Will Hedge Fund Returns Drop?

The last couple of years have seen aggressive enforcement of the insider trading laws by the U.S. Department of Justice and the SEC. The use of wiretap authority has given federal prosecutors a powerful tool not deployed in years past, and greatly amplified investigators' ability to uncover illegal tipping. It seems that, almost every month or two, another hedge fund or traders associated with hedge funds, plead guilty, settle civil charges or both. Entire networks of tipping and insider trading have been blown up.

Traders at surviving hedge funds have no doubt taken notice of the downfall of many of their peers. Those that were dancing at the edge of the curb, or beyond, may well be cooling their jets. Many phone lines on Wall Street are probably less busy these days.

Competitive pressures were doubtless a major reason for hedge funds to engage in insider trading. If a hedge fund that takes 2% of a customer's assets and 20% of gains wants to stay in business, it has to beat the S&P 500 by quite a lot. That's much more easily said than done in the secular bear market that has existed since the stock market downturn in 2000. Inside information offers an edge that can't be beat (as long as you're not caught), and many hedgies just couldn't resist the temptation have a soto voce telephone conversation or twenty-six.

However, explaining lame returns to dissatisfied investors is a lot better than sharing a cell with Bubba. Even if you lose your investors, you don't have to clean latrines used by a lot of other guys. With it likely that many fewer "just between you and me" conversations are taking place on the Street, one must wonder whether hedge fund returns will drop. If you're an accredited investor, or managing money for one, you naturally don't want your money involved in illegality. But you also might ask yourself what returns hedge funds might offer now that federal electronics are policing the markets. A guy who wants 2 and 20 needs to be pretty talented in order to legally make the returns that justify a hedge fund investment, especially with that industry crowded with firms competing for the special profits that economists call "rent" (meaning profits above the level that a competitive market would provide). Think carefully before locking up your money in a hedge fund.

The Greek Debt Crisis and the Failure of Credit Default Swaps

The Greek debt crisis, from which the entire European sovereign debt morass arises, comes down to a dispute between the Greek government and a group of private investors who hold large amounts of Greek bonds. These investors, many of whom appear to be hedge funds, are refusing to swallow as much loss as the Greek government demands. The Greek government is threatening default. The investors respond by, in essence, saying, "Go ahead. Make my day."

If the Greek government defaults, the investors will turn to credit default swaps they bought to protect against losses on Greek bonds. These CDS's are like insurance coverage against a Greek default. The government wants the investors to "voluntarily" agree to concessions, which wouldn't trigger CDS payouts. The investors have bargained hard, apparently emboldened by the knowledge that they can turn to their insurers if negotiations fail and Greece defaults.

Although usually described as insurance, the CDS's in this instance are being used for speculative purposes. The hedge funds may actually profit more by forcing the Greek government to default, than by working toward a consensual resolution. A default could have severe consequences, triggering a credit crisis in Europe that could circumnavigate the global financial system at the speed of a broadband Internet connection and plaster the world economy with a major credit crunch. Economic dislocation and recession would surely ensue.

When an "insurance" contract turns out to encourage recklessness, it has failed. Insurance is meant to protect against outsized loss, not to encourage insureds to foster or instigate losses. CDS's appear to be motivating speculators to disrupt a nation's finances. That's undesirable, no matter how you look at it.

Regulators and the financial services industry have done little to prevent derivatives, and credit default swaps in particular, from wrecking the financial system, as happened in 2008. Now, derivatives again pose a similar danger. People who don't learn from their mistakes are doomed to make them again. A sense of impending doom is growing.

The Great Government Risk Transfer

One of the most singular characteristics of government policy since the Great Depression has been to shift financial risks from private hands to the government. Early programs in this respect had broad support because they benefited most citizens. Federal deposit insurance, Social Security and Medicare are notable examples. Other such programs benefited those thought to deserve special protection, such as subsidies for farmers, Aid for Dependent Children, and Medicaid. Fannie Mae, Freddie Mac, Ginnie Mae and HUD were created to boost home ownership, which was believed to promote good citizenship. America, once riven by dissension and social conflict from the sufferings of the Great Depression, stabilized and prospered (helped in part by the fact that it was the one big industrialized nation left standing after WWII). The middle class, in particular, enjoyed the fruits of a life in which many of the vicissitudes of dependency in an industrialized world were lessened. Income inequality shrank and optimism swept away the despair of the Depression.

