Wednesday, December 28, 2011

The Devil's Deal

By Bill Bonner

And now the bankers have made their devil deal too.

There was a time when banks were honest businesses. Bankers took deposits and made loans. The banker himself was responsible for the losses. If the bank went down, so did he. More than one banker, ruined by losses, blew his brains out rather than face the embarrassment of his own mistakes.

Now banks are shielded from the harsh light of legal liability by corporate veils and federal umbrellas. They can still make money — more than ever. But now they are no longer working in the private sector, providing a service, making profits and always threatened the risk of fatal losses. Now they are practically public utilities — like Amtrak or the Post Office.

Here’s the deal: the feds keep the incompetent bankers in business...and the bankers help the feds borrow money.
That is the message of the European bank bailout last week. Banks are no longer private sector enterprises. They provide a public service. In return, they are protected from their own gross errors.

What public service?

The Bank of Tokyo Mitsubishi recently noticed that it now owns more government debt than private loans and corporate bonds. It is no longer a private enterprise; it made its pact with the feds. It takes bailout money; and it helps fund the government’s deficits.

But given all that has gone on over the last 5 years, you have to wonder whether bankers are clever enough to figure it out. So, French President Nicholas Sarkozy spelled it out for them: the ECB would give them 489 billion euros (and call it a loan); they should use the money to buy government bonds (and call it an investment).
This cozy arrangement suits the bankers. They make profits without taking real risks. Besides, how hard is it to borrow from the ECB at 1% interest and re-lend to European sovereign nations at 6%? Even a banker could make money under those circumstances.

Where is the inflation?

Martin Armstrong


Germany has been obcessed with the fear of hyper-inflation that was its worst nightmare of the 1920s. The United States lives in fear of deflation as took place during the 1930s. Both are still fighting the last war. Yet this period in which we are entering is unique for it is by no means a mirror of these events of the recent past.

We are suffering the simultaneous effects of
DEFLATION and INFLATION, which can be called STAGFLATION. In other words, there will be no hyperinflation at this stage in the game and the increase in currency by the Federal Reserve using the "elastic money supply" tool, will not even be inflationary despite creating nearly $3 trillion.

How is this new world of STAGFLATION possibe? Debt & Marx! It is true that the national debts are exploding. This in isolation would appear to be inflationary as with the Fed creating almost $3 trillion. However, this is not a fish bowl. We are simultaneously suffering from a deleveraging of the economy that takes place during an economic decline where the paper values of tangible objects evaporates. We suffered in general a 60% destruction in money supply as defined by all things PEOPLE consider to be a store of value especially their real estate that serves as good collateral for loans. All the studies show people will spend more "currency" as long as they perceive that their net worth (money supply including home value) represents a profit amounting to savings – that store of value.

If we look at the peak in debt in 2007 in the United States, only one slice of the real money supply, the general leverage stood at nearly $60 trillion, This is based upon Federal Reserve data. If we now factor in the deleveraging of 60% we get a figure of $24 trillion. Of course, this is well below official estimates because they are not marking to market all debt. This would be at the most extreme nadir. Nonetheless, if the Fed increases the money supply by $2.3 trillion through its elastic capability, we can see this is like pissing in the wind – consquently QE1 and QE2 produced no inflation even if the deleveraging was only 25% say $15 trillion off the top rather than 60%.

In cycles, this is known as the
Superposition Principle. We are experiencing a Destructive Inference whereby we have INFLATION being generated by government through the expansion of debt in the classic sense and the elastic money supply capacity of the Federal Reserve. This, however, is being offset by the DEFLATIONARY trend created by the deleveraging and fall in value of the "real" money supply composed of all things tangible including real estate, stocks, and even gold. If government were expanding the currency supply (currency and bonds) in isolation, we would have the risk of HYPER-INFLATION. However, since we are deleveraging still in the private sector, these two trends are offsetting each other creating a DESTRUCTIVE INFERENCE, which is why gold has NOT broken through that $2,000 barrier. These are two trends that are diabolically opposed to one another. Leaving out the Sovereign Debt Crisis of 1931 from the history books to further the Marxist agenda has clearly prevented us from moving on and understanding the whole economic world in which we live.

