Henry Waxman, Hedge Fund Managers and 'Mr. Market Miscalculates'
Kirk W. Tofte
by Kirk W. Tofte
13, 2008 the heads of our nation’s five largest hedge funds were
summoned before a U.S. House committee headed by the inimitable
Henry Waxman. Although it initially appeared to be a "show
trial" in an almost Soviet sense of the term, the hearing surprisingly
turned into a rather informative affair.
asked each of the hedge fund managers how their investment portfolios
could have thrived when most financial markets have been in total
disarray. One of the managers replied that he had shorted subprime
mortgage-backed securities after researching their underlying assets
diligently for months. His firm found that most of the mortgages
were issued with no down payments having been made, to parties with
bad credit histories and with virtually no documentation provided
(because none was required) to the lender. Their conclusion was
that most if not all of the mortgages would go into default, despite
the fact that "independent" rating agencies had deemed
as being investment grade – even declaring them AAA-rated in some
instances – the securities behind which these same mortgages stood
banks, credit rating agencies and – now – Henry Paulson, this hedge
fund manager obviously did his homework. We can do a little of the
same for ourselves in order to come to grips with the financial
mess that has resulted by reading James Grant’s new book, Mr.
read the book twice during the past four days, I can say without
equivocation that it is a must-read item. Grant lays out on the
table almost all of the key pieces involved in the current credit
crisis that is enveloping the world, even though the last essay
was written late this spring. Fortunately, James Grant gives us
most of the last pieces of the puzzle in his op-ed, The Confidence
Game, which was published in the Wall Street Journal
on October 18, 2008. It, too, must be read in its entirety to be
arguments involve the insight that interest rate cycles in the United
States take generations to complete and that we have now reached
the end of one of the greatest bull markets in debt securities of
all kinds that his country has ever seen. In his opinion, interest
rates can only go up from here over the next couple of decades.
But it is
the transition from falling interest rates to rising ones that is
shaking the foundations of the credit markets currently. For odd
and various historical reasons, since the early 1980s Americans
have seen the government, corporate and private debt that they have
incurred over the past twenty-five years lapped up in world markets
at ever lower interest rates and on increasingly better borrowing
terms for the debtors.
times this free flow of credit extended to the United States from
around the world has seemed indiscriminate. In Grant’s view, this
lack of discrimination was most obvious at the tail end of the bull
market in debt securities he has been watching with a gimlet eye
for over twenty-five years. How else could one explain, he asks,
the fact that until at least halfway through 2007 securitized debt
derived from subprime home mortgages originated in the United States
could be priced to yield very little more than Treasury issues with
comparable implied maturity dates? How, indeed! In his recent Wall
Street Journal article, Grant comes very close to providing us with
the answer to his own query.
originated from a known source in this country – everywhere. But
from where was all the credit derived? Increasingly in recent years,
it has come from foreign countries and, especially, from emerging-market
nations in Asia and elsewhere.
in these foreign countries would take the dollars they obtained
through the trading of their goods sold in the United States to
their respective central banks and have the dollars redeemed for
local currencies. Since many more exports went to the United States
than did imports from America go to these countries, certain foreign
central banks accumulated huge surpluses of our currencies. Rather
than hold non-interest bearing dollars, these foreign central banks
purchased debt securities issued by American entities of virtually
As Grant puts
it, "Our foreign creditors accepted dollars in payment for
their goods and services – and then obligingly invested the same
dollars in America’s own securities. It’s as if the money never
left the 50 states." But it is important to note that most
of these securities were of the debt variety. And the central banks
of emerging market countries may not have been as indiscriminate
in their purchases of this debt as it might first have appeared.
debt that foreigners can buy is that issued directly by the U.S.
Treasury. As worldwide demand for this debt increased and yields
dropped, foreign creditors would naturally have looked – as they
did – to debt issued by government sponsored entities (e.g., Fannie
Mae and Freddie Mac) for its higher yields and implied U.S. Treasury
backing. Finally, these conservative debt investors began to consider
the purchase of investment-grade debt, particularly AAA-rated securities.
Due to America’s
trade imbalances with the rest of the world, the demand for all
three kinds of debt (treasuries, GSE-related and investment-grade
securitized obligations) soared. Wall Street was more than happy
to try to meet this demand and did so until it got to the point
of creating "mortgage contraptions so complex as to baffle
even the people who invented them."
these "contraptions" gave new and dire meanings to the
phrase "the alchemy of finance" pioneered by George Soros
many years ago. The conjurer’s trick in this case was to turn debt
that was decidedly not investment-grade (i.e., subprime mortgages
or, as Grant calls them, "junk mortgages") into AAA-rated
securities. Wall Street was only able to apparently do so by plugging
optimistic assumptions into complex computer models and then selling
the conclusions spit out as justifications for AAA investment ratings
provided for them by compliant rating agencies – all for big fees,
commissions and underwriting profits, of course.
As Wall Street
continued to push the envelope, additional assurances of the soundness
of these collateralized mortgage obligations (CDOs) began to be
demanded by creditors. Synthetic CDOs were created to add "insurance"
in the form of credit default swaps and the band played on for a
little while longer.
But then the
music stopped when subprime mortgages began to default and all the
participants in the game realized that there were not enough safe
seats for each of them to sit in. At this point, the Federal Reserve
and the United States Treasury intervened. First they secured Fannie
Mae and Freddie Mac by taking over ownership of them. Then they
purchased eighty percent of AIG, the largest issuer of credit default
swaps in the world. Finally, the U.S. Treasury has begun the process
of injecting $350 billion to $700 billion into the capital structures
of America’s largest financial institutions.
You can read
all about the folly in Mr. Market Miscalculates and you should
probably weep while doing so. But James Grant writes too well, thinks
too clearly and is just too darn funny to distract one from the
narratives that make this book worth every penny it might cost you
to purchase it.
W. Tofte [send him mail] is
the manager of the BWIA Private Investment Fund and the author of
Principled and Grow Rich: Your Guide to Investing Successfully in
Both Bull and Bear Markets. He lives in Des Moines, Iowa.
© 2008 LewRockwell.com
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