In the past thirty years or so, the nature of government risk transfers has changed. More recent federal policies have taken financial risks off the hands of the well-to-do and transferred them to taxpayers. Most prominent has been the Federal Reserve's relentless low interest rate program, which boosted the value of risk assets like stocks, bonds and commodities. The Greenspan/Bernanke put--a dramatic lowering of interest rates and expansion of the money supply every time the stock market throws a hissy fit--is now a permanent feature of federal monetary policy. The Fed could not step back from providing, at zero cost to investors, the Grand Put without triggering a horrendous stock market crash. It's no wonder that the rich--whose burgeoning wealth derives mostly from stocks and other risk assets--have gotten richer. With the almighty Fed running interference for them, it's hard for the owners of risk assets not to get wealthier.

Other aspects of federal risk transfer benefitting the wealthy include Fannie Mae, Freddie Mac and HUD, without which the mortgage-backed securities market could not exist. Wall Street banks and financiers are among the biggest beneficiaries of this market. Other familiar examples are the evolution of large-scale farming subsidized by large amounts of farm subsidies and physicians who speed-treat patients to maximize their Medicare billings. Developers and homeowners in flood zones benefit from federal flood insurance, at the expense of taxpayers living on higher ground. Bailout programs like TARP disproportionately benefited the wealthy, while federal mortgage refinance and principal writedown programs that would benefit the unfortunate, have been largely ineffectual.

It's no surprise the wealthy have gotten the most out of federal risk transfers. They control the political process and can steer government policy in their favor. Mitt Romney's narrow victory in the Iowa caucuses only reinforces this trend. Money talks. Those with money have staying power in the political process. The ABM movement in the Republican Party (read Anyone But Mitt) isn't over his wealth, but his moderate views. So if another candidate surpasses Romney in the end and wins the White House, expect the Republicans not to disturb the prosperity of the well-to-do, although those less well-off and retirees should be apprehensive.

The Obama administration, for all its rhetoric, has presented little true threat to the wealthy. It agreed to a moderate temporary version of the estate tax, and has grudgingly gone along with a temporary continuation of the Bush II income tax cuts. Its Treasury Secretary has, overall, been a solid supporter of Wall Street (in spite of occasional politically motivated rhetoric to the contrary). And, despite policy proposals floated to the contrary, Fannie Mae and Freddie Mac continue in their central role financing the U.S. real estate market.

The question is whether this risk transfer can continue. Taxpayers don't have endless resources. Already we have a fierce debate over federal deficits, and there is much talk of imposing more risk on those of moderate and low income (by reducing Social Security, Medicare and Medicaid benefits). In Europe, we see the makings of a taxpayer revolt, with those in southern Europe objecting to paying more to cover the profligacy of their governments while those in northern Europe object to paying more to cover the profligacy of their southern neighbors.

American taxpayers haven't really honed in on the Great Government Risk Transfer in the U.S., even though it underlies many of today's political controversies. If the costs of such risk transfers continue to mushroom, citizens will eventually figure out that their pockets are being picked. If we truly believe in a market-based economy, governed by the principles of free markets, we have to cut back on the government's risk transfers, especially the ones benefiting the wealthy. Those who have capital to invest can do the most for society if they invest in ways undistorted by government subsidies. As things stand now, the wealthy have the incentive to profit off of taxpayers. It's fine if someone works hard, saves, invests wisely and gets rich. It's not fine if someone pigs out at the public trough. Income inequality honesty earned is deserved. Income inequality fostered and supported by government policy is unacceptable.

European Central Bank Bets the Ranch

The European Central Bank has evidently been taking EU sovereign debt as collateral, even as it expands its balance sheet to a record size in order to finance the EU's banking system. Taking sovereign debt as collateral bets the solvency of the ECB on the solvency of the EU. In the event of a sovereign default, the banks borrowing from the ECB may well not be able to repay their debts to the central bank. The ECB might theoretically try to sell its collateral to recover its losses. But the very act of selling the sovereign debt would likely push down its value, impair European banks all the more, and further weaken the ECB. The ECB, for practical purposes, may be making uncollateralized loans when it takes EU sovereign debt as "collateral."

The ECB surely realizes this. But it may have little choice, since Europe's banks probably have limited amounts of other assets they could tender to the ECB as collateral. Without the ECB's loans, the European financial system would probably have to pull back on lending, forcing an economic contraction at a time when Europe desperately needs growth to escape the claws of the sovereign debt crisis. So the ECB probably has little choice but to bet the ranch. Its hopes of repayment rest primarily on whether or not Europe grows. Europe's prospects for growth depend heavily on whether or not its governments can institute effective fiscal policies. Given the EU's political dysfunction, one cannot help but wonder whether the ECB will lose the ranch.

