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 Wishful thinking 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 (see Why are so many people going hungry?), 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.
See also:
- The dollar down the pan – monetary chaos to follow? by Mick Brooks (May 1, 2008)
- Capitalism beared by Michael Roberts (March 27, 2008)
- US slides into recession - who's next? by Mick Brooks (March 17, 2008)
- Financial meltdown: another day, another finance house bites the dust by Mick Brooks (March 17, 2008)
- 1929: Can it happen again? by Mick Brooks (March 17, 2008)