Executive Intelligence Review
This article appears in the May 27, 2005 issue of Executive Intelligence Review.

'Hedge Fund' Blowout
Threatens World Markets

by Lothar Komp

Decades of insane economic policies, and the stubbornness of central banks papering over the symptoms of a systemic crisis by providing ever more liquidity, have produced an impossible situation as of late May, after the GM/Ford credit shocks.

One of the effects of this unprecedented liquidity pumping has been the biggest explosion in mortgage and other private debt titles in history, as well as the emergence of new financial bubbles in the bond, housing, and commodity markets. All of these financial assets are again just the basis for financial bets of even larger proportions: "derivatives." As most of the derivatives bets are traded outside of official exchanges, in the form of private deals between two counterparties, nobody really knows the actual dimensions. A substantial amount of derivatives betting is done by "hedge funds," which are not subject to any kind of regulation or supervision. According to the Bank for International Settlements (BIS), the outstanding volume of OTC ("over-the-counter") derivatives alone amounts to $248 trillion, while the annual turnover of exchange-traded derivatives is close to $900 trillion. It's a conservative guess to estimate the current rate of derivatives trading at $2 quadrillion per year; that is, 50 times more than the annual economic activity, measured by the gross domestic product (GDP), of all countries on the planet. (See Glossary of terms on derivatives and hedge funds.)

On May 5, a big shoe dropped into this giant financial minefield. Standard & Poor's downgraded $453 billion in outstanding debt of General Motors and Ford Motor Corporation to junk. On May 8, Lyndon LaRouche indicated that the General Motors crisis is not only a "national disaster" for the United States, but could actually detonate the world financial-monetary system. Two days after LaRouche's statement, markets were shaken by the fear of an imminent repeat of the Long-Term Capital Management (LTCM) disaster, which almost destroyed the entire system in Autumn 1998. Stock and corporate bond markets suffered massive losses on May 10, after traders pointed to evidence of severe problems at several large hedge funds, as a direct consequence of GM's and Ford's downgrading. The hedge funds mentioned in this respect included Highbridge Capital, GLG Partners, Asam Capital Management, and Sovereign Capital. The London-based GLG Partners has $13 billion under management, and lists as the largest hedge fund in Europe and the second-largest in the world.

GLG issued a statement on May 10: "All the funds are fine and we have no concern." Highbridge Capital, that same day, wrote a letter to investors, noting: "It is our understanding that recent volatility in the structured credit markets is apparently related to the unwinding of an unprofitable CDO [collateralized debt obligation] tranche correlation trade by one or more parties.... The purpose of this letter is to inform our investors that Highbridge has no exposure to the trades." Highbridge was bought up last year by U.S. megabank JP Morgan Chase. Sovereign Capital, a British hedge fund, is closely linked to Lazard Brothers. The fund is heavily involved in East Asian markets, and news of the possibility of its collapse had caused panic among Asian bankers. Sovereign Capital's chairman, John Nash, formerly worked for Lazard. Since May 10, the "LTCM-word" is in everybody's mouth. Asam Capital Management is based in Singapore and reportedly has lost most of its investors' money.

Top Banks Involved

The stocks of the same large banks that participated in the 1998 LTCM bailout, and which are known for their giant derivatives portfolios—including Citigroup, JP Morgan Chase, Goldman Sachs, and Deutsche Bank—were hit by panic selling on May 10. Behind this panic was the knowledge that not only have these banks engaged in dangerous derivatives speculation on their own accounts, but, ever desperate for cash to cover their own deteriorating positions, they also turned to the even more speculative hedge funds, placing money with existing funds, or even setting up their own, to engage in activities they didn't care to put on their own books. The combination of financial desperation, the Fed's liquidity binge, and the usury-limiting effects of low interest rates, triggered an explosion in the number of hedge funds in recent years, as everyone chased higher, and riskier, returns.

There can be no doubt that some of these banks, not only their hedge fund offspring, are in trouble right now. And the top banks are starting to point fingers at each other. Particular attention has been paid to Deutsche Bank. On May 17, Merrill Lynch issued a report noting that Deutsche Bank probably has suffered significant derivatives losses following the GM and Ford downgrading. The report states that Deutsche Bank will not be able to maintain its rosy performance, culminating in a pre-tax return on equity of 30% in the last quarter. Not only has the volume of bond emissions managed by Deutsche Bank dramatically declined during the second quarter, but the bank may have suffered reduced business from hedge funds because of the "recent turbulence" in the credit derivatives market, as well as losses in its own trading positions. "Deutsche must be taking some pain at present," concludes the report, which appeared just one day before Deutsche Bank's annual shareholder meeting in Frankfurt. According to Merrill Lynch, about 17% of Deutsche Bank's clients in its debt sales and trading business are hedge funds.