This is why government is becoming aggressive. It is fighting for its life and this trend of consuming more resources/capital to sustain itself is like a drug addict. It will not stop! Government will turn more and more against the LIBERTY of the people to retain its perceived power. It will not see its own actions as a cause and effect.

Gold reaction ?

Martin Armstrong

Our first Monthly Bearish Reversal lies at 1465.70 and the next Weekly Bearish is at 1522.70. The major support begins at 1225 and our year-end number is 1434.
I may be the only long-term bullish analyst who is bearish on gold near-term. It is often hard to explain to people all the nonsense surrounding gold is just that – nonsense. Everything from fiat to the predictions we will head into hyperinflation are just so wrong, yet to say that guarantees 100 emails of pure hate.

Let me explain one more time why there is no inflation
NOW despite the fact the Fed created almost $3 trillion of elastic money. When you have almost $60 trillion in debt, forget the derivatives and the unfunded liabilities, that contraction is far greater than the $3 trillion the Fed created. At the very least, there is a bare minimum of $15 trillion that evaporated in the deleveraging in debt on top of all the extreme numbers on derivatives. The efforts of QE1 and QE2 failed to stimulate and they failed to create inflation. We are suffering from DEFLATION at this time that is not yet over.

At the most extreme, gold could even collapse back to retest the 1980 high of $875 if we were to see a Quarterly closingBELOW 1113. That would shift the real rally most likely into the 2015-2020 time slot. For those that were at the Conference, we are reaching that point of maximum entropy where everyone who thought of buying has bought, and in the correction is likely to shake the tree.

When will gold rally? When we see new bond offerings go unsold in the USA. The critical place to watch is Europe and Japan.

Saturday, December 24, 2011

Liquidity Crisis in Indian Banking System?

The Marginal Standing Facility

Deepak Shenoy
In an attempt to unravel what’s happening with liquidity in India, let me explain a new concept called the Marginal Standing Facility (MSF).
When you deposit money in a bank, it has to keep 6% of that money as a reserve called Cash Reserve Ratio (CRR) against withdrawals by depositors as a whole. It also has to put 24% in Government of India bonds as a “Statutory Liquidity Ratio” (SLR) requirement. The rest it can lend out.
Usually banks buy excess SLR-able bonds, maybe upto 28% of deposits. The excess they can use to generate quick liquidity if they so desire.

To meet liquidity requirements, banks get to borrow from the RBI, with auctions conducted everyday for overnight (or over weekend) borrowing. This is called “repo” – or “repurchase” operations, where banks borrow overnight from the RBI and place, as collateral, the excess SLR securities. This happens currently at 8.5% per annum, but repo rates change.
Now the operation is conducted as a sell-repurchase operation – so the RBI actually buys the security from the bank, but the bank is forced to buy it back at a higher rate (the rate differential is at the 8.5% annualized rate for the period borrowed).

What happens if banks don’t have any excess SLR bonds, but are desperate for some cash? This has happened in the early part of 2011, when the RBi started to conduct TWO repo auctions per day instead of one, and relaxed SLR requirements. (They are called LAF auctions, or “Liquidity Adjustment Facility”. Don’t ask.)

To avoid this – since the SLR is in a way a sacrosanct figure – the RBI introduced the Marginal Standing Facility or the MSF. I call this “despo” borrowing, since it’s done just like Repo except:
a) it comes at 9.5%, not 8.5% (a full percentage point higher than repo).
b) banks must place GOI bonds as collateral. But if they do that, since it’s a sell-and-repurchase operation, the bank will not own the GOI bond after the auction (it’s sold to the RBI). Which means it will violate SLR requirements of 24% of deposits. But if used for the MSF, the RBI allows the bank a relaxation of SLR limits. This relaxation is only upto 1% of the deposit base of the bank; above that is still subject to RBI penalties.

