A BAD TRADE

The present period in financial history favors ducks and undertakers.

 On the banks of the Thames and the Hudson, every day they fish a couple more cadavers out of the water. And then the medical examiner opens them up so we get to see what caused them to go under. What a sight! It is amazing that any sane investor ever had anything to do with them in the first place.

We are speaking about the entire financial industry, in general, and hedge funds in particular.

Picking at the innards of the deceased, we find their plumbing so twisted, it’s a wonder they lived as long as they did.

Of course, every mother wanted her babies to grow up and work on Wall Street or the City. Why? Because the money was so good. No sector was more profitable; no employees were better paid. But that was the basic problem too.

People who worked in the financial industry were encouraged to take outsize gambles in the hopes of outsized bonuses. And as long as the credit cycle was on the upswing, the wagers paid off.

“Until the recent tempest,” says Fortune magazine, “Wall Street firms looked like just about the world’s best businesses. Year after year they boasted sumptuous profitability, ever-rising share prices, and, if you believed their claims, a new generation of chief executives who had mastered the art and science of risk management.”

In the period, 2002 to 2006, the sun never shined more brightly for the five big independent firms - Goldman Sachs, Merrill Lynch, Morgan Stanley, Lehman Bros., and Bear Stearns. Their earnings rose 200%, to more than $30 billion, with an average return on equity of 22%. Too bad they didn’t hold onto the money. But when the money was on the counter, the clerks at financial firms didn’t put it in the till. They took it home.

Fortune continues with the numbers: In 2006, the top six employees at Lehman pocketed $150 million, and James Cayne, who was at the time Bear Stearns’s CEO, paid himself $40 million.

Employee compensation at Wall Street’s big five investment banks included restricted stock and options equal to 26% of the companies’ outstanding shares.

As long as the weather was good, no one complained. But in 2007, the monsoons began. Since the middle of the year, just three firms alone – Bear, Merrill Lynch and Morgan Stanley – have taken more than $40 billion in writedowns.

Bear drowned...while managers at other firms looked for ways to stay afloat. Shareholders, meanwhile, raced to the cupboard to look for the companies’ rainy-day reserves. Alas, employees had stripped the company of capital.

As for hedge funds, we have nothing against them. Au contraire, we value them as we value influenza and Russian roulette....they help carry off the weak and eliminate the stupid.

It was a bad week for hedge funds. Poor John Meriwether, for example, was back in the news; we get to laugh at him twice. He was the captain of LongTerm Capital Management which sailed along beautifully – thanks to the aid and comfort provided by two Nobel Prize-winning economists, Myron Scholes and Robert Merton – until it hit a reef in 1998.

After the LTCM sinking, Meriwether swam ashore, dried himself off, and went back to doing what he did best – taking a big piece of investors’ money. But in 2008, his flagship fund is down 28%. And he’s not the only one. It was the worst quarter ever for the hedge funds. And March was almost as bad for hedge fund managers as it was for Julius Caesar; the average fund was down 2.4% in the month alone. Some of the big, well-known funds fell much more. Endeavor Capital dropped 34%.

London Diversified Fund Management’s flagship fund lost 10%. And in New York, Pardus Capital Management, which seems to specialize in airline stocks, refused redemptions on its $2 billion fund.

Alert readers will already be asking questions. Isn’t the whole idea of a ‘hedge’ fund to hedge against market disasters, by taking countervailing positions in different asset classes? We assume that was a rhetorical question, since everyone knows hedge funds ceased to hedge a long time ago. Instead, they are some of the biggest go-for-broke gamblers in the financial world.

It is the old principal/agent problem – a traditional bugaboo among economists – says a colleague. You hire someone to do a job for you and you assume he’s on your team. And then you discover than your doctor operates a funeral parlor on the side. It’s a problem in business and politics as well as the investment world.

Turn your back for just a moment and your CEO is awarding himself stock options and your kids are wearing your socks; your local politicians are hiring their girlfriends, and your hedge fund manager is taking extraordinary risks with your money.

In the world of hedge funds, the problem was particularly acute. Because the managers have such lopsided incentives. If they make money, they take 20% of it off the table and put it in their own pockets. If they lose it, you, the investor, get to keep the whole loss. Heads I win, tails you lose.

This is why Warren Buffett calls hedge funds a “compensation system,” not an asset class. Over time, the hedge fund manager is practically guaranteed to end up with more of your money than you have.

John Kay, writing in the Financial Times last month, demonstrated that if Buffett had charged like a hedge fund, he would have ended up with 90% of his client’s money in the 42 years he’s been investing.

But in the recent stormy weather, 50 hedge funds have washed up.

Only about 7,950 left to go.

Until next week,

Bill Bonner