The Paradox of Market Chaos?

Hedge funds are hitting some old high-water marks, with assets in North American funds topping the $1-trillion (U.S.) level for the first time since November of 2008, according to tracking firm Eurekahedge.

Globally, hedge fund assets have passed the $1.5-trillion level and are likely to surpass $1.75-trillion by year-end at the current pace.

It’s a big turnaround for a group that had some of the biggest winners and losers of the crisis. On the winning side, funds like Paulson & Co. took home huge returns from bets against housing. Losers found themselves long equities or mortgage-backed securities in 2008, then had their pain compounded by margin calls on their leveraged portfolios.

For the moment, some of the hottest returns are at distressed debt funds as default rates have proved nowhere near what was priced in at the nadir of the crisis.

Eurekahedge said distressed debt funds have posted 13 months straight of positive returns, giving them a 50 per cent gain since March of last year.

Two trillion in hedge fund assets may not sound like a lot, but when you add leverage, it’s huge. Many of the larger hedge funds also engage in algorithmic trading and OTC derivative trading, adding more volatility in market moves.

I bring this up because it baffles me when “experts” compare today’s markets to those of the 1990s, 1980s or 1930s! The structural changes in the markets are huge, bringing more volatility in periods of uncertainty, and less in periods of stability.

And what really concerns me is what effects this will have on defined-benefit plans and individual retirement plans. Moreover, the Prime Minister of Greece, George Papandreou, raised an important point last week in his interview with CNN’s Fareed Zakaria. Mr. Papandreou addressed the “paradox” of bailing out banks that turned around and funded hedge funds that speculated on sovereign debt:

MR. F. ZAKARIA: You know, you are in some ways the bellwether for the Western world. You are the first Western country that is going to try in a comprehensive way to pare back some of the excessive guarantees, commitments and expenditures of the welfare state.

Do you think you can do this and survive politically? I know that you made a reference to taking a voyage like Odysseus, and a Greek columnist said yeah, but it took Odysseus ten years. All his comrades died, and he ended up naked and washed ashore in Ithaca. Do you think you’ll have a few more people than Odysseus did, when this journey is over?

MR. G. PAPANDREOU: Well, we know that these journeys are not easy and there are casualties. But we also know we can reach this goal.

What we lived through in the last few months was also somewhat of a paradox, because – and again I am not trying in any way to get away from our responsibilities; we are fully aware of our responsibilities and what we must do – but there are also the financial markets.

In 2008 we had actually the governments coming in to bail out the financial markets and the banks. They had to accrue a huge debt very often, for stimulating the economies, so that we don’t go into not only a recession but a deep depression.

Now you have banks funding hedge funds. They are actually then betting against governments that had actually helped the banks.

So this is a paradox, and I think this is where we need to also regulate markets.

MR. F. ZAKARIA: Do you think that Greece was a victim of the American investment banks?

MR. G. PAPANDREOU: We right now have a parliamentary investigation in Greece, which will look into the past and see how things went the wrong direction and what kinds of practices were negative practices. There are similar investigations going on in other countries, and in the United States.

This is why I think yes, the financial sector – I hear the words ‘fraud’ and ‘lack of transparency.’ So yes, there is great responsibility here.

MR. F. ZAKARIA: Could you imagine going after any of these banks legally? Do you see that you have some legal recourse?

MR. G. PAPANDREOU: I wouldn’t rule out that this may be a recourse also, to go into this legally. But we need to let the due process proceed, and then make our judgements once we get the results from the investigations.

MR. F. ZAKARIA: And do you think you will make it, like Odysseus, in the end, personally, politically?

MR. G. PAPANDREOU: I am doing what is best for my country, and I think that’s the best way to make sure that this country does get to its destination, which is Ithaca.

What happens to me is of less importance, as long as I feel that I am doing what is best for my country and I can sleep well at night, with my conscience clear, that maybe taking very tough decisions and decisions that very often hurt, not only me but also many of the Greek people, but in the end knowing that this is the best.

On Friday, I had lunch with a buddy of mine that came in from Greece. He told me that he was surprised with the speed that Papandreou’s government is moving to implement reforms. He also told me that many of these reforms are hurting individuals like his aunt who was a schoolteacher for many years and is now seeing her pension decline from 1,200 euros a month to 900 euros a month.

As far as speculators are concerned, my friend told me: “I told you a long time ago that major financial regulations are coming”. Indeed, politicians are not going to let hedge funds and banks run amok, threatening the integrity of the capital markets.

Let me be clear on something: I’m not against hedge funds or banks with huge prop desks. They provide liquidity to markets and hedge funds that deliver true alpha (not levered beta) are worth paying fees for.

But the paradox remains. Banks that got bailed out are funding hedge funds and so are public pension funds looking to increase their leverage to meet their required actuarial rate of return. What worries me is that by doing this, they’re increasing systemic risk. Without taking into account their collective actions, they’re sowing seeds of more market chaos.

This is something which needs to be addressed on a global level. Individual countries are powerless to deal with these structural changes and their implications for global systemic risk.

Finally, as you listen to Mike Ryan, head of wealth management research for the Americas at UBS Financial Services Inc., talking with Bloomberg’s Matt Miller and Carol Massar about the outlook for U.S. equity markets and prospects for a continued U.S. economic recovery, keep in mind the structural changes I discussed above. Nothing shocks me any more. Erratic moves have become the norm, not the exception.