Now banks don’t pay 9.5% unless they are in a liquidity crisis, have maxed out repo and can’t access the call money markets. Then, the MSF borrowing is used, but is a sign of stress: that’s why it is “despo” borrowing. RBI reveals MSF figures every day in a press release marked “Money Market operations).

The RBI is the lender of last resort – that MSF is being used indicates that banks really need money, and they can’t get it from depositors (perhaps depositors are withdrawing money in large numbers – like for advance tax payments) Banks can’t generally go to people they have lent money and say give me back the loan earlier than its term, so they use the RBI facility like repo, and failing that, the MSF, to tide over any intermittent demands for money.

Friday, December 23, 2011

Bill Bonner on Human History

And so, yesterday, the northern hemisphere had its shortest day of the year. In Baltimore, the sun never rose and never set. It was gray all day. Then it was night again.

And so the days dwindle down to a precious few. In astronomical terms, the year is already over. We have passed the winter solstice. From here on out the days grow longer. In terms of the Gregorian Calendar, we still have a few more days to go in 2011. Then, we face a new year. New challenges. New crises. And new opportunities. Will 2012 be the year the human race goes into a downturn...a slump...a correction?

Time moves on. So do opinions.

Investors were all hot to put their money on stocks on Tuesday. They thought the euro debt crisis had been solved. And housing was looking up in the US.

But yesterday, there was no follow-through. It was as if they had forgotten what they were so excited about.

That’s the way it has been all year. One day, investors are sure recovery is right around the corner. Then, they turn the corner and there’s nothing there.

2011 began with most people expecting a recovery. Now, they know; there’s something else going on. Something more complicated...something different from the typical recession/recovery pattern they’ve been used to.

If they looked more closely, they would notice that each of the recoveries since the ’80s has been a bit weaker than the one that preceded it. The feds still fight downturns in the same way — with counter-cyclical fiscal and monetary policy. Each time output goes down, the Fed reduces interest rates. This cuts the price of credit, which usually gets people going again — with new investments and new hiring.

But credit is not so different from everything else in the world of economics. The law of diminishing marginal utility applies. The first dollar you borrow pays off. You put it to work building new, more efficient and more productive businesses. The investment pays off. Later borrowings are less effective. Finally, they don’t work at all.

Part of the explanation is merely that the borrowers shift from borrowing for very productive purposes to borrowing for less productive borrowing not to produce at all. There’s no payback when you borrow to consume. Zero.

Finally, the recession of 2001 was met with a muscular Fed response — with much lower interest rates and a federal budget far in the red. But the recovery was the weakest ever. It was a “jobless” recovery, with an unusually slow rehiring pattern.

Now, 10 years later...we have something new — a jobless non- recovery! People are beginning to wonder. What is really going on?

Even Martin Wolf, chief intellectual at The Financial Times is beginning to ask questions. “The future is not what it used to be,” he writes.

Here at The Daily Reckoning we have known for a long time that the Great Correction is no ordinary recession. We didn’t know exactly what it was correcting, but we had a list of possibilities.

Is it correcting the 60-year boom in credit that began after WWII? Seems like it is... Credit, in the private sector, has been going down since 2008.

Is it correcting the bull market in stocks that began in August 1982? So far, not much sign of it...but we think so. People are bound to realize, sooner or later, that business profits cannot expand when credit is contracting.

Is it correcting the power of the US empire? Yes...perhaps...but that’s a long story for another time...

Is it correcting the paper-currency, faith-based, centrally-planned monetary system put in place by Richard Nixon in 1971? Not yet. Instead, US debt — denominated in those paper dollars — gets more respect than ever. But we have a feeling that it will be corrected before this crisis complex is over.

On Monday, word got out that the European Central Bank has lined up with the Fed and other central banks to fight the debt crisis by...yes...creating more debt. And more paper currency. It will lend another half-trillion euros — or so — to the banks. The banks are supposed to make more new loans and buy up more old ones. Specifically, they’re expected to take money from the central banks and use it to buy government debt, thus keeping the chickens from coming home to roost as long as possible.

