Hedge funds are in the news again. They don’t much
like being in the public gaze. We wonder why. Does their speculation cause
prices to go up? Do they drive firms into bankruptcy so workers lose their jobs?
These are the questions being asked. Let’s see what they get up to.
Where does the name ‘hedge fund’ come from? It has a
bucolic feel to it, and that’s the way they want us to think of them. ‘Hedging
your bets’ means trying to minimise risk. If a farmer wants to know where he
stands, he may sell his 2009 crop, which he hasn’t planted yet, on the futures
market. This will give him the money to buy the seedcorn up front and a feeling
of security about the future. He’ll get a known price whether the harvest turns
out to be good or bad. He hasn’t eliminated risk, just let someone else take it
on. If you’ve sent a cheque in for the ‘Reformism or revolution’ book (which is
still being printed) you’re playing the futures market! Futures are the
simplest form of derivative. The derivatives market is called this because the
instrument is derived from another transaction. It is contrasted to the spot
market, where goods and money change hands at the same time.
This ‘everyday story of country folk’ is a long way from
the reality of what modern-day hedge funds get up to. Some of the derivatives
they deal in are so complicated that they need a bank of linked computers to
work out the odds. Nobel prize-winning mathematicians have been sucked into the
City to feed this tide of ‘financial innovation.’ And the sums of money that
they deal with are awesome. Hedge funds are already playing with $2 trillion of
other people’s money. There are $600trn of derivatives floating around the
globe. They are a form of what Marx called
fictitious capital. By way of comparison, the world produces less than $50trn
in new goods and services each year. (See https://communist.red/wishful-thinking.htm
by Michael Roberts)
The scale of operation is bigger but the principle is
the same as before. The farmer didn’t want to bet on whether the 2009 harvest
will be good or bad. But that meant somebody else did take a bet – the hedge
fund. That’s what hedge funds do – bet with other people’s money. And bets can
get more and more complicated. Ever heard of forecasts, trifectas, jackpots,
placepots or pool bets? These are all ways of betting on horses. Usually they
make it possible to win more money for a smaller stake. (This is called leverage
in the financial markets.) Provided…always provided the horse you pick runs a
bit faster than the others. And, as we shall see, leverage makes it possible to
augment losses in the same way.
The attraction for rich people in ‘investing’ in hedge
funds is that they promise, and deliver, returns of 30% a year. How is this
possible? It’s a grisly story. Recently hedge funds have been betting on banks
failing. After all you can win money betting on which horse comes last the same
as which horse comes in first. Everyone knows the banks have been leaking
profits since the credit crunch started last year.
Bradford and Bingley, for instance, declared a loss of
£8m for the first four months of 2008, compared with £108m profits over the
same period last year. The main reason for this was because they had to write
down £89m in assets, discovering that it was actually bad debt. B & B
decided they needed more money in the vaults. They chose to recapitalise by
offering a rights issue. This means that they ask existing shareholders to
stump up money for extra shares. B & B wants £400m. (Don’t we all?) Shareholders
don’t like rights issues. They want to be left in peace with their money. So B
& B shares went down in price.
The hedge funds have been on the case like jackals
spotting a sick wildebeest on the veld. At one time they held 10% of B & B
shares. A firm called GLG still holds 4.1% stake in B & B shares. But Texas-based TPG Capital has pulled out of
the hunt. In fact B & B shares have now dipped so low they are said to be
‘virtually worthless.’
Other banks are still being stalked. Hedge funds have
been buying up shares in Northern Rock since its collapse last year. They
actually brought the bank to its knees in the first place by short-selling its
shares (see below). They are punting on the prospect that Gordon Brown and his hapless
Chancellor Darling will hurl more money at the shareholders, thinking that
they’re all little old Geordie ladies with votes.
In the USA
Lehman Brothers bank claims rumours are maliciously being circulated that they
are virtually bankrupt and will soon be pulled to pieces like Bear Stearns was
a few months ago. The fall of Bear Stearns Bank became a self-fulfilling
prophecy once enough money got on the story. Is the threat to Lehman really just
a case of incompetent managers blaming others for their firm’s misfortunes? Or
are the hedge funds really up to something? Your guess is as good as mine.
So are hedge funds the bad guys? There is a different
point of view, given by headlines such as ‘Hedge funds bail out ailing
corporate world.’ (Financial Times 02.07.08) The article shows hedge funds
rallying round Barclays in its search for funds and underwriting, not
sabotaging, HBOS’ rights issue. Angels or assassins? Hedge funds are just capitalists.
They will tear a firm to pieces if it makes money and then put it back together
again if it makes more money.
But hedge funds work in the dark. And they’re now so
mighty that, if they shout ‘fire’ in a crowded theatre, they can create a panic
and amuse themselves later by looting the dead bodies of those caught in the
crush. A wall of money can make things happen.
So what? Bear Stearns went belly up because of the
financial crisis, not because of the machinations of hedge funds. Banks’ shares
are going down because of the financial crisis, not because of manipulation. The
financial crisis is part of a crisis of capitalism, not the product of evil
minds. But, by golly, capitalism certainly produces plenty of evil minds.
