Commentaries

What banks can learn from hedge funds

Should the banking industry look more like the hedge fund sector? That’s the surprising suggestion made last week by two Bank of England officials.

In a fascinating paper, Piergiorgio Alessandri and Andrew Haldane explore the level of public support given to banks in the crisis and the problem of institutions that are too big too fail. Their main point is that if this issue is not addressed it will lead to new crises and even bigger bailouts in the future – a state of affairs they describe as a “doom loop”.

But the most eye-catching passage is a suggestion that banks have a lot to learn from hedge funds:

It may be coincidence that the structure of the hedge fund sector emerged in the absence of state regulation and state support. It may be coincidence that the majority of hedge funds operate as partnerships with unlimited liability. It may be coincidence that, despite their moniker of “highly-leveraged institutions”, most hedge funds today operate with leverage less than a tenth that of the largest global banks. Or perhaps it might be that the structure of this sector delivered greater systemic robustness than could be achieved through prudential regulation. If so, that is an important lesson for other parts of the financial system.

This is quite a change of heart. Until a few years ago, regulators viewed hedge funds as the main threat to financial stability. These fears have proved unfounded. Though plenty of hedge funds have blown up – or turned out to be massive frauds – none has so far threatened to drag down the system.

Some things that currently take place in banks are probably better suited to hedge fund structures. Proprietary trading is a prime candidate. There is also a strong case to be made for private partnerships. Would investment banks have grown so large if they were owned by partners who were exposed to any losses?

Even so, it seems fanciful to suggest that the hedge fund model is better. Banks fund themselves by taking retail deposits that customers believe to be safe. That precisely the reason they are so heavily regulated. Hedge funds raise money from institutional investors and wealthy individuals who – in theory at least – realise they could lose it all. Without deposit insurance, the failure of a bank can spark a loss of confidence across the industry. The failure of a hedge fund is less likely to have systemic consequences.

John Meriwether writes to investors (again)

This purports to come from the hedge fund investor John Meriwether but mysteriously carries a Nigerian postmark:

Dear friend,

Greeting,

Permit me to inform you of my desire of going into business relationship with you. I got your contact from the International web site directory. I prayed over it and selected your name among other names due to it’s esteeming nature and the recommendations given to me as a reputable and trust worthy person I can do business with.

My name is John Meriwether and I am a very wealthy financier in Greenwich, Conneticut, the economic capital of US. I have been managing investment funds for welthy business associates, taking advantage of relative value arbitrage strategies. This is 100 per cent guaranteed safe way to make double digit investment returns every year and was revealed only to me by internationally renowned Nobel prize winning economists. My track record – with LTCM and JWM Partners – speaks for itself.

I have now identified new investment opportunity, that has caused the need for another big transfer of funds. If you would assist me in this, it would be most renumerative to you.  Sir, I am honourably seeking your assistance. I need the funds as quickly as possible. I am offering a double digit return on these funds, net of my 2 and 20.

To provide a Bank account where your commission would be transferred to after the successful transfer of this fund to your designate account overseas, please feel free to contact ,me via this email address johnmeriwether1000@yahoo.com

So much for that de-leveraging

You would think it would take a little longer for hedge funds and other investors addicted to using borrowed funds to juice returns before they started loading up on high-yielding junk. But with short-term borrowing costs so low, I suppose it was just too hard to resist yields found in the depths of high-yield bond market.

CCC-rated bonds, the darlings of the current rally in corporate debt, have broken though another milestone , according to Martin Fridson of Fridson Investment Advisors. Its spread over Treasurys as measured by Merrill Lynch, fell to 12.18 percentage points this week, below it’s historical average. Meanwhile, higher-rated junk spreads are still much higher than their averages.

Fridson notes that leveraged investors have been fueling demand for the junk bond market’s junkiest debt.

Not all of them, but some, have a simple strategy:  Maximize the differential between the interest rate on borrowed money and the yield on assets in the portfolio.   If the investment strategy does not take into account the adequacy of the yield on those assets, relative to their credit risk, who is to say what constitutes an excessively tight spread?  As long as the yield exceeds the cost of funds, the trade is a money-maker…until the defaults begin.  To get the maximum “benefit” from this strategy, leveraged investors gravitate to the highest-yielding segment, the Triple-Cs.

Just as long as they don’t need to get bailed out…

Wall Street is being judged

Capitol Hill has yet to get its act together on financial regulatory reform. But another arm of the federal government, the judiciary, is emerging as the new best friend of investors.

It started a few weeks ago when Judge Jed Rakoff refused to approve the Securities and Exchange Commission’s wimpy $33 settlement with Bank of America over the bank’s failure to come clean with shareholders about its acquisition of Merrill Lynch.

The judge ordered the SEC to explain why it didn’t hold anyone at Bank of America personally accountable for Merrill’s decision to pay nearly $6 billion in bonuses before the merger was completed.

