Bank or hedge fund?

Could you define "hedge fund" for me and explain why they should be arrested?

The original definition was a fund that could hedge the market by going both long and short, often at the same time. This can be a very conservative investing approach and hardly damaging to markets as a whole.

Since mutual funds are restricted on how short they can be (30%), hedge funds could only be offered to high net worth individuals and institutional investors. The strategies got more complex, so the term expanded to cover funds offered to high net worth individuals and institutional investors that used a wide variety of trading and investment strategies.

I don't see hedge funds as automatically evil. I'm not sure reinstating Glass-Steagell would help. It separated investment banks and commercial banks. There aren't any investment banks left.

On the other hand, I do think we need to do something to turn down systematic risk. Limiting bank size? Limiting leverage? The article did say that banks are no longer permitted the 30x leverage that took down Merrill and

-- Doug

Doug -

Seems to me you defined an original hedge fund and its "morphing" very well. Originally hedge funds were "sold" in the public perception exactly as you described. Today there are so many types of 'artificial' transactions, and types of hedge funds, and 'hedge fund type activities' that I would fall back on what Volker said ~ derivatives were designed as a means to facilitate liquidity and they may do so, but they were never intended as an end in and of themselves.

Is "money" a "product", or is it a "medium of exchange?" (Is "making money" by whatever means actually "producing" something in the way of goods and services?)

Three illustrations: a) When one lends, the borrower has some need for capital in the production of goods and services (electric utilities use a lot of leverage - 50%), and one receives interest for the use of one's capital. b) Those who bought shares of Microsoft in 1986, gave capital to goods and services, and bought a share in the sales and profit. c) Financial engineers (within banks) drew billions off in compensation, but their "production" led to financial crisis. It is being sold under the label "risk" but I would call it closer to "gambling" since it depends upon nothing more than probabilities,

My outspoken opinion is, these "guys" are not just yokels who made a mistake and should be forgiven. Lawyers and legal accountants involved are just as guilty - any number of them knew it was just a question of time before it all blew up. Bank CEO's are also guilty, for not understanding what they were getting "their" banks into. It is a question of being responsible for one's actions. I wholly agree that no leverage beyond ability to cover the loss should ever be permitted for a financial company. A major problem today is that SEC reporting allows "hidden assets" larger than the bank or fund itself.

But I go back to the fundamental question above.

Dapper.

I think we are mixing up hedge funds and the investment banks. Most (but not all) hedge funds are small and no threat to the financial system. The article was primarily talking about the traditional investment banks. As we all know, most of them are plenty big enough to threaten the system.

The more I think about money, the more confused I get. But the answer to your question is "both". The product of banks has always been money. They buy it, sell it, store it, create it, and guarantee it.

I don't see a bright line here. All investing depends on probabilities. Stocks usually go up over time, but only probably.

An important point is that It is gambling to go into a casino and put all your money 00 in roulette. It is not gambling for the casino to take that bet. They have diversified their risk.

Those guys are certainly not yokels. They are, for the most part, very smart and highly educated. They also tend to be young, aggressive, and risk tolerant. They are certainly at fault as are their bosses. The bosses hired and rewarded the financial engineers for taking those risks.

In my mind, they outsmarted themselves. They developed instruments that were so complex, even they could not understand them. They failed to see the common failure possibilities in them. They thought they were the casino, when they were actually the gambler.

This would kill our financial system. Let's think of a mythical little local commercial bank. It might have $10,000,000 in capital. This would let it raise $100,000,000 in deposits and make $100,000,000 in loans. As long as loans are made with good standards and diversified (the casino) all is well.

But if the loans have some common failure possibility (the only factory in town shuts down), then the bank starts looking like the gambler and not the casino.

Basically, this is what happened to Bear Stearns, Leahman, and others. But a bank (any bank) has to be leveraged. But the only way to insure that the bank could cover any possible loss is to limit it to loaning $10,000,000 on $10,000,000 of capital.

So we get all the way around to needing to manage the risk on the liability (loan) side of the portfolio. That's where the investment banks failed. It wasn't loans that they screwed up, but much more complex liabilities that they didn't really understand.

Moderators: sorry about the length.

-- Doug

I love this quote from the article:

"And they, too, are profitable again after a dismal 2008. The 1,000 largest hedge funds in Morningstar's database posted average returns of 11.9 percent through July."

I tend to agree with Doug on this one. Arrest them on what charges? And with what proof? Some kind of kangaroo court to enforce some ex post facto law?

--Bill

Doug,

Fine. you win all arguments.

This last sentence seems oxymoronic with your statement about how smart and educated these numerologists were. ('Financial engineers,' come on. They did not know what they were doing.) These boys, and the older executives that bought the young guys' sales pitches as long as they seemed to make money, are the sort that excel at playing games (literally games) of all kinds well. Lacking the wisdom that only comes with experience or a close study of history, they failed to see that theirs was ultimately a Ponzi scheme. As long as they were making money, they let numerology (hocus pocus woo-woo chance) convince them that real life economies are games that follow easily defined rules. But real life economies are much more complex than games. There is little difference between how these fellows justified pushing up markets using credit and how the markets were pushed up circa 1929 on credit.

At least one of the regulars here talks from time to time about seeking 'arbitrage opportunities,' including exploiting peculiarities in prices which are not readily available to the masses. Goldman Sachs for one seems to dedicate a lot of time to finding these. But ISTM the markets can be somewhat less free when not all can access such information.