The Sovereign Debt Crisis: Europeans To Live In Glass Houses

The latest EU proposal for resolving the sovereign debt crisis promises "automatic" consequences if member nations' annual budget deficits exceed 3% of their GDP. The European Commission, the executive arm of the European Union, can also impose additional requirements. All this is supposed to keep EU members on the straight and narrow, never spending excessively, texting while driving, or using any cuss words.

But there's a catch. EU members holding 74% or more of the union's voting power (votes are allocated among EU members by size, similar to the U.S. House of Representatives) can vote to lift the sanctions. Virtually all of EU members fail to comply with its requirement to keep total national sovereign debt at not more than 60% of GDP. Many have trouble meeting the 3% budget deficit requirement. In other words, the members of the EU are not without sin. If a fellow member nation needed dispensation from the "automatic" consequences and the EC's sanctions for going over the 3% limit, would the other EU nations be the first to cast a stone? When you live in a glass house, you will do unto others as you would have them do unto you. The 74% catch (we can call it "Catch-74") renders the "automatic" consequences semi-automatic and creates a go along, get along dynamic that is antithetical to the notion of fiscal discipline.

Only Britain dissented from the latest proposal, steering its own course in turbulent seas, Union Jack snapping briskly in the wind. It's unclear that Britain's tack makes economic sense. But if the EU fails to definitively resolve the crisis, there may be many on continental Europe who will think themselves accursed not to be among the happy few who chose to keep their monetary policy independent.

Will EU Members Learn to Share?

The latest leaks from high ranking EU officials concerning the sovereign debt crisis hint at the possibility of not one, but two bailout funds. Details are scarce; but maybe that's the idea. They can keep the palaver going as long as you don't ask what army of investors is supposed to step out front and center to fund this financial engineering. That's the key to making the bailout work--or not. Someone has to plop a lot of cold, hard cash money on the barrel head in order to truly end the crisis. S&P, however, is threatening to downgrade most of Europe. Whence will investors find the courage to buy the EU's financial engineering when they see the price of sovereign debt credit default swaps escalating?

This is something the leaders of Germany and other wealthy EU nations spend little time publicly admitting. Instead, they focus on how to impose discipline, austerity and clean living on the profligate. Greece, Ireland, Portugal, Italy, Spain and perhaps other nations would have to earn every Euro they spend, and would pay penalties for deficits, failing to wash behind their ears, and using cuss words. Somehow, enough righteousness is supposed to transport the EU to the utter bliss of true currency union.

But the EU is missing an important point. The world's most successful currency union, the United States, exists perennially in a state of financial imbalance. For over a century, the wealthy states on the East Coast, more recently with the wealthy states on the West Coast, have subsidized less wealthy states in between. These imbalances have existed in the form of federal subsidies to farmers, ranchers, the mining industry, the railroads, and more. The Interstate Highway System was another big subsidy, benefiting large, thinly populated rural states more per capita than it benefited densely populated states. But none of the United States tries to hold others of the United States to fiscal rectitude. Imbalance is implicit in the structure of the Constitution, apportioning as it does two Senators to each state no matter how large or small. And imbalance runs the other way. On a per capita basis, the less wealthy states probably provide more people to serve in the military than the wealthier states, resulting in steeper non-financial costs on the former when America goes to war. Americans tolerate imbalance because national unity is more important to them than any rigorous reconciliation of ledgers.

To make the EU really work, Europeans need more than just their economic welfare. Financial self-interest isn't the superglue required for political union. Neither is sheer power. Rome's legions, Napoleon's armies, and the Third Reich's panzers all failed to hold Europe together. Angela Merkel, Nicholas Sarkozy and other proponents of the EU have shrewdly played their cards to keep the crisis from tipping over into financial panic. But the EU needs greatness in its leadership, calls to electorates to seek a new destiny. That's missing, and given the historical divisions among Europeans, a most tribal collection of peoples, it's not surprising that issuers of EU sovereign debt credit default swaps are selling their contracts dearly.

Retire By Making Your Dollars Last

Managing your money in retirement is often depicted as a problem of how to allocate your portfolio, how quickly to draw down your net worth, when to begin taking Social Security and whether or not to buy long term care insurance. But managing one's financial assets is only part of the picture. Consider how you spend--the less your cash outflow, the easier it is to afford retirement. And you don't necessarily need to become a connoisseur of cat food or learn the dozens of ways to prepare rice and beans.

Pay off the mortgage. One of the most surefire ways to reduce month expenses is to pay off the mortgage. Since your retirement income will probably be less than your income while working, offloading the mortgage will improve the quality of your sleep.

Take the auto mechanic off your speed dial. Buy cars that are reliable and known for longevity. With the increased computerization of cars, the cost of repairs is skyrocketing. You don't have to buy a tinny econobox. If you can afford a luxury car, choose an Acura or Lexus, not some other brands that enrich repair shops.

