David Stockman, Budget Director under President Reagan and then a partner at private-equity firm Blackstone Group, mercilessly dissects hedge funds – “the last thing hedge funds do is hedge” – in Chapter 23 of his bestseller, THE GREAT DEFORMATION: THE CORRUPTION OF CAPITALISM IN AMERICA.
The operative word with respect to these giant hedge fund pools is “capricious.” Savers traditionally functioned on the free market as agents of financial discipline, allocating funds to asset managers who had established a well-seasoned record of diligence, rigor, and consistency. By definition, old-fashioned savers on the free market deliberately chose to defer immediate consumption and gratification; they were looking for stable, reliable returns over the longer haul, not overnight riches.
Needless to say, the Fed’s prosperity management model has led to the extinction of the traditional saver class. During the fourteen-year period since the Greenspan Fed panicked at the time of the LTCM crisis, its interest rate repression policies have resulted in an inflation-adjusted return on six-month bank CDs of exactly zero percent. In so many words, the policy message of the nation’s central bank was “don’t save through any instrument which is liquid.”
This unconscionable blow to traditional savers was especially perverse because it harmed the middle class far more than the wealthy. Much of the middle class was discouraged from saving entirely, as the dismal data on the household savings rate clearly documents. Worse still, out of desperation, greed, or both many others were induced to speculate in the serial stock market and housing bubbles generated by the Fed after September 1998, a course of action which led to serious loss of capital.
At the same time, the Fed’s destructive interest rate repression policies literally revolutionized the saving and investment habits of the top tier of wealthy households. Unlike hapless savers among the middle class, the rich had an escape route. In their wisdom, regulatory policy makers had decreed that the legal drinking age for financial risk taking is $5 million of liquid net worth. Accordingly, hedge funds were exempted from SEC regulation as long as they didn’t solicit undersized speculators.
For several decades after the SEC was established, this financial carding threshold didn’t matter too much because the wealthy had no reason to get frisky with their savings. Between 1953 and 1971, annual inflation-adjusted returns on bank deposits averaged 2 percent; corporate bonds yielded 3 percent after inflation; and equities including dividends returned 5 percent in inflation-adjusted dollars.
By contrast, the incidence of rocket-ship gains was very low. As has been seen, the likes of Marriner Eccles and William McChesney Martin didn’t see great merit in the speculative urges.
When the Greenspan Fed inaugurated the era of bubble finance, however, the picture changed dramatically. The wealthy did not arrive at their august financial stature out of conviction that the meek shall inherit the earth. So when flushed out of their traditional fixed-income safe havens, they proactively formed “family offices” and hired professionals to pursue alternatives to negative real returns.
At the same time, the rise of financial market leverage and momentum trading dramatically increased the probability of hitting the jackpot in risk asset markets. It became rational to speculate and especially to “buy the dips” because it was the deliberate policy of the nation’s central bank to inflate risk assets.
For fleet-footed traders who could stay ahead of the Fed’s money market maneuvers and smoke signals, the odds were particularly rewarding. They could chase the continuously revolving cast of highflyers in the speculative precincts of the market, while relying on the Greenspan-Bernanke Put to insure their trading book against an unexpected plunge in the broad market averages.
It is ironic that the Fed has never comprehended the awful damage the Greenspan Put wreaked upon the financial markets, because the proof was right there in its Long-Term Capital Management birth event. The proximate cause of the great LTCM crisis, in fact, was the failure of the downside insurance mechanism that John Meriwether perfected to protect his speculative book. In that case, LTCM’s “long” speculations were embedded in a massive portfolio of exotic fixed-income and currency positions, so the downside risk was the threat of significant rise in “benchmark” interest rates as embodied in the yield of US Treasuries.
An increase in benchmark rates would result in sharp losses to LTCM’s entire book of yield-sensitive speculations. The insurance mechanism, therefore, was shorting the Treasury market so that if worldwide interest rates rose, possibly due to a tightening by the Fed, LTCM would profit from falling Treasury bond prices. In this manner, gains on the Treasury short position would offset the losses on LTCM’s book of speculative longs.
This downside insurance worked like a charm for Meriwether over the better part of twenty years, until the Russian default of August 1998. That triggered a violent flight to safety in US Treasury paper that was unprecedented in speed and scale, and could be found nowhere in the data histories that drove LTCM’s Nobel Prize–winning trading models. Indeed, it was the first great “risk off” panic of the Greenspan era. It turned LTCM’s portfolio of advanced financial alchemy into the equivalent of a bug on the world’s financial windshield.
The fund’s longs got clobbered due to the flight from risk assets. At the same time, its short position in Treasury debt turned out to be not a rainy-day insurance policy but a protracted nightmare. Treasury bond prices did not fall like they were supposed to but, instead, rose relentlessly. A global tidal wave of panicked treasury buying thereby caused gargantuan losses on LTCM’s long-standing short. In only a matter of days, therefore, LTCM’s insurance plan devoured the fund’s assets and the end came hard upon.
What this celebrated episode actually revealed was that Meriwether had been wrong all along about the true cost of his portfolio insurance: it was much higher than he had been booking during years and years of prodigious profits.
The true high cost of the short Treasury hedge lay hidden in the financial market weeds, as it were, until it showed up as the sudden, violent inflation of a “fat tail.” Accordingly, Meriwether’s access to underpriced portfolio insurance led the team of gifted traders he assembled over two decades to run a book that did not have a sufficient loss reserve for the fat tail cost that someday would come all of a sudden. Indeed, had the all-knowing accountant in the sky been charging Meriwether’s accounting statements each and every quarter with a pro rata share of the coming fat tail loss, the curve of his spectacular earnings history would have been crushed back toward the mean.
The spectacular blow up of LTCM was therefore a godsend. It warned that the maestro’s fretting about “irrational exuberance” in December 1996 had been spot-on and that risk taking and leverage had already reached dangerous extremes by August 1998. But even more crucially, it highlighted the incendiary effects of underpricing downside insurance against an unexpected plunge of the broad market.
LTCM’s demise came because its downside insurance had been under-reserved. But now the Fed’s solution to the modest market turmoil its demise caused was to extend downside insurance to the entire machinery of Wall Street speculation at essentially zero charge. What had been a de facto Greenspan Put now became explicit commitment, and thereby was taken by speculators as a near-solemn pledge that the central bank henceforth had their back.
Then and there, the deformation of the stock market went into a far more virulent and ultimately destructive phase. Now the surging pools of speculative capital being assembled by the hedge funds would become ever more reckless in their trading behavior and ever more insistent that the Greenspan Put be honored at all hazards.By David Stockman, author of THE GREAT DEFORMATION: THE CORRUPTION OF CAPITALISM IN AMERICA.