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Hedge Fund Problems Start With the Fed
February 5, 2007

Hedge Fund Problems Start With the Fed

"On the loan side, we've seen no evidence of rationality on the part of the [banking] industry. Prices continue to narrow for most products, spreads are tighter from a credit standpoint, and you see the same thing replicated in capital markets.� There just isn't a great risk return profile from the standpoint of taking credit risk."

Tom Wutz, CFO
Wachovia Bank
American Banker

For those�too busy to�pay attention, a gentle reminder that�Institutional Risk Analytics is participating in the Frontiers in Credit Forum�sponsored by Professional Risk Managers International Association on February 16th, 2007, in New York City.� We are moderating the final panel of the program, the Practitioners Forum, which will include Martin Fridson, CEO, FridsonVision, LLC; and Curt Deane, Deane Group.� Beverages and networking�shall�follow.� For more information or to register, click here.

While preparing for the PRMIA panel last week, we asked�Marty Fridson, a veteran observer of the credit markets,�about the�current challenges facing risk professionals.� His chilling reply: "The big issue is that all the current prices are propped up by extraordinary liquidity. Take that away and prices will be much lower, plus many issuers will default."

Sound familiar?

We've been focused on the negative effects of excess liquidity on credit risk tools�for years now, in large part because of anecdotal reports we receive from readers of The IRA, who describe a bewildering deterioration in prudential standards and the ability of risk managers to detect the latest products and�trends.� But most�inhabitants of bubbleland just don't want to know.�

Credit derivative spreads are so tight as to make no economic�sense, yet the markets and the�big media that dominate investor perception�go on pretending that the credit environment is stable, even positive.� The mid spread for B-rated issuers in the Dow Jones credit derivatives index was just 230bp last week, a ridiculous level�when you recall�that one�of every three issuers in that ratings band�likely will default.� The corollary to tight credit spreads is a bullish tone in the equity markets,�but in either case, the relationship between risk pricing and financial fundamentals has�broken down -- at least for the moment.�

So sparse�are�investment opportunities, in fact, that the market is�entertaining equity investments in hedge funds, the very liquidity driven, derivative wielding�speculative vehicles that are the prime suspects in�the�compression of risk premiums.�� The impending IPO of Fortress Investment Group LLC�may be just the first in a series of new transactions where investors are given the "opportunity" to buy equity in a hedge fund.�

Reading through the risk factors of the Fortress prospectus, a reasonable person might ask why anyone would want to deploy capital in such a venture, but that's not the right question.� Instead, given the aggressive expansion of the supply of dollar liquidity by the Federal Open Market Committee over the past decade, better to ask why every American man, woman and child�doesn't go out and start a hedge fund of their very own.�

Hedge funds, you see,�are not the problem.��Hedge funds and�the excessive leverage they employ are the logical response of rational, savvy investors to irresponsible fiscal and monetary policies in�Washington.� Between the inability to control domestic spending,�long-term entitlements,�and costly foreign adventures like the Iraq war, the US is on track toward national insolvency.� Indeed,�with the US Treasury's direct and indirect indebtedness soaring to heretofore unthinkable levels under the Bush Administration, the Fed has set about implementing a slow-motion debt default by debasing the US dollar.�

Under the two decade tenure of Fed�Chairman Alan Greenspan, the FOMC aggressively expanded the US money supply, creating the inflation scenario�described by classical�economists of too many fiat paper dollars chasing too few real assets. The Fed's aggressive "reflation" strategy following the 2001 "mini" recession added even further impetus to financial professionals to find new ways to earn reasonable returns.� Foreign investors reacted rationally by selling dollars.�

Between January 2001 and June 2004,�the Von Mises Institute reminds us, the Fed lowered the federal funds rate target from 6.5% to 1% by June 2003.� To attain this goal, the Fed raised the yearly rate of growth of Fed credit from 0.7% in January 2001 to 12% by September 2001.� During most of 2003, the growth rate of Fed credit was in excess of 9%, a rate inconsistent with long-term price stability, but necessary to keep the heavily indebted US economy afloat.

No surprise that during this same period and thereafter, as the dollar really�began to slide against most major currencies,�the number of hedge funds multiplied�and the trading strategies used by these vehicles -- and just about every other individual and financial intermediary -- swung far in the direction of�excessive leverage.��Whether you were buying a house or managing money, maximizing leverage�became the strategy of choice -- a grim comment on the future inflation expectations of US consumers and financial professionals.�

And�even less of a surprise to see the CEOs and CFOs of major banks fretting about the tightness of credit spreads and the lack of attractive risk-return relationships in today's markets.� When we hear reports from the credit channel of hedge funds and other vehicles employing effective leverage ratios of 20, 30 or even 50 to 1, how can the leaders of the major dealer banks be anything but pessimistic?� Fact is, no matter how much risk the major dealer banks think they have shifted onto the hedge funds via the trading desk, most of that risk is coming right back onto the dealers' books�via the back office,�through credit relationships and�transaction risk -- what is politely called "potential future exposure" by federal regulators.�

When Fed Chairman Ben Bernanke told the Senate Banking Committee�that the "hands off" policy by federal regulators is the best way to manage the systemic risk posed by�hedge funds, we had to laugh, but really we wanted to cry.� Bernanke told the Senate that the dealers have a "self interest" in policing the trading practices and leverage strategies used by hedge funds.� True enough.� But this assumes that the dealer banks�actually are free�to say "no" to their largest and most profitable�clients.

What the Fed chief did not say is that both the hedge funds, the major prime broker�dealers, and investors as a community, are caught in a�liquidity trap created by Chairman Greenspan�and Ben�Bernanke's other�predecessors on the FOMC; a financial cul-de-sac whereby the hedge funds employ�excessive leverage�and OTC derivatives�to stay ahead of the game, at least nominally,�in a marketplace awash in fiat paper dollars.� And the dealers have little choice but to go along and accommodate increasingly reckless trading strategies�because the biggest part of their profits is earned by servicing the hedge funds.� So much for market discipline.

When, not if, the next�serious hedge fund default�event takes a significant chunk out of a major dealer bank, and possibly ignites a systemic financial crisis, the Fed and other federal regulators will attempt to place the blame on "irresponsible" members of the hedge fund community and their counterparts at the major rating agencies and�dealer banks.� Bankers will be paraded before the Congress,�prosecuted criminally for financial fraud and crucified in civil litigation on the cross of Sarbanes-Oxley.�

But the true culprits in the approaching�perfect�storm of systemic financial risk�are�the Fed�and the US Treasury, an evil�pair whose relationship is not unlike that between�a dealer bank and a very large, extremely reckless hedge fund; a hedge fund which has borrowed so much money to finance its�strategies that the bank CEO, in this case Fed Chairman Ben Bernanke, cannot say no.

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