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An Economy Too Clever For It's Own Good

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By WatchingTheHerd
October 2, 2006

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Newspapers and blogs have been filled recently with commentary on the impact of nearly a half TRILLION dollars in mortgages originated in the past few years which will now hit their first interest rate reset in 2006. Big stories have also come out about the melt-down of several hedge funds providing high-risk / high-reward investment services to corporations and wealthy individuals.

These looming problems seem to be opposite sides of the same economic coin. Both involve financial strategies that create or attempt to leverage economic multipliers in the economy. Both are over-used by "customers" who originally probably thought they understood the mechanics involved (but probably didn't) and now are being used as a crutch to maintain an impossible level of consumption (in the case of consumers) or impossible levels of profit growth (in the case of businesses). More importantly, both trends pose major problems for the American economy for exactly the same reasons.

Unsophisticated Consumers + Sophisticated Mortgages = Trouble

During a recent drive around the neighborhood here in "Herdaburbia", I was struck by the sheer number of storefronts devoted to all things financing. You have the normal complement of branch locations of megabanks but lots of national and local "mortgage specialists" focused on re-re-re-re-financing, branch locations of national chains of financial advisors (not traditional brokers) and even a few "Check 'n' Go" type payday loan or check cashing stores.

Fifteen years ago, the only places one normally saw (ahem) "payday loan" stores were in poorer urban areas. The customers for these businesses were either high credit-risk customers who need loans or people who don't even have enough money to warrant a banking account to deposit a paycheck. I live in an area where virtually no new standalone homes are built for under about $220 and most start at $350k+ so the appearance of check cashing outlets is rather troubling from a macro-economic standpoint. There are clearly more households near the financial edge than one would first think.

Fifteen years ago, a mortgage was not an everyday product. Americans average about 7 years in one place so the average American probably only took out a mortgage every 7 years as well. I can't even remember any radio, TV or print ads for mortgage services. The ads obviously existed but were such a small part of the advertising landscape that they never really dented one's conscience. Now, in my market, morning radio literally has traffic reports sponsored by one home equity mortgage company while the news is sponsored by another competing firm with two or three other mortgage lender ads often interspersed between. Those ads are there because the market is there.

In a stable economy, the availability of zero-down loans and inventive ARMs helps many afford a home earlier than they would have otherwise or allow more home to be afforded than would have been the case. However, most homeowners probably don't understand how older, more traditional lending practices actually worked in all homeowners' favor. A requirement of a ten or twenty percent down payment for a home mortgage provides benefits not just to the borrower/lender involved, but all borrowers/lenders in the market.

For the borrower, traditional terms ensure the borrower has demonstrated the ability to save money which increases the likelihood they have the discipline to continue saving money for a financial cushion to cover payments if they experience an interruption in income. This actually HELPS THE BORROWER by reducing the chance they lose (roughly) 6 percent of their equity on a real estate commission and possibly lose even more on the home itself by setting a fire-sale price to unload the home quickly because they lack the cash for a few months' payments.

For the lender, traditional terms allow the lender to avoid fire sale pricing of a repossessed property, increasing the likelihood the lender makes a profit even if the borrower defaults. Even a 90 percent LTV usually provides enough cushion to cover a few months of interest while the house is for sale and still produce a profit for the bank as long as the overall market values haven't dropped 10 or 20 percent.

What seems to have been overlooked in the past five years are the protections traditional terms provide all borrowers and lenders in the market. If you purchase a home for $200,000 and borrow $160,000 (80 percent) for the purchase, the bank has a $40,000 cushion. If you default, they only have to sell the property for $160,000 to break even. However, most banks don't use the cushion to unload the home and make a few pennies. They use the cushion to wait out the market to get the highest price they can without dumping the house with a fire sale price. They do this to protect THEIR interest in both the defaulted property and other properties in the area but this also benefits other homeowners and lenders in the area.

In contrast, if the bank lent $200,000 on a home appraised at $200,000, once the borrower defaults, the bank is IMMEDIATELY exposed to a loss, creating a powerful incentive for them to sell the property ASAP. This causes downward pressure to be applied to home prices IMMEDIATELY, affecting all homeowners and lenders in the market. (Caveat: at this point, so many consumers are defaulting that banks have become far more lenient before foreclosing precisely to avoid triggering a flood of fire sales but they can only defer the inevitable for so long.)

When the economy is growing steadily or doing very well, these lending rules appear overly cautious for potential homeowners on the verge of being able to afford a home. However, these rules were developed in part in response to past boom and bust cycles and reflect a great deal of sound logic. In 2006, we have an economy where about 25 percent of loan originations were interest-only loans nationally with some expensive housing markets showing even higher percentages. (#1) Most Americans can't even explain the mechanics of a traditional fixed rate mortgage, much less these new variants, yet 25 percent of the growth in recent home sales depends upon them and depends upon a rosy employment and interest rate scenario to avoid a collapse.