Now Judge Shira Scheindlin, who works in the same federal courthouse in lower Manhattan as Rakoff, has picked up the torch of investor rights.

Just before the start of the Labor Day holiday weekend, Scheindlin issued two decisions that could hold Wall Street accountable for more of its actions. In separate rulings, the judge sided with investors bringing lawsuits against a prime broker and two major credit rating agencies.

The prime broker case stems from the $1 billion hedge fund fraud perpetrated by Michael Lauer, who once managed money for Britney Spears, the University of Montreal Pension Plan and Morgan Stanley, among others.

Scheindlin ruled that the hedge funds’ offshore investors can press ahead with an aiding-and-abetting claim against Bank of America, which had been the prime broker for Lauer’s long defunct Lancer funds.

Hedge funds = households?

Data showing that American households and their spendthrift ways meant big purchases of U.S. Treasuries got a lot of traction earlier this week. Not surprising given the ongoing concerns that one day we’ll wake up and foreign central banks and other overseas investors will decide they’re no longer enamored with the growing pile of U.S. debt. Someone has to step up and it may as well be those U.S. savers.

The data in question came from the Federal Reserve’s flow of funds data. David Ader, CRT Capital’s intrepid bond analyst, decided to take a closer look to see what’s going on.

From Ader:

What we found was that the category includes…get this…”domestic hedge funds” … Jim Bianco, an old friend, points out the category is a plug figure and that after all the other Treasury buying sources are accounted for what’s left is this category.  In short, a very flawed and titularly misleading measure.

But individual investors are still plowing their new found savings into safe securities like Treasuries.

Clearly someone domestically is buying…and that may be the only point…net bond fund flows have surged this year even as yields backed up. Indeed the cumulative buying as of the end of June was about $135 bn, the most on record by far.  It may come as little surprise that bond funds have seen greater inflows than equity funds.

Cioffi: My investors? What investors?

Ralph Cioffi, the indicted former Bear Stearns hedge fund manager, is trying again to get an insider trading charge dismissed in advance of his upcoming criminal trial. 

And this time his lawyer’s have come up with an interesting legal argument, which essentially is that a “hedge fund manager owes no fiduciary duty to its investors.” Rather, a hedge fund manager’s “fiduciary duty runs only to the hedge fund itself.”

Using this bit of twisted logic, Cioffi’s lawyers contend their client didn’t commit insider trading by secretly pulling some of his money out of the Bear funds before they collapsed because he had no duty to tell the investors he was making the withdrawl.

I’ve never been convinced that the insider trading charge against Cioffi is a strong one. But that’s because Cioffi didn’t pull all of his money out of the fund–only some of it.

But this argument that a hedge fund manager owes no fiduciary duty to his investors really stands things on its head. If the judge were to accept this argument and dismiss the insider trading charge, no investor could ever trust a hedge fund manager ever again.

Oh, in the court papers, Cioffi’s lawyers also say:

Never before has the government attempted to prosecute a hedge fund manager for insider trading for a redemption of his investment in the hedge fund he manages.

Mary Schapiro is no money manager

Let’s hope Securities and Exchange Commission Chairman Mary Schapiro is a better regulator than a money manager.

That’s because The Financial Industry Regulatory Authority, the last place Schapiro ran, lost $696 million last year. Almost all of FINRA’s red ink stemmed from losses on investments, including ownership stakes in hedge funds and private equity firms, stocks and bonds.

In all, investment related losses totaled $624.1 million, compared with a $156 million gain in the value of those investments in 2007.

FINRA’s tale of woe is included in its most recent annual report, a copy of which was posted recently on the regulator’s website.

Oddly, FINRA’s miserable year has received no media attention, even with Schapiro regularly testifying on Capitol Hill about greater regulatory reform. Schapiro, of course, is the former chief executive officer of FINRA.

The regulatory agency doesn’t provide a detailed list of its specific investments, so there’s no way of knowing which hedge funds or limted partnerships it has sunk money in. The losses in 2008 reduced FINRA’s still substantial investment portfolio to $1.56 billion.

The portfolio, which is managed by several unidentified money managers, represents the proceeds from sale of stock FINRA had in the Nasdaq Stock Market. FINRA’s predecessor, the NASD, had acquired the block of stock when the electronic stock market went public.

Could Goldman pinch CIT?

It appears the federal government is on the verge of walking away from CIT Group and the same can be said for Goldman Sachs–even though the investment firm is one of the mid-market lender’s biggest bankers.

On Monday, I suggested that Goldman CEO Lloyd Blankfein could turn around the public’s nasty impression of his Wall Street firm by stepping in an buying-out CIT. But I didn’t really expect it to happen. Then yesterday there was a rumor floating around that Goldman, with the tacit support of the Obama administration, was trying to put together a private-sector bailout package for CIT.

