Thursday, March 19, 2009

AIG: “A Hedge Fund with No Hedges”?

Several recent reports have pointed out that, in the years before its global train wreck, AIG ran itself less like an insurance company and more like a hedge fund. Consider this comment by New York Times columnist Tom Friedman, for example:

AIG an Un-Regulated Hedge Fund?

Let’s not forget, A.I.G. was basically running an unregulated hedge fund inside a AAA-rated insurance company. And — like Madoff, who was selling phantom stocks — A.I.G. was selling, in effect, phantom insurance against the default of bundled subprime mortgages and other debt — insurance that A.I.G. had nowhere near enough capital to back up when bonds went bust. It was a hedge fund with no hedges.

Hedge or Not To Hedge

“A hedge fund with no hedges.” Well, there’s been a lot of that going around. Read now this quote from the May 2008 Elliott Wave Theorist by EWI’s founder and president Bob Prechter. And keep in mind that Bob wrote this months before the Bernie Madoff hedge fund scandal broke and before AIG’s first bailout in September ’08 (italics added):

May 2008, Elliott Wave Theorist

Hedge Funds: The Same Story as 1999-2000 but Bigger

The spectacle of hedge funds losing money has surprised investors who thought their managers were experts at investing and that their expertise would accrue to the providers of capital. Everyone seems shocked that “the smart money was not so smart.” But actually the fund operators are very smart. Making money for clients is certainly one of the goals of hedge-fund managers, but another goal—if not their primary goal—is to make money for themselves. Managers get paid a percentage of profits over fixed intervals, and they do not participate in losses. So, the clever thing to do is to leverage the clients’ money to the hilt, because two or three super-profitable years allow a manager to retire immensely wealthy. That’s what managers did, and for many of them it worked. It worked so well that they will never have to work again. It is the investors who were naïve, not the managers who were stupid.

One thing that bothered me from the start about the whole hedge-fund mania was the media’s cultivation of another misnomer. Hedge funds hedge; but these funds are entirely on the opposite end of the spectrum: as leveraged and vulnerable as you can get. The term “hedge fund” so egregiously mis-applied is like what happened to another useful, venerable and previously accurate term in the early 2000s. That’s when the media foisted the term “market timer” on people who cheated the market by back-stamping the times of trades. Market timers and hedge funds used to be considered practitioners of decent professions. Now the terms are used for people who run—or are perceived as running—scams. The ticket back-daters should be called frauds, and today’s so-called hedge funds should be called spec funds.

Investors in spec funds also seemed to believe that their managers would buy and sell as necessary in anticipating market conditions, as if they are smart traders. But they are not traders. They are buyers on leverage. There is hardly a trader among them. Traders go long and short and sometimes they go to cash, depending on their analytical outlook. Buyers just buy. Does this sound familiar? It should, because the spec-fund phenomenon since 2003 has been nothing but a beefed-up, more-leveraged version of the equally erroneously named “day-trader” phenomenon of 1999-2000. Back then, mild corrections in the stock market in 1999 and 2000 decimated these so-called traders who were really just buyers.

Just as small corrections erased the profits of the “day-traders” of nine and ten years ago, all it took was a slide in the extreme fringes of the debt market to wreak havoc on leveraged funds’ profits. And it has happened for the same reason: They are simply one-sided buyers, and the market finally reminded investors in these funds that TANSTAAFL. (If you don’t know this term, Google it.)

Which brings me to the next issue: The buyers in these markets, armed with formulas, really did seem to think that there was such a thing as a free lunch. Hey, just borrow short and leverage long, and you get free interest! As the song says, “Money for Nothing.” But formulas never work in the stock market, because they tend not to include a built-in expectation of radical change. With Elliott waves, an analyst has a bias toward expecting change. Sometimes it is a counterproductive bias, but I think it is less potentially ruinous than a bias toward increasingly expecting conditions to maintain the longer they persist.

Formula creators almost always seem to figure that the past will be like the future, and the longer a trend or condition has been in force, the more they think it will continue, which is backwards. Some options models, for example, rate a period of low volatility in the market as increasingly low-risk for options writing, when in fact the risk of bigger volatility is increasing with every passing day. Some of these hedge-fund-management programmers believed that they had established the cost of “guaranteeing” the value of their underlying bond positions with insurance. When they built the programs, the cost of insuring a million dollars’ worth of the IOUs in its portfolio was low. And bond insurance had been cheap for half a century, so why should anyone think it would change? As the crisis unfolded, however, insurers panicked, and the cost of the same insurance zoomed. The funds’ investing formula did not need just a tweak; it broke. Many managers could no longer afford insurance, and suddenly they were as naked as nature intended.

That word panicked is important. Formulas don’t take into account the abruptness and violence of mass human emotions, and they certainly don’t try to predict in what violent actions they will manifest themselves. Elliott waves are waves of optimism and pessimism, and big ones are so important that they have implications for social action. That is why Conquer the Crash anticipates a radical, mass-psychological change toward the idea of debt, from historic complacency to fear. When insurers are confident enough to guarantee financial outcomes, the old financial trends and conditions are likely mature.

Like the day-trading era, the whole hedge-fund affair has been a mess from the beginning. And the story is not really new. It is much the same story as 1999-2000 with the day traders, with just enough superficial difference to seem new.

Insights like these – which often come days, months, or even years ahead of the news – are exactly why you should be reading Bob Prechter’s Elliott Wave Theorist. The latest “Special Investment Issue” is online now – read it risk-free today.