Hedge Funds: In Theory and In Practice

If home equity loans and non-traditional mortgages have become an irresistible temptation for individual consumers to use in expanding their purchasing power for McMansions, Viking ranges, $2000 plasma TVs and $50,000 SUVs, hedge funds seem to be filling a similar role for multi-billion dollar multinational firms and the uber-wealthy.

Hedge funds originated as specially organized investment firms focused on protecting large amounts of wealth from wide fluctuations in value caused by fluctuating exchange rates, economic instability or political instability. Corporations producing billions in cash that cannot be immediately invested back in the business and (for some reason) cannot be paid back to shareholders aren't content to put piles of cash in a vault for safekeeping with no return. Corporations with revenue produced in multiple countries face even more pressure if they are publicly traded since investors expect steady or growing quarterly earnings but currency fluctuations can wipe out major gains as they are repatriated back to the corporation's country of origin.

Hedge funds attempt to balance and eliminate these international risks by selecting investments whose values are expected to have a strong negative correlation with one another. For example, if hedging risks related to exchange rates between the US and China for a firm with cash in both countries, a hedge fund might try to find investments which

a) are relatively safe in their own right
b) vary with (ideally) a -1.0 correlation with one
another so that if investment A in China declines
by 10%, investment B in America grows by 10%

This sounds very scientific and mathematical (and thus, do-able) but in reality the process is incredibly complicated and error prone since it depends upon events governed by human psychology and greed, not science. For example, even if you could find Investment A and Investment B above which had a perfect negative correlation to each other, there is no assurance that both investments would permit equal assets to be invested, since Investment A might only be a $20 million opportunity while Investment B might require $300 million. That leaves $280 million that must be "protected" via some other combination of investments.

To fulfill their mission, managers of large hedge funds inevitably wind up making hundreds of smaller, more intricate bets on highly complicated derivative instruments, options and speculative investments. As a result, the average hedge fund manager probably understands far more about the risks associated with currently fluctuations, futures markets, etc. than the average stock or bond trader or certainly the average investor. However, their greater understanding is COMPLETELY outweighed by the fact that nearly 100% of what they do every day is operating on this fringe.

Hedge funds have gained a particularly dangerous influence on the overall economy for three reasons. First, most hedge funds have begun straying away from their original purpose of PRESERVING WEALTH to strategies aimed at CREATING WEALTH for their clients. Of course, the hedge funds are simply conforming to the wishes of their investing partners. No corporation or individual with the kind of wealth needed to invest in hedge funds is content to put $100 million under a mattress with no gain.

Expecting to obtain a 1 to 5 percent return wouldn't be out of the question for such an investment just as brokerages often pay a nominal interest rate on margin account balances. However, many hedge funds have been tempted to use the vast cash at their disposal to "swing for the fences" to produce much larger profits, partly to pad the pockets of the fund managers and partly to allow their investing partners to use hedge fund gains as another source of profits on the company's bottom line. In effect, many large firms expect their hedge fund assets to return profits just like their continuing operations.

Hedge funds have responded to the pressure to produce profits instead of stability by attempting to use their specialized knowledge about exchange rates, anomalies in commodity prices or economic / political risks in what are essentially day-trading strategies. However, instead of short term trades based upon direct prices of traditional concrete assets (stocks, bonds, commodities), hedge funds frequently trade on derivative investments and are magnifying their exposure to risk by using the massive amounts of cash on hand to make huge bets on small variations on these highly volatile assets.

The second problem with hedge funds is that continued consolidation in many industries is producing huge multinational conglomerates that are producing HUGE amounts of cash profits by squeezing costs across a global supply chain. Due to management practices at these firms, many firms are reluctant to return this cash to shareholders in the form of dividends. Instead, they prefer to retain the earnings for some future acquisition to take the company to some even larger scale of efficiency or for some speculative investment in an unrelated industry that will supposedly produce "synergies" for shareholders. In the mean time, the firm expects to use the enormous horde of cash to contribute to the bottom line growth of the company.

As Cisco, GE and others can attest, this is easy to do if you're a mere $1 billion dollar company. If you're a $50 billion dollar firm, it gets more difficult. If you're a $500 billion dollar firm, it is IMPOSSIBLE to find investments that can grow at 10 percent yearly rates that can absorb the billions in free cash produced by a $500 billion dollar firm. However, that hasn't stopped many firms from trying to the detriment of their shareholders.

The massive amounts of cash available to hedge funds and the relative lack of regulation and oversight into their operation constitute the third major problem they pose to the economy. Traditional mutual funds must register with the Securities and Exchange Commission and follow strict guidelines regarding diversification, dividends and reporting. Hedge funds operate as private partnerships between their principal investors and have virtually no public reporting requirements. As a result, hedge funds act to funnel enormous amounts of wealth into the control of a very small number of investment managers who focus on the riskiest segments of the financial markets with virtually no oversight or accountability.

