Wednesday, August 1, 2007

Roach Motel Hedge Funds

As the credit crunch continues, more and more hedge funds are getting squeezed between lower asset values and margin calls. The news is everywhere and in my opinion will get much, much worse. The credit crunch is morphing into a confidence crunch, whereby previous "savvy investors" suddenly realize that they were in fact "delirious speculators" and rush to save whatever money they can by pulling it out.

This is somewhat of a throwback to bank runs and thus the suspension of redemptions is very ominous. In plain words, you can't get your money out. "What? Outrageous!", you say. "Read the fine print", they say. After obtaining a 10x magnifying glass and poring over the 300+ pages of print in the offering document that you so quickly signed when visions of sugar-plums were dancing in your head, you discover that, lo and behold, fund managers can indeed do that. It is supposedly for your protection, so as to avoid selling assets at distressed prices.

I am of the opinion that most of the hedge funds that have sprung up in the last 3-4 years are becoming financial "Roach Motels" (R). Money has checked in - but it won't be checking out and as more "investors" get news of suspensions the rush to get their money out will only intensify.

The situation will also impact private equity funds, but the process will likely take longer (at least the portion that will become public). The game there involves much bigger boys and girls (think "Carlyle") with similar-sized greed and tanker-fulls of hubris - notice the word "tanker", it is significant. It also happens that such "participations" come with very complicated strings attached, a web that reaches to the very heart of global government and corporate elites. They make stupid mistakes like everyone else (human folly is as old and common as stones), but they have far greater means to cover them up, at least until they have left center stage. Nevertheless, for some it won't be so easy.

I am referring to Sovereign Funds, that immense financial folly so fashionable with au-courant government officials and their well-fed bankers, who know better than their peon "subjects" what they should be doing with their money. More services? Oh no, no. Better health and education? Are you daft? Investment in alternative energy R&D? Please... A majority of such Sovereign Funds prefer...hedge funds and private equity funds. I repeat, this is investing money from the public purse. Is that apropos? Hell, no. (Is it lucrative? Hell, yes.)

A private investor can always choose if he will or won't check into the Roach Motel Fund - but in the case of Sovereign Funds the public at large is never consulted. If a private investor has only himself to blame for his credulity, in extremis masses have more direct and effective ways of exacting recompense for losses sustained by decisions made by corrupt or inept officials. If this plays out as I think it ultimately will, I won't be surprised to see major political upheavals in some capital cities, with some denizens checking into real roach motels, complete with barred windows and barbed-wire fences - or worse. After all, if a mild case of construction-related kickbacks merits the death sentence, what punishment is appropriate for the loss of $10 billion when vox populi is shaking the President's?Chairman's/Sheikh's windows?

If this sounds almost barbaric to western ears, it is the way the cookie crumbles in most of the rest of the world. Why does this matter to us, right here, right now? It does, because those that have previously signed-off on such sovereign investments are well versed in the principles of survival under Mosaic Law, as applied to official government scapegoats. In other words, if ANYONE expects Chinese or Oil money to save them with fresh infusions of cash, they are simply deluding themselves.


  1. As usual an excellent to the point analysis that cuts through the BS to get to the nitty gritty.

    For those whose greed and stupidity got them trapped in hedge fund "roach motels" I have no sympathy at all.

    They should have remembered the old slogan " bulls make money, bears make money, but pigs get slaughtered".

  2. I think you're missing the main point about "the evil of hedge funds." Possibly, you've made this point in earlier posts.

    Only a few hedge funds are going to suspend redemptions or employ gates. But when we look back on this episode of ruin in 4-5 years, people will ask: "How could we let hedge funds increase risks for all investors in their own self-interests?"

    Once upon a time, there were Fed-controlled limits on how much borrowing stock market investors could employ. Now, there are none.

    As liquidity dries up and margin calls come in to the hedge funds, they can easily shift their carry trade from net long positions to net short. Why wouldn't they? In that case, markets will plummet, and the hedge funds won't be the ultimate bag holders. The models they watch closely, those that correlate weak yen to speculative stocks, will get them out fast with minimal losses, compared to vast gains made. But ordinary investors will lose all confidence in markets. Why did market regulators let this fiasco happen?

  3. Re: hedge funds

    It is extremely difficult for any investor to do an about face on a dime. First of all there are psychological reasons, i.e. admitting you are wrong and then having the guts to go against your previously wrong convictions. In may ways this is the biggest problem.

    But there are more practical problems: if you run a big enough hedge fund your own positions will move the market - and it is simply amazing how quickly the whole market will know what you're doing, no matter how many blinds you try to use. Selling a relatively illiquid holding (say a CLO) and then selling some more to go net short is almost impossible in a market such as this. Of course I am referring to doing things in size, not a mere few tens of millions.

    The big boys essentially "become" the market and there is no one to sell to. Redemption requests come in - they are most definitely screwed because they HAVE to sell. Or cease redemptions...

    Maybe they can open positions in more liquid instruments with a negative correlation to their own. For example, a fund may have an illiquid possy on CDO's and they decide to go long yen in the (rational) expectation the carry trade will unwind. But that action will put more pressure on markets, and that will come back to them as lower CDO values.

    It is not at all as easy as you make it sound. Unless you are very small and nimble, in which case you can come and go as you please...


  4. Equities are different than CDOs. I believe the carry traders have chosen to pump their borrowed money into equity asset classes that are thin enough to move yet liquid enough to exit fairly quickly, if lossses start to mount. I think they have models and triggers, and they are using a combination of equities, ETFs and derivatives to enhance liquidity.

    I think their prime targets have been Asian emerging markets and U.S. small cap stocks. The correlations between yen weakness and up moves in those classes has become spooky.

    One thing that identifies carry traders is their persistence. They are addicted to what has worked, and they keep coming back to borrow yen again and again, until it falls apart. As it does, I expect many of the yen carry traders to go from net long equities to net short to recover losses and keep the party going.

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