When it comes to appliances, spare your back. High quality in home appliances isn't, to borrow a stock market phrase, closely correlated with price. The most reliable and long lasting washing machines and dryers tend to be the traditional, modestly priced top loaders. Currently fashionable side loaders have their attributes, but at the cost of higher purchase prices and less longevity. Plus you have to bend over or kneel down to get access to them. Your back and knees may have an opinion as to whether or not that's a good idea. Cheaper, more reliable, longer lasting, and easier on the back and knees is a pretty good bargain.

Use generics whenever possible. Generic drugs can be much cheaper than name brands. Why pay for a fancy name when the medication is the same at a lower price?

Avoid credit card debt. The most expensive loans most Americans take are credit card balances carried over from month to month. If you use credit cards, only charge what you can pay off at the end of the month. That way, you earn rewards, cashback bonuses, etc., without paying any interest. Why enrich banks in your golden years?

The Federal Reserve and Its Petard

Even casual readers of today's financial news know interbank lending is drying up on an international scale, and that the world financial system is getting the shakes. That's why the Fed and other major central banks announced yesterday a currency swap program to ensure dollar liquidity in Europe and elsewhere. But even as the Fed mounts up and tries to lead the charge, we should remember that it is tripping over its own ultra low interest rate policy.

The Fed's principal monetary weapon is to control the fed funds rate. That's the rate banks charge each other for overnight loans. The Fed has targeted a rate of 0 % to 0.25%, and has promised to hold it there until Antarctica is covered by tropical rain forest. A bank with excess funds can't hardly make a plugged nickel when its lending rate is virtually indistinguishable from zero. And when you consider that many of the larger European banks that are now desperate for dollar funding are, by virtue of the EU sovereign debt crisis, not glowingly golden credit risks, it's no surprise that American and other banks with excess dollars are stuffing entire bulbs of garlic into their mouths any time an EU bank asks for a loan. In other words, the Fed's own zero interest rate policy is hampering interbank lending that could alleviate the very credit crunch it's now desperate to combat.

I leave it to you, dear reader, to decide what to say about the Fed and its petard.

Does the Federal Reserve Have a Secret Bailout Plan For Europe?

Today's announcement of a coordinated monetary easing program led by the U.S. Federal Reserve, providing currency swap lines to the central banks of other major nations, was the news the stock market wanted to here: a walloping big dose of moral hazard that infused dollar-denominated liquidity into an increasingly stressed European banking system. The Dow Jones Industrial Average blasted upward 490 points, the largest move in two and a half years. Markets always love it when a governmental body reduces their risks. Recall, however, that there is no such thing as the elimination of financial risk. It can only be transferred. If risk is transferred away from market participants by a government program, you know who just got the short end of the stick. (Hint: look in the mirror.)

The Fed's move came when the EU was wobbling precariously at the edge of the precipice. The recent spasms and convulsions of EU member governments has accomplished nothing except prove that the EU's governance process couldn't hold together a neighborhood book club. The absence of action by elected officials has led many to urge that the European Central Bank monetize the EU's sovereign debt by buying it up. But the ECB, hewing to its charter purpose of maintaining price stability, has only dipped a toe or two in the shark infested waters of the EU sovereign debt markets. Even as it buys a distressed nation's debt, it sells debt of stronger nations in order to keep the supply of Euros stable. This, however, doesn't monetize debt.

The Fed, by contrast, has promised with its currency swap program, to print dollars early, often and in bulk. The swap lines are priced to provide Black Friday discounts, except for the next 14 months. The Fed provides to other central banks dollars in exchange for Euros (or Canadian, British, Japanese or Swiss currency), with the other central bank obligated to return the dollars at the same exchange rate as existed when the swap was entered into. Thus, the Fed nominally has no risk.

Consider, however, what might happen when the Fed is dealing with the ECB. The latter won't print money; and consequently has available only so many Euros to swap with the Fed. If the ECB needs more dollars than it has Euros to offer in swap, it's out of luck under the currency swap program. But the Bernanke Fed is clearly hellbent on delivering liquidity, and the delivery process used would only be a technicality. If one process isn't enough, they'd use another. This is the approach the Fed took in the 2008-09 financial crisis, when it expanded the scope of its quantitative easing to buy mortgage-backed securities, commercial paper, business loans, car loans, and other consumer loans. Had the crisis worsened, the Fed probably would have bought the kitchen sink and Uncle Arnie's old lawnmower.