In the meantime, economic growth, it is hoped, will finally get into action. Growth, they think, is the “mean” to which the developed economies will revert...which will raise GDP and tax receipts, reducing deficits and debts.

But what if growth itself were being corrected?

What if the entire period from the invention of the steam engine to the invention of the internet were not the normal thing, but the abnormal thing? What if the “lost decade” we have just gone through is actually the mean...the usual...the normal thing? And what if — after nearly 3 centuries — we have just now reverted to it?

Until about two weeks ago, we thought human beings had only existed for 100,000 years. Now, archeologists are guessing that we’ve been around as a species for twice as long.

You know what that means? It means that our mean rate of growth — already negligible — is actually only about half what we thought it was. In other words, it took not 99,700 years for humans to invent the steam engine, but 199,700. And now, what if we are not going on to something new, but back to something old? What if the New Age is really more like the Old Age...where growth and progress were unknown.

Let’s see, the typical person in 1750 lived better than the typical person in say 100,000 BC. The person in 100,000 BC lived in a cave or maybe a wigwam. The typical person in 1750 lived in a hovel. There were some great houses too, of course. By the 18th century, humans had been building with arches and columns...and domes...dressed stone with elaborate decoration...for thousands of years. But most people had no access to those monuments. They lived in whatever they could put together — usually of wood or mud.

They lived on what they could grow...with their own hands, or with the help of domesticated draft animals. They hunted wild animals...or got their calories from their own herds and flocks.

The person from 100,000 BC was a hunter-gatherer. But his life was not all bad. At least he got plenty of fresh air and didn’t get caught in traffic jambs or have to watch television.

But the progress between 200,000 BC, when mankind is now thought to have 1765, when Watt produced his first engine...was extremely slow. In any given year, it was nearly negligible...imperceptible. Over thousands of years there was little progress of any sort, which was reflected in static human populations with static levels of well-being.

Then, after 1765, progress took off like a rocket. Over the next 200 years, the lives of people in the developed countries, and the human population, generally, changed completely.

It took 199,700 years for the human population to go from zero to 125 million. But over the next 250 years it added about 6 billion people. Every five years, approximately, it added the equivalent of the entire world’s population in 1750. “Progress” made it possible. People had much more to eat. Better sanitation. Better transportation (which eliminated famines, by making it possible to ship large quantities of food into areas where crops had failed). The last major famine in Western Europe occurred in the 18th century when crops failed. After that, the famines in the developed world at least have been intentional — caused largely by government policies.

Progress abolished hunger. It permitted huge increases in population. And it brought rising real wages and rising standards of living.

By the late 20th century, people took progress and GDP growth for granted. Governments went into debt, depending on future growth to pull them out. So did corporations and households. Everyone counted on growth. Spending and tax policies were based on encouraging growth. The enormous growth in government itself was made possible by economic growth. After all, as we’ve seen in our Theory of Government, beyond the essentials, government is either parasitic or superfluous. The richer the host economy, the more government you get.

Today, there is hardly a stock, bond, municipal plan, government budget, student loan, retirement program, housing development, business plan, political campaign, health care program or insurance company that doesn’t rely on growth. Everybody expects growth to resume...after we have put this crisis behind us.

Growth is normal, they believe.

But what if it isn’t normal? What if it was a once-in-a-centi- millenium event, made possible by cheap energy?

Saturday, December 10, 2011


Martin Armstrong

Hypothecation of client assets takes place in investment banking, when assets deposited with a broker may be sold if client fails to keep up credit payments or if the securities drop in value and the investor fails to respond to a margin call (a request for more capital). Re-hypothecation occurs when a bank or broker utilizes collateral posted by clients, including those of hedge funds, to back the broker’s own trades and borrowings.

