt, that investment bankers (who make the big bucks when companies are bought and sold – mergers and acquisitions) decided that you really didn't need a whole lot of equity to buy huge companies either – you could use stock and, gotta love ‘em, debt. Lots of it, not a whole lot different from people buying houses without much of a down-payment.

They even figured out how to make even more money by creating layers of debt – the top guys (senior debt) got paid 100% with interest before the next level (mezzanine debt) gets paid off with its higher rate of interest (being in second position is always riskier than being on top). The shareholders (the equity) sit at the bottom, hoping their management made the right decision.

The investment bankers figured out how to get still higher fees by structuring and supplying the high interest mezzanine debt. And giant hedge funds were created, some within these very investment banks, to raise all that capital needed to fuel the mortgage demand, the mezzanine debt demand and all of the other “needs.” A little equity, not a whole lot of government interference (the government even made interest rates so cheap, why not borrow?!), the debt just got higher and higher.

As long as the marketplace was going up, who cared about the debt load? You got a new house or a nice new company or a nice new investment. The housing market woke up in 2007; the financial markets awoke slightly after Bear Stearns went down, but went back to sleep only to awaken to one of the greatest market crashes in American history in the last few days. Lehman Bros. was gone. AIG, an insurance company alive only by government intervention. There was blood in the streets and no short term “fixin’s” gonna right a ship that has run so far aground.

Bottom-line: The laissez-faire lending markets do not work. The derivative markets are a disaster. Without government oversight, required limits on how much real equity you need to borrow and how you will pay it back, we will watch the markets react over time, minus a whole lot of companies and homeowners, until the next debacle. What kind of America will we be then? Competitive? Vibrant? Hopeful? Or a worse version of what the unregulated economy gave us this week?

I'm Peter Dekom and I approve this message.