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Hedge Funds, Private Equity Funds and Stock Markets

Prof. Peter Morici - 8/11/2007

The recent market meltdown had much less to do with bad subprime loans than advertised. It was caused more fundamentally by excesses at hedge and private equity funds.

Those contraptions, invented by the sinfully wealthy Barons of Wall Street, have lied to themselves and their investors about the efficacy of their schemes. Now they are quiet in their sins as bad home loans take the rap for a global meltdown the U.S. housing market is not large enough to cause.

Essentially, hedge funds have been pairing put and call options with borrowed money from banks. Derivatives may have fancy drapings but most of what goes on boils down to complicated buy-sell pairing.

Those pairings are based on computer models, and the like, which establish patterns of stocks moving in opposite directions. That can work for one or a few investors, with a very small share of market capitalization, betting against the market. But when hedge funds multiply, they essentially bet against one another and require one another to validate their bets. So betting on borrowed money endangers commercial banks stupid enough to believe the Brahmans that peddle their paper.

It's akin to a Las Vegas bookie taking only bets on the Washington Redskins and none on its opponents, while financing the book on money borrowed from a New York bank. An Ivy League Ponzi scheme!

In this environment of complex financial derivatives operations, private equity firms like Cerberus have been pushing paper that is not backed by sound business plans. For example, Chrysler is merely a grand subprime scheme. Chrysler may be redeemable but John Snow has not explained how. He doesn't have the skills for that.

The European Central Bank was correct to shore up banks balance sheets by providing more liquidity. But its high profile tender offer did more to scare markets than calm them. Banks are calling in notes from hedge funds and denying private equity funds new loans for questionable investments. It's a modern day run on the bank, where the banks become the depositors and the hedge and equity funds are the banks.

Unfortunately, the ECB behaved as if it were Franklin Roosevelt and is in out of its depth

Roosevelt did more than provide liquidity, he closed the banks so that depositors could not withdraw their savings and stopped the banks from foreclosing on farm and home loans until sanity resumed.

The ECB and Fed need to get between the banks and the hedge and private equity funds, much as New York Federal Reserve Bank President William McDonough did in the Long-Term Capital crisis, or they need to simply provide liquidity and take a lower profile.

In the end, the ECB and Fed need to reassure markets through steady calm action and not behave as the ECB did--like a frightened child.