Even under the U.S. Federal Reserve Board's Regulation T and SEC Rule 15c3-3, a broker-dealer may re-hypothecate assets to the value of 140% of the client's liability to the broker-dealer. In other words, assume a customer has deposited $1000 in various securities and has a current debt deficit of $500, resulting in net remaining equity of $500. The broker-dealer can then re-hypothecate up to $700 (140% x $500) of these assets. This now leverages the taking of client’s money on an undisclosed basis.

In the UK, there is unquestionably no statutory limit whatsoever on the amount that can be re-hypothecated. In fact, brokers are free to re-hypothecate all and even more than the assets deposited by clients is truly astonishing. However, at least there it is up to clients to negotiate a limit or prohibition on re-hypothecation whereas in America it is not even disclosed. Therefore, US broker-dealers have an advantage when opening a UK operation allowing them to bounce back and forth exploiting both systems. Why do you think that AIG was operating in London? This irregularity of rules between the two markets enables exploiting the UK regime very attractive to international brokerage firms to employ European subsidiaries to create pools of funding for their U.S. operations, without the bother of complying with U.S. regulations even if they did bother to enforce them.

This is why the collapse was so devastating following the 2007 high. The re-hypothecation in the REPO market had grown so enormous also using the mortgage backed securities rated AAA amounting to half of all the activity within this "shadow banking system" known as REPO. Prior to the Lehman Brothers collapse, the International Monetary Fund (IMF) had actually calculated that US banks were receiving $4 trillion worth of funding through this re-hypothecation scheme, most of which was being sourced from the UK. With even the mortgage backed assets being re-hypothecated many times over in London (the "churn"), the original collateral being used may have been as little as 25% of the total volume reported to have been $4 trillion. This is why $700 billion was needed in Tarp. Nobody was looking at just how big the bailout had to be and behind the curtain the Fed and Treasury had to see this degree of leverage. The fact that MF Global has blown-up, demonstrates that Congress did not address the real issues in this whole mess allowing the shit-to-hit-the-fan hoping that the bankers would make a ton of money and grow the economy out of this mess all on other people’s money!

The practice of re-hypothecation today runs into the trillions of dollars and is faultlessly legal under current law. If Congress is not grandstanding once again, then write a statute and state banks and brokers can do NOTHING with client’s assets whatsoever without a contract and payment for the use of such assets. It can no longer be justified that banks and brokers on the basis that it is a capital efficient way of financing their operations that amounts to trading illegally with other people’s money. Investors in hedge funds should DEMAND that assets NOT be left on deposit in ANY Investment Bank right now until this issue is clearly made illegal. 16

US broker-dealers have been making great use of their European subsidiaries since re-hypothecation is so hugely profitable being free money. US client’s assets are being transferred to the broker dealer’s UK subsidiary to circumvent US re-hypothecation rules.

MF Global

Martin Armstrong

MF Global was allowed to take customer funds for their own use and this has been allowed by the regulators who are bought and paid for and have NEVER prevented a damn thing. MF Global plowed money into an off-balance-sheet maneuver known as a repo, or sale and repurchase agreement. A repo involves a firm borrowing money and putting up assets as collateral, assets it promises to repurchase later. Repos are a common way for firms to generate money but are not normally off-balance sheet and are instead treated as "financing" under accountancy rules. In this case, MF Global used the version of an off-balance-sheet repo called a "repo-to-maturity." The repo-to-maturity involved borrowing billions of dollars backed by huge sums of sovereign debt, all of which was due to expire at the same time as the loan itself. Since the collateral and the loans matured simultaneously, MF Global was entitled to treat the transaction as a "sale" under US GAAP. This is how MF Global moved $16.5 billion off its balance sheet hiding its bets on Italy, Spain, Belgium, Portugal and Ireland.

Backed by the European Financial Stability Facility (EFSF), it was a clever bet (at least in theory) that certain Eurozone bonds would remain default free whilst yields would continue to grow. Ultimately, however, it proved to be MF Global’s downfall as margin calls and its high level of leverage sucked out capital from the firm. For more information on the repo used by MF Global please see Business Law Currents MF Global – Slayed by the Grim Repo?