Capitalism is a dog-eat-dog world where only the nastiest and most ruthless
survive. That’s just the way it is.
The Financial Services Authority has recently demanded
that the shadowy people ‘short-selling’ company shares should be identified.
It’s the hedge funds. Short-selling is a practice where a capitalist borrows 10
shares worth £100, for instance, on the expectation that they are going down,
so that if he is right he can buy them back for £80 and keep the other £20 as
profit. This is the opposite of ‘going long,’ when a capitalist buys a security
in the expectation that its price will rise, and can keep the extra as profit
if he is right.
Will Hutton fingers the hedge funds in an article ‘As
we suffer, City speculators are moving in for the kill.’ (Observer 29.06.08)
“The hedge funds weren’t even buying back the shares, they were ‘borrowing’
them from pension funds to manipulate the market,” he complains.
He goes on. “A
spotlight has been shone on some very murky corners of the financial markets.
There practices occur that challenge the very conception of what we consider a
company to be, and the accompanying obligations of ownership. A multi-billion
pound business has emerged in which shareholders lend their shares to hedge
funds to be played with. For a tiny fee, a hedge fund will arrange to borrow
shares from a great insurance company or pension fund which it proceeds to
sell. Share-loans are believed to exceed a stunning £7.5 trillion.
“What then happens is the opposite of a bubble, a kind of financial black
hole. The hedge funds sell the shares simultaneously, and the downward movement
becomes self-reinforcing, with companies raising money during a rights issue
particularly vulnerable. This is why the government forced disclosure. The
hedgies reacted as if they were in Stalin’s Russia; their freedom to kill a
company stone dead was being challenged. Let’s not mince words, that is the
aim, and it gets ugly and personal. A senior official told me that in one case
some hedge funds had allegedly warned the banks underwriting one rights issue
to abandon it or face speculative attack – mafia practice.”
Will Hutton is an intelligent commentator, and his
apocalyptic article raises important issues. Hutton’s basic mistake through all
his writings is his search for a decent, humane long term form of capitalism as opposed to the
rapacious bunch of spivs who actually dominate our economy. We have to ask, why
should pension funds lend their shares to hedge funds, who then short-sell the
shares in order to make the pension funds’ holdings worth less? And, if the
pension fund managers really are that stupid, shouldn’t the funds be
nationalised right away just to safeguard people’s pensions?
What is wrong with short-selling? Is it unethical? Under
capitalism prices go up and down. They do so because people buy and sell, often
with the aim of making money from the transaction. Is Hutton going to ban
short-selling, so prices can only go up and never down?
The core of Hutton’s argument, and it has been raised
by others, is that the wall of money moved by modern hedge funds can actually
make things happen. Share prices go down because hedge funds sell, and not for
any other reason, he argues. In that case they are just parasitic plunderers.
But Marxists believe that capitalism is an inherently unstable system, and the
operations of hedge funds and other speculators are merely the executors of the
market forces through which the laws of capitalist anarchy work.
This point is at the heart of a controversy among
capitalists and capitalist economists. Milton Friedman asserted that destabilising
speculation was impossible. This was supposed to be the case because
speculators who ‘got it wrong’ would be buying dear and selling cheap. They
would lose money and soon disappear. Friedman, a notorious apologist for
capitalism whose disciples advised General Pinochet’s regime of torturers in Chile, assumed
that capitalism is a stable system. In that case the market just nudges people
and things in the ‘right’ direction. But what is the ‘right’ direction?
Friedman totally ignores the fact that markets can
systematically move in ‘wrong’ direction’ – the opposite directions to the economic
‘fundamentals.’ (Whatever they are and whether or not they exist.) This is proved by the existence of financial
bubbles. Bubbles have been a feature of capitalism since its inception. For
instance during the 1630s Holland
was seizes by a mania for tulips. Tulips passed from hand to hand at
ever-increasing prices. A rare tulip could sell for more than a farm. Why?
Because each speculator assumed that, since prices were going up, they would be
able to get more for the bulb than they paid for it. And why were prices going
up? Because people were buying bulbs. The whole thing was a classic bubble,
based not on ‘market fundamentals’ but on speculative mania.
Charles Kindleberger defines a bubble as “A sharp rise
in the price of an asset or a range of assets in a continuous process, with the
initial rise generating expectations of further rises and attracting new buyers
– generally speculators interests in profits from trading in the asset rather
than its use or earning capacity.” His book ‘Manias, panics and crashes’ is a
cracking good read and an expose of the follies and villainies of capitalists over
hundreds of years. Manias, panics and crashes have all been constant features
of capitalism since its dawn – from the South
Sea bubble that popped in 1720 to the
housing bubble in the USA, Britain, Spain
and Ireland
that has just been pricked over the past year.
In 1953 Friedman wrote an article called ‘An essay on
the methodology of positive economics’ in which he denied that the assumptions
behind economic theories need be realistic. Indeed he applauded theories
consciously built on unrealistic
assumptions. “A theory is to be judged by its predictive power,” he asserts.