That rumor, however, proved to be idle hedge fund specuation. It doesn’t appear Goldman, which says it has no material exposure to CIT, will be part of the CIT solution. Goldman says it has sufficient collateral from CIT and from unspecificed hedges, to minimize any of the risk it may have on a $3 billion secured line of credit.

But it appears Goldman may have a good reason to stand pat and let CIT sink or slowly drown. A hedge fund source just reminded me that last October–just as the financial world was melting down–Goldman announced it had closed a $10.5 billion fund to make “senior secured loans” to companies.  This is how GS Loan Partners describes itself on a Goldman website:

Our focus is on originating loans for mid- to large-sized leveraged and management buyout transactions, recapitalizations, refinancings, financings, acquisitions and restructurings for private equity firms, private family companies and corporate issuers.

Leaving aside the LBO-stuff, that sounds a lot like the kind of business CIT had been famous for. It makes you wonder if there is any angle Goldman isn’t playing?

UPDATE:

Ralph Cioffi faces the music

We’re just three months away from the criminal trial of former Bear Stearns hedge fund managers Ralph Cioffi and Matthew Tannin and federal prosecutors have just produced a witness list.

Sadly, there are no big marquee names on the list of 32 people, who are scheduled to take the stand and raise their right hands in a Brooklyn, NY federal courtroom. If you were expecting to hear from former Bear CEO James Cayne, don’t adjust your work schedule to take time off.  Warren Spector, Bear’s former president, who Cayne fired a few weeks after the Bear funds collapsed in the summer of 2007, also doesn’t make the grade.

The most notable government witness is Rich Marin, the former head of Bear Stearns Asset Management, the division that nominally oversaw the giant hedge funds that bet big on subprime-backed CDOs. Marin, you may recall, got a bit of unflattering attention after The New York Times reported about all his movie reviews on his personal blog, “Whim of Iron.

Other witness include a number of former hedge funds employees, former top Bear broker Shelley Bergman and investors. Cioffi and Tannin are charged with lying to investors about the trouble at the fund, which began in early 2007–just as the subprime housing market was blowing up. The collapse of the Bear funds in June 2007 is widely seen as the start to the now two yearlong credit crunch/worst financial crisis since the Great Depression.

A number of hedge fund managers, whose funds presumably lost money in the collapse of the $1.6 billion Bear funds, are slated to testify. Two such managers are Victor Cain of Treflie Capital Management and Benjamin Schliemann of Accumulus Capital Management.

It’s hard to believe that two years into the financial crisis, Cioffi and Tannin are the only prominent Wall Street types to face criminal charges.

from Margaret Doyle:

COLUMN –Investors return to hedge funds: Margaret Doyle

Margaret Doyle is a Reuters columnist. The opinions expressed are her own

By Margaret Doyle

LONDON, July 10 (Reuters) – If fear and greed are the motivating forces in financial markets, then greed appears to be in the lead again. Hedge funds had a torrid 2008 - losing money, barring withdrawals, displaying abysmal due diligence and even shutting down – despite the industry’s promise of “absolute return”. However, figures released by Eurekahedge show that investors are returning to the industry. There are plenty of reasons to stay away. There is an old joke that a hedge fund is a remuneration scheme masquerading as an asset class. One of the few things that the industry has in common, across a multiplicity of investment strategies and styles, is its proclivity for hefty fees. The industry has always defended “two and twenty”– 2 percent management fee and 20 percent of the annual return above a certain threshold – on the grounds that supe rsmart hedgies would outperform their rivals at dull long-only fund managers. Moreover, because the industry focused on “alpha” – the industry jargon for returns that are uncorrelated to market returns (“beta”) – the idea was that hedge funds would deliver “absolute” (rather than relative) returns. They might not beat, or even meet, market returns in the good years, but they would not lose it in the bad years. 2008 put paid to that theory. Moreover investors discovered that many of the previous excess returns were derived from excess leverage rather than super smarts. Worse, when investors tried to redeem their depleted capital, many funds invoked the small print to gate their funds. The coup de grace was (or ought to have been) the revelation that several of those who invested with the fraudster, Bernie Madoff, were funds of hedge funds which had been charging a further layer of fees, supposedly to do due diligence. In some ways, the investing environment is getting worse: regulators around the world are bearing down on the industry in a way they never did before and credit has dried up. This tale of woe ought, at the very least, prompt those re-investing in hedge funds to demand better terms. Some distressed hedge funds have already refunded or reduced fees. In addition to smaller fees, investors ought to be clearer on when and on what terms they can get their money out. Unfortunately, the signs are that healthy hedge funds are making few or no concessions on fees. For example, Man Group, Britain’s biggest listed hedge fund, reported that its gross margin on private investors remained “robust” in the year to the end of march, slipping slightly to 4.33 percent, and remains strong. Yet retail inflows exceeded outflows in the quarter to the end of June. With investors’ memories this short, perhaps it should not surprise us that fund managers hold fast to their fees.