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By RodgerRafter
February 1, 2008

Posts selected for this feature rarely stand alone. They are usually a part of an ongoing thread, and are out of context when presented here. The material should be read in that light. How are these posts selected? Click here to find out and nominate a post yourself!

A couple of unrelated articles caught my interest this morning. For both of them you have to to be able to read between the lines to get real meaning out of them because these publications and interviewees are so careful with their words. Still, both articles get to the heart of what's going on in the market right now.

1. Hedge-fund concerns weigh on stock market
http://tinyurl.com/22fm73

Speculation on Friday focused on Numeric Investors. The Cambridge, Mass.-based quant hedge-fund firm, which oversees more than $16 billion, was rumored to have liquidated some of its positions earlier this week.

However, Numeric Managing Director Edward Goldfarb rebuffed the speculation in an interview Friday. "We have no idea where this rumor came from," he said.


The quotes provided don't actually deny the rumor, and as I explained in my last post it's pretty obvious that many quant funds experienced an extreme squeeze early this week:
http://boards.fool.com/Message.asp?mid=26313498&bid=114903

(For the record, I gained back about 1/4 of my losses on Thursday and Friday, so the squeeze may be over for now for the quant funds.)

"What happened on Monday was one of those types of events that you can't set programs and models to handle, and that probably hurt some people," said Peter Laurelli, a research analyst at Hedgefund.net, which tracks hedge-fund performance. "There was a lot of forced selling that moved a lot of markets in one direction very quickly, and that's probably going to affect these larger model-driven funds."

I expect that Numeric is just one of many funds that were forced to take large losses to the long term benefit of those liquid and nimble enough to play the volatility. The nature of quant funds is to compute based on past data how much leverage is safe for their existing strategies and then to maximize their leverage in order to maximize their gains. But too many quant funds using similar strategies ensures that eventually there will be wild gyrations that create margin calls for many of these funds. That was clearly behind the wild movements in August that Mauldin's column described and the much wilder movements I observed earlier this week.

IMO, so much of what has gone on in the markets in the past 5 years has been a result of the rise in prominence of the hedge fund industry. From 2003 on, small caps took off as many hedge funds took on oversized positions in companies where their accumulation ensured their own success. Leveraged hedge fund borrowing helped drive money supply growth, especially late in 2007 as other sources of credit dried up. The Yen Carry Trade helped prop up the dollar and hold down the Yen on a monumental scale. And most interestingly, hugely successful quant funds are becoming victims of their own success in causing wild swings for individual stocks.

"Experts also said Friday that hedge-fund performance in January will likely be poor."

Hedge fund manager compensation is based on yearly performance, with managers typically taking 20% of the gains of the fund. There's a clear incentive for managers to bid up their positions at the end of the year and the huge late surge in the money supply points toward a big rush in the industry to borrow and increase their positions.

I believed that the hedge fund industry was very much over-leveraged at the end of 2007, and this is a big part of why I was especially bearish going into 2008, buying (ultrashort) SDS and shorting QQQQ. Some of that was unloaded this week so that I could try and take advantage of the sharp moves caused by the Quant funds.

Things really started unwinding for hedge funds over the Christmas holiday. From December 24th to January 23rd:
The Yen rose from 144.45 to 105.42.
The Russell 2000 fell from 794 to 693.
And the money supply may actually be contracting (M2 averaged $7.454 B in week of 12/24 and $7.441 B in week of 1/14).

I expect that this latest event was probably a cleansing of the weak rather than the start of a full systemic meltdown. However, the market decline in 2000 also started with a cleansing of marginated retail investors that stabilized in the summer before really heading down in September. Our government and financial leaders are fighting furiously right now to try and patch things up, but I expect this will only postpone the inevitable.

Big hedge fund returns came largely from padded paper gains last year and every year before. Nevertheless managers extracted fees of more than 20% of gains on average. If investors try to redeem their shares in large numbers they'll find that there really isn't enough capital to go around. America's private and public pension plans have been the biggest suckers in this Ponzi scheme. This in turn qualifies many pension plans as Ponzi schemes that should begin to come unwound as baby boomers start trying to live off of them.

OK, enough of that, on to the next article:

2. SEC to Rework Rules After Funds Struggled With Subprime Prices
http://www.bloomberg.com/apps/news?pid=20601087&sid=aceNBDq.uQzc&refer=home

The U.S. Securities and Exchange Commission is updating rules for how mutual funds value holdings after they struggled to price mortgage-backed investments during the subprime-lending crisis.

"Struggled to price" really is a euphemism for "committed outright fraud."

Bank of America Corp., SunTrust Banks Inc. and Legg Mason Inc. all propped up funds holding mortgage-linked securities in 2007 after markets dried up amid the worst U.S. housing slump in 17 years...

To prevent investor losses, Baltimore-based Legg Mason has arranged $1.47 billion in financing for its money-market and cash funds since November. In December, Atlanta-based SunTrust injected $1.4 billion into two money funds, and Bank of America, the second-largest U.S. bank, said it would wind down a $12 billion cash fund. Cash funds, which are sold to institutions and wealthy individuals, offer higher yields by investing in riskier assets.


Maybe that should read "To prevent investor lawsuts..." I'm guessing that these institutions will pay out very low returns for a long time as a result of recent losses rather than taking a charge immediately like they should on the funds:

Inaccurate asset prices may prompt mutual-fund managers to overestimate a fund's net value and overpay when shareholders sell back their stakes. That can shortchange long-term investors.

In other words, take your money out now if your money market fund is hiding losses.

"Within the $12.1 trillion U.S. mutual-fund industry, the biggest subprime-debt investors are taxable bond and money-market funds, which managed a combined $3.93 trillion of assets as of November, according to the Investment Company Institute.

Yes, that money market fund that is supposed to be the safest place to put your money may really be blatantly lying about the value of its assets, many of which are invested in worthless mortgage backed securities.

So here's what has really happened to the wealth of this country... almost all of it got spent on imports. Sure there are plenty of assets in this country, but the liabilities are unbelievably huge. Gross external debt (to foreigners) was about $12.5 Trillion by the end of September 2007.

We've compensated by learning to overstate the value of our assets and and understate liabilities or shift them off the balance sheet. Our government does this regularly as do most of our financial institutions. Each of us should and every American corporation should recognize that we have individual liabilities as a result of our share of the National debt. It is already resulting in rising tax burdens and a loss of buying power due to inflation and the falling dollar.

I've been singing the same tune for over three years now, and the music has only gotten more clear:
http://boards.fool.com/Message.asp?mid=21870365&bid=114903&sort=recommendations

I still believe that America is bankrupt. Culturally we beginning to come to terms with our indebtedness are in the process of learning about bankruptcy, foreclosure and other ways of defaulting on our personal responsibilities. I think it is only a matter of time before the US defaults on its tens of trillions of dollars of obligations. It is simply the most politically expedient thing to do and the voters will demand it. When that happens how much do you think those money market funds will be worth?