The Fed has its thumb in the European dike. Its currency swap program has bought a little time for Europe's politicians to get their act together. But let's be real. Even though the politicians fervently claim that they will now give the crisis their full attention, experience teaches that they will fail. The EU has a herd of cats dynamics, and true European fiscal discipline and reform is less likely than Bernie Madoff being paroled.

What if the ECB needs more dollars than the currency swap program could provide? This may be a possibility. European banks may experience yet more difficulty getting dollars to fund their dollar-denominated loans as the EU crisis metastasizes. To prevent a credit crunch, the Fed may decide that it would buy EU sovereign debt. The Fed has wide latitude to decide how to implement monetary policy. While buying sovereign debt denominated in a foreign currency would be a first, one suspects that the Fed would, as it has in the past, liberally interpret its mandate in order to do what it considers necessary.

Buying EU sovereign debt would set the Fed on the slippery slope. If there were losses, where would the losses land? (Hint: look in the mirror.) And what if the Fed's money printing were inflationary? Where would the burden of inflation land? (Hint: don't shift your gaze.)

Of course, high ranking government officials in the U.S. and Europe would decry such a scenario as preposterous. But consider that Europe is deadlocked in a death spiral. The politicians can't function and the ECB firmly believes it is legally precluded from monetizing the EU's sovereign debt. The one governmental body in the world that has the resources and willingness to step in is the Fed. Today's action takes the heat off Europe's politicians, if only momentarily. They will probably take it as an excuse to stall and delay instead of impose harsh conditions on all of their electorates (which would be austerity for the spendthrift nations and payment of the bailout costs by the wealthier nations). They'd probably figure they could get away with inaction because the Fed would surely step in with more moral hazard.

If the Fed monetized EU sovereign debt using dollars, that would likely signal the demise of the Euro, with the dollar substituting as Europe's common currency while European nations again issued local currencies. This was the way Europe worked in the 1940s, 50s and 60s. In such scenario now, the Euro bloc might be able to disentangle itself from the crisis, albeit painfully, without triggering a worldwide credit crunch. Maybe that's the Fed's secret plan.

The Fed's not above acting dramatically if quietly. We've recently discovered that it loaned over a trillion dollars to distressed banks during the 2008-09 financial crisis, far more than it had previously acknowledged. Ben Bernanke demonstrated that he would act when it looked like no one else could or would. The eyes of the world may again turn to him, and we shouldn't expect inaction.

Hidden Bargains

If you want a Black Friday bargain, you have to be ready to be pepper sprayed, horse collar tackled, and perhaps trampled a few times. There are easier ways to get bargains.

Business Laptops. If you're in the market for a laptop, look at less expensive business models. Unlike laptops specifically aimed at consumers, business laptops are designed for heavy duty use, careless handling (it's the company's property, after all), and enough longevity that sales reps can convince corporate buyers the equipment is cost effective. Many business laptops are shock and spill resistant. They are often preloaded with good quality software. This, all for a price in the $500 to $700 range. Business laptops don't come in pastel colors, and are heavier than personal laptops (the additional ruggedness adds weight). But a well-made one delivers good value for the dollar.

Prepaid Cell Phone Plans. Prepaid plans give you direct feedback about your usage, by forcing you to buy more time when you're running low. These periodic demands for money teach you how much your yacking actually costs. You learn to reduce this negative feedback by controlling phone usage. You save by not paying for time you don't use.

Balanced Investing. A portfolio that's about 50% stocks and 50% bonds offers comparative stability in returns (see http://www.cnbc.com/id/45454073). Investors who enjoy stable returns are less tempted to trade, incur lower transactions costs, and face less of the volatility that tempts one to buy high and sell low. By reducing these negative factors, balanced portfolios can deliver good long term returns.

Renovated Homes. It's axiomatic among real estate professionals that home renovations, with rare exceptions, boost the value of a house less than 100 cents on the dollar cost of the renovations. This necessarily means a recently renovated home is a comparative bargain for the buyer who carefully researches prices and figures out where the actual market price is. A home that was renovated in the past year or two has a good chance of being a bargain. One that was renovated five or ten years ago may have appreciated enough that buyers don't really get a discount from the renovations (depending on the market). A beat up, water damaged foreclosure sale may a good deal. But so may be a sparkling recently renovated home. Do your research.

Year Old New Cars. Cars on a dealer's lot that are brand new, but one model year old can be an excellent bargain. The dealer will seriously discount them (sometimes with a quiet subsidy from the manufacturer) in order to make room for current year models. Year old new cars can be a better bargain than year old used cars, because they have no mileage but sometimes sell for not much more than a used car with 10,000 miles. Buying what the seller doesn't want is a good way to get a bargain.