When it was named as one of the victims of the GM/Ford fall-out, Deutsche Bank chief financial officer Clemens Börsig was forced to claim at a New York conference on May 11, that the bank "has no cash lending exposure to hedge funds." Deutsche Bank's "exposure is fully collateralized." Börsig said that the bank's global markets unit "has no investments in hedge funds." The bank has a "conservative" approach to its business with the funds and "very strict criteria" for choosing clients, he added. Nevertheless, according to its own 2004 annual report, Deutsche Bank at the end of that year held derivatives positions, mostly interest rate derivatives, of a nominal volume of $21.5 trillion. That is about ten times the GDP of the German economy.

'Hedging' to Death

The unprecedented downgrading to junk of almost half a trillion dollars in corporate debt, which doubled the total volume of U.S. junk bond debt, had devastating consequences for different kinds of derivatives bets. In particular, the downgrading hit the credit derivatives market, which provides insurance against bond defaults. In the recent period, hedge funds have sharply increased their exposure to a form of credit derivative known as a collateral debt obligation (CDO). CDOs are pools of loans, bonds, and other debt titles from hundreds of different corporations which are bundled and sold to investors in much the same way as mortgages are turned into mortgage-backed securities. In exchange for hefty fees, many hedge funds have taken to selling insurance against corporate defaults. If there is no default during the life of the contract, the seller pockets a lucrative fee, but in the event of a default, the seller must pay out the face value of the contract. To raise that money, the hedge fund must often sell its most liquid assets, and that, often, in the face of a falling market. Such "distress selling" by several hedge funds was actually observed on May 10 and subsequent days. Europe is extremely vulnerable to the current crisis in the credit derivatives market, as 50% of all CDOs are euro-denominated. The same kind of financial instruments led to the Parmalat collapse in Italy last year.

A related kind of derivatives scheme is the so-called capital structure arbitrage (CSA). It's one of the latest inventions in the derivatives casino. CSAs also involve bets on corporate debt titles, or the derivatives on that debt, such as CDOs. But the overall bet is made more complex by adding another element: the stock price of the respective corporation. Usually, when the prices of corporate bonds or their derivatives falls, the stock price of the respective corporation goes down as well. By combining the bond or credit derivative with a bet on a falling stock price, the CSA investor can try to "hedge" against potential losses. More convincing for hedge funds than the limiting of risks, is the empirical discovery that once a corporation runs into trouble, the stock price often plunges much more violently than the bond price of the same corporation. And that is exactly the condition under which a CDA contract generates profit.

Now comes the problem: By the very combination—in the same week—of Kirk Kerkorian's announcement for a partial General Motors takeover, boosting the GM stock price by almost 20%, and the downgrading of GM debt to junk by Standard & Poor's, crashing the GM bond price, the arbitrage traders suffered the worst of all possible disasters.

Nobody knows how many hedge funds have already gone under in May. Further complicating matters is the fact that many hedge fund investors, faced with all the news and rumors circulating about derivatives losses, are panicking, and are right now pulling out their money—if they can. Hedge funds often allow withdrawals of funds just once a quarter. The next date is July 1. But how to pay out investors, when cash reserves are gone and every dollar of capital is tied up in highly leveraged derivatives bets? To be able to meet redemption demands, hedge funds are forced to liquidate contracts under the present, extremely distressed, market conditions. This means piling up even more losses, which in turn—once investors recognize it—will further intensify withdrawals.

One indicator for the ongoing "distress selling" is the average price of credit-default swaps (CDS), which on May 18 hit the highest level since records started one year ago. For every outstanding corporate bond, an investor can buy a CDS contract, by which the default risk is transferred to the counterparty of the contract. In exchange for this kind of protection, the investor pays a certain fee to his counterparty, which works like an interest rate deduction on the nominal return of the bond. Within ten days leading to May 18, the average CDS rate has jumped up by one third, from 42 to 60 basis points (from .42% to .6%). The sharp increase reflects not only the rising fear for corporate bond defaults, but even more, a sudden drop in the number of hedge funds that are willing, or able, to take over additional default risks. The surprising rise of the U.S. dollar and the fall of commodity prices, including oil, are also being attributed to hedge fund emergency sales.

Beyond LTCM

Andrew Large, the deputy governor of the Bank of England, issued a strong warning on credit derivatives on May 18. Speaking at an international conference of financial regulators in Turkey, he noted, "Credit risk transfer has introduced new holders of credit risk, such as hedge funds and insurance companies, at a time when market depth is untested." Large said the growth of derivative instruments has "added to the risk of instability arising through leverage, volatility, and opacity." Regulators should therefore act and, in particular, search for credit concentrations.