Excess Cash + Overconfident Hedge Fund Managers = Trouble

The dangers hedge funds pose to the American and world economies are not hypothetical. In 1994, a team of some of the brightest thinkers in economics founded Long Term Capital Management which used complicated formulas and theories involving government bonds to produce profits for its investors. Like every successful mutual fund, the hedge fund quickly encountered problems producing similar returns at larger and larger scale and began making other speculative investments along with its bond investments. In 1998, a default on Russian bonds triggered a meltdown of LTCM which eventually lost over $4 billion dollars. To avoid a wider panic, a $3.6 billion dollar bailout was arranged by a consortium of institutions including the Federal Reserve Bank of New York.

In September of 2006, a Connecticut based hedge fund, Amaranth Advisors, lost over $6.5 billion dollars on trades based upon the difference between summer and winter natural gas contracts. A single 32-year old trader controlled most of their strategy in this area and bet past patterns of low / high prices for summer / winter contracts would continue. They didn't. Prices for winter contracts dropped 12 percent after the Department of Energy announced unusually high inventory levels compared to the prior year which were unusually low due to production problems stemming from Hurricane Katrina. (#2)

The $4.6 billion lost by Amaranth includes dollars from many pension funds, including 3M ($92 million invested) and the San Diego County Employee's Retirement Association ($172 million invested). Amaranth also had many large banks as investors, including Morgan Stanley, Credit Suisse, Deutsche Bank AG and Bank of New York. (#3) Amaranth wasn't even the only hedge fund to fail recently due to bets on natural gas. MotherRock LP based in New York folded in August. (#4) Overall, over 400 hedge funds have closed in the past two years according to Bloomberg News. (#5)

Another fund currently in the news, Pirate Capital LLC (no joke on the name), actually specialized in taking large, temporary positions in companies with management issues in the hope of inducing management changes that would push the stock price up enabling a relatively quick sale for a profit. In effect, they operated as a leverage buy-out firm but used hedge fund cash instead of junk bonds to finance the short-term positions in their targets. The firm got in trouble when some of its targets proved more resistant to its management / strategy recommendations. (#6)

Opposite Sides of the Same Coin

As mentioned earlier, the growth of complicated mortgage products for consumers and complicated hedge funds and derivative investment products for big business are opposite sides of the same economic coin. In both cases, a financial strategy that makes sense if a limited group follows it can produce disastrous problems if the entire market becomes dependent upon it.

In the case of consumers, interest-only loans or zero-down loans CAN make sense in a market where home prices truly are increasing by 5-10 percent per year. However, if those 5-10 percent increases are being fed by a credit bubble rather than normal population growth and demographic trends, risks become magnified the later into the bubble one buys. Consumers have further compounded the problem by using easy mortgage terms to cash out the inflated value of homes to fund additional spending on consumer goods or even larger over-priced McMansions. Like many other aspects of human herd behavior, the cycle makes perfect sense to the uninitiated until it makes no sense, then it's too late.

In the case of hedge funds, arbitraging temporary differences in options prices and other complicated derivatives makes perfect sense if you truly understand the underlying "science" affecting your positions and truly believe the numbers upon which your positions are taken truly reflect real values. However, if one trader can trade on these fluctuations with huge amounts of cash, countless others can as well. So how do you know if the fluctuation you just saw is due to the actual market you think you understand or someone else's arbitrage strategy you might not understand or even know is at work? What if you bet correctly on the "science" but someone else bets incorrectly and tanks the same market you trade in? You lose.

The dangers posed by hedge funds also point out interesting applications and limits to the "invisible hand" concept. One could argue hedge funds are a direct, logical, justifiable consequence of an efficient global market that allows firms to produce billions in cash that need protection and appropriate venues for short-term investment. How efficient is it to allow $6.5 billion dollars to be destroyed in ONE MONTH by a single 32-year old natural gas trader making horrendous bets on future gas prices?

One could argue that the "invisible hand" would operate much more effectively if large multi-billion dollar multi-national companies would promptly distribute more of their excess cash back to SHAREHOLDERS rather than keeping it on hand as a temptation for the CEO and officers to use in chasing unsustainable growth. Even if it is incredibly efficient for a single company to operate at a scale that produces billions in free cash every year, that efficiency serves no purpose if the resulting cash is horded by a small number of managers who then squander it trying to produce even larger gains. It should be returned to shareholders who, operating independently using their own information, actually make up the invisible hand.


WTH

===============

#1) 2006 Loan Origination Trends:
http://www.dfw.com/mld/dfw/business/15598421.htm

#2) Hedge Fund's Collapse Met With a Shrug:
http://www.washingtonpost.com/wp-dyn/content/article/2006/09/19/AR2006091901388.html

#3) Amaranth hedge-fund losses hit 3M pension, Goldman:
http://www.thejournalnews.com/apps/pbcs.dll/article?AID=/20060921/BUSINESS01/609210307/1066

#4) Energy hedge fund closes shop:
http://money.cnn.com/2006/08/04/markets/energy_hedge/index.htm

#5) Over 500 Hedge Funds Shut in the past two years:
http://www.iht.com/articles/2006/09/18/bloomberg/sxhedge.php

#6) Pirate Capital Loses Its Swagger:
Wall Street Journal, page C1, September 27, 2006


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