Are Hedge Funds Dangerous?

We have had a credit financial crisis. Hedges funds are levered and marked-to-market. There have been close to zero hedge fund failures that have cost creditors money. Citibank and Merrill Lynch seem more worrisome.

Credit Losses as a Result of Debt Resale to Remote Investors?

There's a common view that had debt been held by the originators, their incentives would have kept them from making bad loans. No theory is offered as to why the ultimate holders didn't have an incentive also to avoid extended credit unwisely, thought they might not have known they didn't have enough knowledge. But how do we explain Countrywide, Citi, Merrill Lynch, etc? How many mortgage originators are bankrupt?

Buffet, Derivatives and Financial Weapons of Mass Destruction

Mr. Buffet has called derivatives "financial weapons of mass destruction". As we survey the first financial crisis since he made his remarks, it isn't derivatives which are at fault. Rather, it is one of Mr Buffet's companies.

It is ironic that Mr. Buffet has been a large shareholder in Moodys which, along with the other credit "agencies", is at the center of and responsible for the current credit crisis via their at best faulty credit analysis (at worst fraudulent). Who would have owned the CDOs that were rated AAA and AA had they not been so rated? How much less would have been produced? We will never know but as we observe the worldwide propensity to hold these instruments just because of their rating (which was even true for financial market participants like Citi), it's hard to believe that the market wasn't created by the rating agencies.

CFIUS Review of Foreign Investments in US Financial Institutions

CFIUS should seriously examine these investments in order to make sure that national security is protected. If CDO technology were to fall into the hands of hostile powers, the damage that could be done to the United States is immense.

WSJ Finds Failure in Citi's Assumption of SIV Liabilities

Dec 15, 2007:
"Citigroup's bailout of seven investment entities effectively killed one of the centerpieces of the Bush administration's approach to fix the mortgage crisis. If other moves fail, Congress could take a much more aggressive approach."

Citi found itself with sufficiently little need to use the super-SIV that it auto-bailed itself out. Is this a failure of a centerpiece policy or evidence that things aren't bad enough for the super-SIV to be needed?

Press Coverage of the Fed Action

Greg Ip, of the Wall Street Journal, the most eminent of the Fed watching journalists writes, "Officials said reducing or eliminating the spread between the discount and federal funds rate could have drawn an unlimited and unpredictable amount of borrowing, and caused banks to completely abandon the Federal funds market. That would cause the funds rate to plummet and make it hard for the New York Fed to get it close to the target rate chosen for monetary policy purposes."

Imagine that. The unsecured lending rate between banks much below the collateralised rate for lending by the Fed. Why would the unsecured rate be much lower than the secured rate? Are the discount window requirements in terms of counterparty, collateral and margin so lax that banks would pay more to borrow with this collateral than they would to borrow unsecured? If so, that's a story worth telling. If not, perhaps Mr. Ip's sources have it backwards.

Fed Action to Auction Funds for Term

If the Fed's action doesn't incur credit risk to the Fed, they won't be auctioning any funds. The rate for loans for a month collateralised with treasuries is much lower than the OIS for a month and the Fed is requiring that the rates paid on the funds it auctions be higher than the OIS for a month.

So, the Fed is proposing to take credit risk at a price lower than the current market price for that credit risk. That's fine but it would be appreciated if commentators or the Fed would note that instead of talking about "injecting liquidity". The Fed's discount window program was designed to avoid taking credit risk in the extension of credit to banks. If they aren't keeping with that principle, explicit admission would be credibility enhancing.

If the Fed is concerned that 3 month libor isn't as low as they'd like due to the changed relationship to the overnight fed funds rate, why don't they just target the 3 month fed funds (or libor) rate for now, or some average of the overnight and 3 month fed funds rates? It's easy to do and they would be admired for the clarity of their thought and action (not to mention the efficacy of their action). They have been trying with various non-economic methods (jawboning, maneuvers relying on perception changes for their effect) to affect the 3 month rate. Perhaps they should try economic methods.

Mr. Pandit - Citigroup's New CEO

Perhaps the board should have split the company in two and found two CEOs, each with the requisite knowledge. It's been a long time since synergies were claimed between the institutional and consumer businesses.

It's difficult to know whether Mr. Pandit will be a successful CEO at Citi. However, it is clear that his incredible overreach in starting a hedge fund has paid off. Morgan Stanley has precious few alumni who've started successful hedge funds (unlike, famously, Goldman Sachs). That's because the employees Morgan Stanley by and large don't conduct the kind of trading and investing that hedge funds do (it's hard to think of another reason that there are so few successful alumni). Mr. Pandit, nevertheless, coming from a background that deemphasized risk taking in favor of client business, started a sizable hedge fund that was quickly sold to Citi for $800 million. Though the hedge fund is still young, the results are consistent with what one would expect given the modest investing background of the founders. Meanwhile Citi, having bought Mr. Pandit's services by overpaying for the hedge fund, would have been in an awkward position had he left over the selection of someone else as CEO.

One wonders whether, had Mr. Pandit been at Morgan Stanley this year, whether the results there would have been different, or whether he, instead of Zoe Cruz, would have been blamed for the subprime and other credit losses.

Goldman Sachs Practices, Whatever They Are, Are Great

Whenever a firm (or person) has a period of success, characteristics (real or just claimed) of that firm attract compliments as if they caused the success. John Plender of the FT writes that "the culture of partnership...still survives [at] ... Goldman.... That is clear from remarks...by...Goldman's...chief executive".

Goldman Sachs has many more successful, high quality hedge fund alumni than any other firm, created over many eyars. These alumni couldn't be explained by the culture of partnership since they left the partnership. Perhaps they are explained by Goldman's having a deeper trading culture than other firms. In that case, perhaps that explains the firms recent successs, instead of the stories told by the CEO.

Also, it was once thought that splitting the CEO and Chairman's jobs and having a board dominated by outsiders was a better way to govern. Now apparently, as the FT observes, it's good to have a board with lots of management on it since they understand the business (as if management's insights on risk wouldn't be available to a board were they not members) and the combination of CEO and Chairman in one person at Goldmans doesn't appear to disallow their governance's being so good that it's a model for others. (we can discuss whether the effect of 4 out of 12 on the board being current or former Goldmans executives creates an unbalanced board in another note).

Carbon Equivalence not Good Enough

An article by Jeffrey Ball in the Wall Street Journal on Monday, prompted by the UN global warming conference starting in Bali, reports extensively without criticism on the defect in the cap and trade system that while it reduces global warming gas output (like HFC-23, which is 11,700 as potent per unit mass as CO2), it hasn't much affected CO2 output. There is fretting that the market reduces global warming gasses most cheaply per CO2 equivalent unit, without regard to whether actual CO2 production is reduced.

The only way I can make sense of this is that there's an implicit idea that were CO2 reduced, it would be the result of technology improvements that would come in discrete steps of sufficient size that more than the targeted amount would have been achieved or that those improvements would reduce the future cost of improvements in CO2 reduction technology. I don't know of any reason to think this. CO2 is 77% of all CO2 equivalents and is produced in many ways some of which may be much more expensive to affect and via a much different manner than others (eg., nuclear energy works better for electricity than for the current stock of cars).

The article notes that most of the HFC-23 reduction that can be had is already set to be had, so that further reductions will come from other gasses, thus eliminating the problem that the article finds with the reduction's coming from HFC-23 (methane also looks a little overrepresented but not by much).