Marxists deny this. We believe a theory is to be judged by its explanatory
power, though we note in passing that Marxist political economy has vastly
superior predictive power to the ravings of Milton Friedman.
He goes on, “To be important…a hypothesis must be
descriptively false in its assumption.” And by Jiminy does he follow his own
advice! He postulates a stable crisis-free capitalism, He ‘abstracts from,’
that is to say he ignores the existence of bubbles, of panics and manias, and
of crises. Friedman has an infinite capacity to ‘forget’ about the shambles of
real capitalism and instead sings us lullabies about the ‘rationality’ of the
market.
But this is not the real market at all. Friedman is conjuring
up the ‘invisible hand’ of Adam Smith, the hand of a wise man in the sky with a
beard – god. Actually what we call market forces are the unconscious resultant
of decisions taken by millions of individuals. These market processes are not
willed or planned by any of the participants. Naturally markets are anarchic
and can look chaotic.
Can speculators make money by putting up prices or
destroying the livelihood of firms? Some argue that it’s all a zero sum game.
If one speculator buys a piece of paper and makes money, then somebody else
must have sold and lost money. Certainly society as a whole is not made one
penny richer from speculation, a parasitic activity that burns up wealth. But
if there are a group of people with inside information such as hedge funds,
then they can profit at the expense of the savings of widows, orphans and
others not in the know.
Secondly, hedge funds are not just gamblers. They are
also the bookies. In addition to a share of the winnings, (made with other
people’s money) they charge a management fee.
As we know, whichever horse comes in first, the bookies always take
their cut.
George Soros believes that markets can get it wrong
and that bubbles can be blown up by speculative activity. He believes a wall of
speculative money is partly responsible for the ever-rising price of oil. There
is a difference between Friedman and Soros. Soros has played the markets and
won – big time. He’s not just someone who has spent their life telling fairy
stories about the delights of capitalism. He knows what it’s really like.
This is what Soros has to say about the fantasy of
stable, self-correcting capitalism. "Unfortunately, we have an idea of
market fundamentalism, which is now the dominant ideology, holding that markets
are self correcting; and this is false because it’s generally the intervention
of the authorities that saves the markets when they get into trouble. Since
1980, we have had about five or six crises: the international banking crisis in
1982, the bankruptcy of Continental Illinois in 1984, and the failure of Long
Term Capital Management in 1998, to name only three. Each time, it’s the
authorities that bail out the market, or organize companies to do so. So the
regulators have precedents they should be aware of. But somehow this idea that
markets tend to equilibrium and that deviations are random has gained
acceptance and all of these fancy instruments for investment have been built on
them."
Soros’
big coup was when, as hedge fund manager, he bet against the pound remaining
within the European Exchange Rate Mechanism in 1992. As sterling was being
squeezed out of the ERM the Tory government spent billions of our money, in
effect throwing schools and hospitals at the foreign exchange markets. To no
avail. Soros is believed to have made a billion dollars in a few days. Many
economists argue that Soros did us a favour. The Tories had lodged sterling in
the ERM at an overvalued rate. The pound was in effect suspended in mid air
with no visible means of support and exports were hurting. It was only because
of the Tories’ mistake that speculators such as Soros could make money.
Soros argues
that a wall of money ($200 billion at last count) is powering up the future
price of oil in particular. "The institutions are piling in on one side of
the market and they have sufficient weight to unbalance it. If the trend were
reversed and the institutions as a group headed for the exit as they did in
1987 there would be a crash,” he warned the US Senate.
As
we argued earlier, ( https://communist.red/world-food-prices-people-go-hungry.htm
) for Marxists
speculation does not cause shortages, though shortages can lead to speculation
– which makes the shortages worse. Ted Grant once compared the role of
speculation to loose ballast in a ship’s hold. If the sea were calm, there
wouldn’t be a problem. The storm is the cause of the problem. But in a storm
the ballast can punch a hole in the ship’s hull and cause disaster. A wall of
money can make things happen, but only when they’re prone to happen anyway.
To
coin it in, speculators have to go with the grain of economic processes. Hutton
goes on about oil prices, “One
witness, hedge fund manager Michael Masters, argued that there were two identifiable
sources of new demand over the past five years – from China and from
speculation – both around the same scale. Without the speculation the oil price
would still be below $100 a barrel.” Masters knows that, if capitalism hadn’t
given us a shortage of oil, he wouldn’t be able to make money out of it.
But speculation
in petroleum is profitable because demand is outstripping supply. Ten years ago
oil stood at $10 a barrel. Oil companies could not be bothered to search for
new sources of supply, and the western world guzzled petrol on the grand scale.
Nobody knew how much oil the world would want in 2008. Now it’s panic stations.
So the problem
is capitalism, not speculation. Prices go up anyway because capitalism is
unplanned. Capitalism inevitably creates shortages at some points and gluts
elsewhere. Firms go bust and workers lose their jobs because that’s how capitalist
‘competition’ works. Let’s kill it.
