Mid-July, I spent a couple of days with David Stockman in Aspen, and if there is one single word that sticks out more than any other from our long conversations, it’s “apostate.” That’s the word he used to describe himself when referring to his history, including his stint as Budget Director under President Reagan.
That’s a word to keep in mind when reading this excerpt from Chapter 23 of his bestseller, THE GREAT DEFORMATION: THE CORRUPTION OF CAPITALISM IN AMERICA. After working for President Reagan, he became one of the early partners at private-equity firm Blackstone Group. So when he, armed with intense first-hand knowledge and decades of close observation, lashes out at hedge funds, it carries the weight of a prediction – though he is writing about the Financial Crisis, and the huge role they played in it.
The Wall Street hedge-fund casino is all the more volatile because it deploys massive leverage in many forms. The tamest form of this leverage, funding obtained in the wholesale money and repo markets, is potent enough. As has been seen, most of the time the resulting carry trade produces handsome spreads and funds a steady bid leading to higher asset prices.
But at junctures of extreme financial stress, the high level of carry trade funding, which builds up during the bubble expansion, results in violent market reversals. In these circumstances, wholesale funding evaporates and involuntary asset sales cascade into a bidless abyss. The devastating broad market collapse of 2000–2003 (45 percent) and 2008–2009 (55 percent) was dramatic proof.
The most potent amplifier of volatility in the hedge fund arena, however, is the embedded leverage of options and OTC derivative concoctions. Exchange traded options require regulatory margin, of course, but in the case of momentum trades the margin factor actually turbocharges volatility.
Options are an accelerator on the way up, since no extra margin deposit is required as the underlying asset price rises, while on the way down, they become a widow maker: any price drop requires the posting of additional margin on a dollar-for-dollar basis. Needless to say, when momentum trades start cratering, the margin clerks become purveyors of pole grease.
Compared to exchange traded options, the OTC derivatives fashioned by Wall Street dealers are even more combustible. In these unregulated bilateral trades, margin requirements are not standard, regulated, or continuous, meaning that margin calls are often lumpy and precipitate; they tend to exacerbate losing positions as the dramatic, margin call–driven demise of Lehman, AIG, and MF Global demonstrated. Such OTC positions are also festooned with fillips like knock-out and knock-in triggers which produce drastic value changes when these defined trigger points are hit. In effect, these “weapons of financial mass destruction,” as Warren Buffett once called them, can simulate leverage ratios so extreme and opaque that they cannot even be meaningfully quantified.
The Myth That Speculators Are Liquidity Providers
The Wall Street fast money casino is thus land-mined with potent agents of volatility. Yet these huge and financially metastasized secondary markets are, paradoxically, portrayed by apologists as agents of economic advance. Hedge funds and Wall Street trading desks are held to be doing God’s work; that is, providing trading liquidity in return for a tiny slice of the turnover.
What looks like churn and hit-and-run speculation, they contend, is actually a sideshow. The real function of these rollicking secondary markets is enabling corporate issuers to sell new securities efficiently and permitting savings suppliers such as pension funds, insurance companies, and 401(k) investors to smoothly enter and exit investment positions.
Like the case of Bernanke’s Great Moderation, however, the truth is more nearly the opposite. The Fed’s prosperity management régime has actually fostered a vast increase in capital market volatility, not a gain in liquidity. The proof is in the pudding. If these vast trading venues were meaningfully enhancing liquidity, then volatility would be abating over time, not reaching increasingly violent amplitudes and frequencies. In fact, the highly leveraged carry trades, the financial elixir of the Greenspan era, actually evaporate abruptly under stress and therefore amount to anti-liquidity.
True market makers, by contrast, minimize leverage in order to maximize their market-making capacity during periods of stress. By thus keeping their powder dry, they can take advantage of that part of the cycle where the bid-ask spread is the widest and dealers can earn above-average returns on their working inventory.
For these reasons, the liquidity function conducted by genuine dealers on the free market bears no resemblance to the leveraged, momentum-chasing prop traders. Beyond that, the free market seeks out efficient solutions to resource allocation, but having trillions of hedge fund capital absorbed in the “dealer” function does not meet that test by a long shot.
It can be correctly assumed, therefore, that the $6 trillion of hedge funds domiciled in Greenwich partnerships and Wall Street banks do not toil in the service of the Financial Almighty. They exist not to bring liquidity to asset markets, but to extract rents from them.
Needless to say, today’s hedge funds do not operate on the free market, and they are neither dealers nor investors. Their business of hit-and-run speculation generates no economic value added, but nonetheless attracts trillions of capital because the state and its central banking branch make it profitable.
Cheap cost of carry and the Greenspan-Bernanke Put are the foundation of this hothouse profitability. They mitigate what would otherwise be the substantial costs of funding portfolios at normalized interest rates and of reserving for asset price risk on the free market. Without these artificial economic boosts, the high-churn style of hedge fund speculation would be far less rewarding, if profitable at all. By David Stockman, author of THE GREAT DEFORMATION: THE CORRUPTION OF CAPITALISM IN AMERICA.