Tuesday, October 28, 2008

Looters after the Hurricane

I thought I was the first to use the term "Financial Terrorism" in the context of today's financial crisis, until I saw Jim Cramer on CNBC's Mad Money going crazy about it a few weeks ago. Seems like the idea that 9/11 type terrorists are going after our pocket books is gaining some ground on Wall Street. Although many banks feel like they've been victimized by motivational short-selling, I don't think we can call this one the result of "nefarious" international investors...yet.

The most popular purported "tool" of these economic pirates is called short-selling. Short-selling is the art of selling something you don't own. Until relatively recently, you could only be rewarded in the market if you correctly forecasted the company whose stock price would increase, but there wasn't a way you could benefit from your ablity to forecast a decrease in the stock price if you didn't own any shares.

Here's an example

XYZ stock price is currently $100/share - I think the stock price of XYZ will go down tomorrow - I don't own any shares of XYZ - I borrow 100 shares of XYZ from a bank for 24hrs and pay $5/share (total cost = $500) - Same day I sell my borrowed shares for $100/share (total proceeds = $10,000) - Next day stock price of XYZ falls to $85/share - I owe bank 100 shares - Purchase 100 shares for $85/share (total coast = $8,500) - I make $1,000 (10,000-500 cost of borrowing - $8,500) and 24 hrs earlier I didn't own any shares and only had a guess.

Short-selling is a popular practice of Hedge Funds. What's a Hedge Fund? The name is somewhat misleading and mostly historical. A Hedge Fund is nothing more than an investment vehicle open to a limited range of investors (either institutions or very wealthy individuals) and, because of the sophistication of their investors, is permitted to engage in a much wider range of investment strategies. It may be helpful for a moment to compare them to mutual funds. A mutual fund is nothing but a "shell", just like a Hedge fund. In other words, saying you own mutual funds doesn't tell us in any detail about your investment strategy. You can have mutual funds that invest in international stocks, in Tech stocks, in large or small companies, or in bonds. So we care more about whats IN the mutual funds. And they are heavily regulated and must stick to the disclosed strategy because they are open to the public. More bluntly, Mutual Funds serve the 80% of the population that make up 20% of the money. And because "Joe the Plumber" can own them, they must be simple (according to the SEC).

Conversely, Hedge Funds cater to the 20% of the population that control 80% of the global wealth. They escape regulations, in most jurisdictions, governing short-selling, the use of debt, and derivatives (options, etc.) contracts. To qualify for these exemptions, you must have fewer than 100 investors AND your investors must be "accredited," meaning an individual must have more than $5,000,000 in investable assets. ALSO, they do not have to disclose their activities to third parties. Approximately 75% of Hedge Funds are registered off-shore, usually in the Cayman Islands. Lastly, Hedge Funds control roughly $2.6 TRILLION dollars, and are attracting approximately $200 BILLION a quarter. Those are scary numbers. If you participate in a Hedge Fund, you are essentially giving your money to a manger with almost full discretion. For all of the reasons listed above, the government is taking a closer look at tighter control.

The SEC Hammer

Last month, the SEC banned short-selling of 799 financial institutions and issued this statement:

"We are concerned about the possible unnecessary or artificial price movements based on unfounded rumors regarding the stability of financial institutions and other issuers, exacerbated by naked short selling. Our concerns, however, are no longer limited to just financial institutions."

Just before 9/11 several Hedge Funds, primarily using the Toronto and Frankfurt stock exchanges shorted the stocks of several airlines and financial companies housed in the Trade towers. Obviously, after the attack stock prices tumbled. Their profits were thought to be huge, and virtually untraceable. This time, the majority of short-selling is being done from London and Dubai. There are literally hundreds of Hedge Funds with murky ownership structures, investors, and strategies. If even a handful of them act in concert and begin active short-selling to "artificially" push the price down it would have a massive impact on the economy and they would be making millions of dollars. Where is that profit going? Who knows. But one thing I do know; because of all the words I've used in this post, I'm sure the CIA has at least read it.


Jessica said...

Wow, this is creepy. It reminds me a little of your book I read called "Devil's Banker."

Financial terrorists, indeed.

It will be interesting to see what kind of regulations on hedge funds come out of the government after the election.
How can the US govt regulate funds that are registered in the Cayman islands?
I also had no idea that Hedge Funds controlled such a large portion of the investable wealth.
How do Hedge Funds relate to PE firms?

great post, btw.

Jenga said...

Still too early to see how regulations will effect Hedge Funds. But look for more disclosure-type rules and 'regs.' Although most are domiciled in the Cayman Islands, they still have to comply with the rules of the various exchanges where they transact. So you could reasonably expect the various exchanges like the New York stock exchange, the American Stock exchange, etc. to come up with more disclosures on certain practices like short-selling. And international exchanges may follow.

Hedge Funds don't directly relate to PE funds. Remember, PE firms will buy a majority share of a business, fix it, then sell it. They'll typically have 10-15 companies in their "portfolio" at any one time. Hedge funds don't do that. They simply trade stock, derivatives, debt securities, etc. They have no interest (or experience) in taking control of a company and figuring out how to operationally enhance the business.

perfectwagnerite said...

Wow--does anyone else smell a major plotline for a future Bond movie?