The Hedge Fund Headache
By
William Cate

Hedge Funds are dangerous. They play with the D-bomb and Hedge Fund managers
don't know what they are doing. They are like children playing with a
landmine in a sandbox. It's fun and exciting until the darn thing goes off.
A D-bomb explosion would have the same impact on the global financial
market, as an H-bomb would have denoted over Salt Lake City. The result
would be a multi-century wasteland after the explosion. A D-bomb explosion
means that our Civilization will be facing a new multi-century Dark Age.

The D-bomb is the Derivatives Market. In theory, derivatives are balanced
risk investments that allow Hedge Funds, banks, insurance companies and
others to profit from the spread created by the bet. The three design
problems with D-bombs are that the risk is usually an either or option that
doesn't factor in a third alternative. Many bundled derivatives have
components that don't represent outside financial instruments that might
have value after a D-bomb explosion. The Derivatives Market represents about
forty times the total value of all world currencies combined. If the D-bomb
goes off, all world currencies would be worthless about forty times over.
There simply isn't enough money to cover a D-bomb meltdown.

In simple terms, a derivative is merely a bet. And it can be a bet on
anything: interest rates, exchange rates, stocks, commodities, etc.Find a
counter-party willing to wager against you, and you havecreated a
derivative. And to make the bet you usually only have to put downa small
fraction of the bet amount. However, if their bet explodes, the Hedge Fund
must cover the leveraged amount of their bets. It's this coverage
requirement for dangerous bets that puts the global financial market at
risk. The D-bomb risk/reward ratio doesn't make sense to anyone who
understands it.

Consider Long Term Capital Management. In 1998, it was the largest
Hedge Fund in the world. It's derivatives shenanigans almost triggered the
collapse of the entire global financial system. It careened to the brink of
failure and would have gone under if the U.S. Government had not organized
an emergency bailout. That bailout took the taxpayers of twenty countries to
cut the timer to D-bomb denotation. And, Long Term Capital Management wasn't
even an American Hedge Fund.

The global derivatives market is around $272 trillion, according to the
recent figures from the Bank of International Settlements. And three big
American banks' JP Morgan Chase, Bank of America and Citicorp - account for
$77.6 trillion of the money being bet.

European banks are at risk for over $100 trillion and are the global center
for D-bomb development. However, America is racing to close the D-bomb gap.
Because they aren't regulated like banks, U.S. Hedge Funds are on the
cutting edge of D-bomb development. American Hedge Funds manage over one
trillion dollars, up from thirty nine billion in 1990. In the first quarter
of 2005, wealthy investors added twenty seven billion dollars to the capital
of Hedge Funds. These Funds are borrowing billions of dollars from major
brokerage firms and others. With the help of Hedge Funds, America is closing
the D- bomb development gap. A small bad bet can easily bring down the
largest financial institution. Hedge Fund trading may account for up to 50%
of the trading volume on the NYSE. A few bad bets would collapse the Dow
Industrial Average. Because there are no reporting requirements, nobody
knows how well or badly Hedge Funds are doing. However, I've never met a
Hedge Fund manager who wasn't seeking new blood for their operations. If
they were doing so well, they wouldn't need a constant influx of new
capital.

GM is in financial trouble. The company is planning to layoff 25,000 U.S.
employees. The troubles were evident to the investment community for over a
year. Hedge Fund managers made a simple bet on GM. Funds bought GM's
corporate bonds and hedged the risk of default by shorting GM stock. The
plan was to hold the bonds and the Hedge Funds would lock in the interest
rate spread between the coupon on the debt and the dividend on the common
stock. This was a simple either or bet. If GM defaulted on the bonds, the
shorted GM stock would cover the bond loss and allow for a profit. If the
Company strengthened its financial position, the interest on the bonds would
cover any losses sustained by the short position. As with many D-bombs, it
appeared the Hedge Funds couldn't lose.

The D bomb exploded when GM debt was downgraded (causing its bonds to go
down) and Kirk Kerkorian made a tender offer for 3% of GM's stock, causing
GM shares to rise. Hedge funds got shredded in this little D-bomb explosion.
A similar thing happened with Ford stock and debt. And, it happens often
with no one the wiser.

The fact is those betting on Derivatives are betting on the future of
Civilization. At some turning point in the economic situation, whether it be
a recession or double-digit inflation, the Hedge Funds will lose sufficient
bets to create a cascading explosion that will destroy Civilization. The sad
fact is most people don't see that the D-bomb is in play and will eventually
explode.

About the Author

He has been the Managing Director of Beowulf Investments [http://home.earthlink.net/~beowulfinvestments/] since 1981 and is the Executive Director of the Global Village Investment Club [http://home.earthlink.net/~beowulfinvestments/globalvillageinvestmentclubwelcome/]