Among the many voices warning against a repeat of the LTCM debacle or worse, is non other than Gerard Gennotte, former senior strategist at LTCM, and now working for another hedge fund called QuantMetrics Capital Management. In statements picked up by London's Financial Times on May 18, Gennotte pointed to the rising risk of a liquidity crisis triggered by hedge fund blowouts, which then could lead to a 1998-style collapse. He emphasized: "You could expect something similar to 1998, with people starting to liquidate their positions. It starts with one position, but then they are afraid of getting withdrawals, and it spreads across strategies."

In private discussions with EIR, an international financier confirmed LaRouche's notion, that the downgrading of General Motors and Ford debt was just the beginning of a much larger crisis hitting the grossly over-extended global financial bubble—in particular the derivatives scam. The financier said that the international financial system is, in fact, facing a derivatives crisis "orders of magnitude beyond LTCM." He observed that one can be certain that the Federal Reserve, the President's Commission on Financial Markets (the so-called "plunge protection team"), and the relevant departments of major central banks around the world, are all on "emergency red-alert mobilization."

Hedge funds and banks are, of course, all publicly denying reports of a major derivatives blow-out. Any bank or hedge fund that admitted such losses without first working a bail-out scheme, would instantly collapse. Such implausible protestations of solvency are another source of instability. The source further said that there is no doubt that the Fed and other central banks are pouring liquidity into the system, covertly. This would not become public until early April, at which point the Fed and other central banks will have to report on the money supply.

Regulating Hedge Funds

In response to the GM and hedge funds crises, Lyndon LaRouche issued a statement May 14, "On the Subject of Strategic Bankruptcy," in which he called for "new governmental mechanisms" for dealing with these "strategic bankruptcies, bankruptcies with which existing mechanisms of governments are essentially incompetent to deal." LaRouche also renewed his call, from the early 1990s, for a transaction tax on all derivatives trades, to regulate hedge funds. By such a transaction tax, government authorities, for the first time, could get an insight into the hedge fund activity. Currently, there exist about 8,000 hedge funds worldwide, managing about $1 trillion in capital, compared to 4,500 hedge funds and $600 billion in capital just two years ago. When LTCM was going under in 1998, for every dollar of its capital, it had borrowed $30 from banks at was running at least $400 in derivatives bets.

Allegedly, the average leverage of hedge funds today is much lower than in the case of LTCM. At least one in ten existing hedge funds, in most cases the smaller ones, are quietly being closed down every year, while at the same time many more are being set up new.

A public debate on the regulation of hedge funds has already erupted both in Britain and Germany. On top of the fears for a systemic breakdown, there is the imminent concern that private equity funds and hedge funds are, right now, taking over or manipulating the stock prices of thousands of corporations in both countries. John Sunderland, the President of the Confederation of British Industry (CBI) came out with an attack on such funds, sounding similar to German Social Democratic Party chairman Franz Münterfering's famous earlier "swarm of locusts" statements. CBI Director General Digby Jones raised the alarm bells concerning certain derivatives—"contracts for differences" (CFD)—by which hedge funds are able to secretly build up stakes in corporations.

In Germany, the chief executive officer of Commerzbank, Klaus-Peter Müller, who also heads the German banking association, raised the question: Why are we regulating small banks, while hedge funds, moving much larger capital, are not being regulated at all? Bundesbank board member Edgar Meister described hedge funds as the "white spots on the map of supervisors," which are growing at alarming speed. Even Rolf E. Breuer, who just resigned as supervisory board chairman of the Frankfurt stock exchange (Deutsche Börse) after losing a power fight with the British hedge fund TCI, has now astonished the banking scene with a surprising conversion. The same person who, as head of Deutsche Bank, had praised derivatives trading as the shortest way to paradise on Earth, and become known in some circles as Germany's "Mr. Derivatives," is suddenly denouncing the short-term speculative investments of hedge funds, that are colliding with the need for long-term productive investments and therefore could "devastate the German economy."


Derivatives `Ticking Time Bombs'

In an article headlined "Ticking Time Bomb in Structured Credit Products," Switzerland's conservative financial daily Neue Züricher Zeitung on May 19 pointed to the precarious situation in the so-called "structured credit" market. This includes the use of capital structure arbitrage (CSA) contracts, combined bets on the stock price and debt titles of the same corporation. The daily states that the purchase of GM stocks by Kerkorian caused a "brush fire" on the bond market, which then, in particular, hit funds specialized in CDAs. The funds faced "painful" losses when the risk premiums on GM bonds "exploded" and the prices of related derivatives plunged, while GM stocks, because of the Kerkorian move, jumped by 20%. Overall, the downgrading of GM, in spite of "the fact that it didn't came as a full surprise, triggered a chain reaction on the bond market," centered around collateralized debt obligations (CDO). These CDOs fueled the "sudden explosion" of the GM risk premium. Trying to escape from their CDO adventure, investors "at some point engaged in panic selling, which then derailed the credit derivatives market."
—Lothar Komp

(See also EIR 1993 Congressional Testimony on Derivatives Tax)

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