Dapperdobbs, if I am reading him correctly, is right to suggest we distinguish between those who actually produce goods and services, and so wealth, and those who only appear to produce wealth but in fact are unsophisticated gamblers and ponzi artists. Unsophisticated because they did not know the odds.

dapperdobbs wrote:

I think this recent New Yorker article on the applied psychology of overconfidence is an interesting companion piece to the above:

---Excerpt-- Since the beginning of the financial crisis, there have been two principal explanations for why so many banks made such disastrous decisions. The first is structural. Regulators did not regulate. Institutions failed to function as they should. Rules and guidelines were either inadequate or ignored. The second explanation is that Wall Street was incompetent, that the traders and investors didn?t know enough, that they made extravagant bets without understanding the consequences. But the first wave of postmortems on the crash suggests a third possibility: that the roots of Wall Street?s crisis were not structural or cognitive so much as they were psychological.

In ?Military Misfortunes,? the historians Eliot Cohen and John Gooch offer, as a textbook example of this kind of failure, the British-led invasion of Gallipoli, in 1915. Gallipoli is a peninsula in southern Turkey, jutting out into the Aegean. The British hoped that by landing an army there they could make an end run around the stalemate on the Western Front, and give themselves a clear shot at the soft underbelly of Germany. It was a brilliant and daring strategy. ?In my judgment, it would have produced a far greater effect upon the whole conduct of the war than anything [else],? the British Prime Minister H. H. Asquith later concluded. But the invasion ended in disaster, and Cohen and Gooch find the roots of that disaster in the curious complacency displayed by the British. ... [B]ecause ability makes a difference in competitions of skill, we make the mistake of thinking that it must also make a difference in competitions of pure chance. Other studies have reached similar conclusions. As novices, we don?t trust our judgment. Then we have some success, and begin to feel a little surer of ourselves. Finally, we get to the top of our game and succumb to the trap of thinking that there?s nothing we can?t master. As we get older and more experienced, we overestimate the accuracy of our judgments, especially when the task before us is difficult and when we?re involved with something of great personal importance. The British were overconfident at Gallipoli not because Gallipoli didn?t matter but, paradoxically, because it did; it was a high-stakes contest, of daunting complexity, and it is often in those circumstances that overconfidence takes root. ... Several years ago, a team headed by the psychologist Mark Fenton- O?Creevy created a computer program that mimicked the ups and downs of an index like the Dow, and recruited, as subjects, members of a highly paid profession. As the line moved across the screen, Fenton-O?Creevy asked his subjects to press a series of buttons, which, they were told, might or might not affect the course of the line. At the end of the session, they were asked to rate their effectiveness in moving the line upward. The buttons had no effect at all on the line. But many of the players were convinced that their manipulation of the buttons made the index go up and up. The world these people inhabited was competitive and stressful and complex. They had been given every reason to be confident in their own judgments. If they sat down next to you, with a tape recorder, it wouldn?t take much for them to believe that they had you in the palm of their hand. They were traders at an investment bank.

The high-water mark for Bear Stearns was 2003. The dollar was falling. A wave of scandals had just swept through the financial industry. The stock market was in a swoon. But Bear Stearns was an exception. In the first quarter of that year, its earnings jumped fifty-five per cent. Its return on equity was the highest on Wall Street. The firm?s mortgage business was booming. Since Bear Stearns?s founding, in 1923, it had always been a kind of also-ran to its more blue-chip counterparts, like Goldman Sachs and Morgan Stanley. But that year Fortune named it the best financial company to work for. ?We are hitting on all 99 cylinders,?? [Former Bear Stearns CEO and Chairman] Jimmy Cayne told a reporter for the Times, in the spring of that year, ?so you have to ask yourself, What can we do better? And I just can?t decide what that might be.?? He went on, ?Everyone says that when the markets turn around, we will suffer. But let me tell you, we are going to surprise some people this time around. Bear Stearns is a great place to be.??

With the benefit of hindsight, Cayne?s words read like the purest hubris. But in 2003 they would have seemed banal. These are the kinds of things that bankers say. More precisely?and here is where psychological failure becomes more problematic still?these are the kinds of things that bankers are expected to say. Investment banks are able to borrow billions of dollars and make huge trades because, at the end of the day, their counterparties believe they are capable of making good on their promises. Wall Street is a confidence game, in the strictest sense of that phrase.

Thast the archaic definition.

Its a fund with a small number of high net worth ($2.5MM) investors. They can charge astronomical commissions, at least ten times that of a mutual fund. They dont have to tell anyone exactly their investment strategy and holdingd . And they can permit as little as one redemption a year.

On Sep 15, 7:20 am, Elle wrote: [snip]

Elle,

Love your phrase "hocus pocus woo-woo chance" - LOL (and I'm still laughing. Hope you don't mind if I quote you in my day-to-day life :-)

Volker also said (approximately), those who expect real life to conform to probabilities are deluded. Between you and Volker, I'm not sure who summed it up best :-)

Some stories I just can't ever lose ... A.P Giannini (founder of Bank of America) was dedicated to the principle of providing a bank for the common man, a place where people could open an account with $5 dollars and save money for their future. I'd bet 1,000 to 1 that guy lived a very satisfying life. The guy who did the same in Bangladesh much more recently got a Nobel prize for it.

Practicalities and common sense ... with a sprinkling of goodwill and humor :-)

George.