MF Global has exposed also the leverage employed by NY firms. In order to lose $1.2 billion of its clients’ money in the acquisition of a sovereign debt position of $6.3 billion, which was more than five times the firm’s net worth, it exploits another loophole between UK and US brokerage rules on the use of client’s funds known as "
re-hypothecation". In other words, the borrower pledges collateral to secure a debt but he retains the title and the creditor technically has only a "hypothetical" control of the title to the assets. The creditor may seize possession ONLY if the borrower defaults.

Here is the legal loophole between the US and the UK. In the U.S., this legal right takes the form of a lien upon a specific asset while in the UK this is a floating legal charge. A floating charge is a security interest over a fund of changing assets of a company or a limited liability partnership (LLP), which "floats" until conversion into a fixed charge or specific lien, at which point the charge attaches to specific assets. The conversion (called crystallization) can be triggered by a number of events. This it has become an implied term in debentures (in English law) that a cessation of the company's right to deal with the assets in the ordinary course of business will lead to an automatic crystallization. This is normally expressed in terms of a typical loan agreement where the seizure of assets takes place upon default by the charger is a trigger for crystallization. Such defaults typically include non-payment, invalidity of any of the lending or security documents or the launch of insolvency proceedings. Under UK law, a floating legal charge can only be granted by companies and cannot be sustained by an individual person or a partnership for in such cases that entails a specific lien on assets. 14

This floating legal charge is known as "one of equity's most brilliant creations" and takes effect ONLY in the absence of LAW. The Judiciary Act of 1789 that created the US district courts states clearly: "SEC. 16. And be it further enacted, That suits in equity shall not be sustained in either of the courts of the United States, in any case where plain, adequate and complete remedy may be had at law." You cannot eliminate the law of a statute by resorting to equity, yet this has become a treasonous standard practice in America. This is at the heart of judicial corruption and tyranny.

In other words, Americans harmed by MF Global taking their assets would have had more rights in Britain than in New York. In practice, as the charger has power to dispose of assets under a floating legal charge, this is only of any consequence in relation to disposals after the charge has crystallized. Since in the United States they NEVER disclose that they are using client’s money, under EQUITY there was no legal right to the "re-hypothecation" of client’s funds since it was not disclosed and the client did not relinquish title to the assets and did not even lease them for such use.

MF Global exploited a loophole between US and UK law that is criminal. A mutual fund/hedge fund is legally different from a broker-dealer. There you invest in the fund and receive shares. You have now relinquished the title to the assets and thus "re-hypothecation" is expected for the fund manager is not managing your specific money differently from another. However, when you open an account at the brokerage house or bank that account is your and you did NOT relinquish title to the assets. Since they also do not disclose they are using your assets for their own trading, you certainly did not give up your title and therefore they legally cannot engage in "re-hypothecation" of your assets for their benefit. If any lawyer tells you different, get a new lawyer. NEVER EVER use a law firm from the same city in which you are filing a suit. He will blow smoke up your ass and "imply" how he knows the judge, the prosecutor, or whatever as if they were friends and that inside position will benefit you in some way. That is a sales pitch that is bogus for it works in the opposite manner. Because of those very relationships and the fact that the practice of the lawyer is in that town, his business relationships long-term are more important to him than you one-time case. He will never piss off the judge because he has to be before him on other cases. So NEVER use a firm from the same city. It is a disaste

Friday, December 2, 2011

Hedge Funds: The New Dumb Money

Much of the fury in yesterday’s nearly 500 point “melt up” in the Dow was generated by hedge funds panicking to cover shorts. Convinced of the imminent collapse of Europe, the impotence of governments, and the death spiral in sovereign bonds, many managers were running a maximum short position at the Monday opening, and for the umpteenth time, were forced to cover at a loss. Meet the new dumb money: hedge funds.

When I first started on Wall Street in the seventies, you heard a lot about the “dumb money.” This was a referral to the low end retail investors who bought the research, hook-line-and-sinker, loyally subscribed to every IPO, religiously bought every top, and sold every bottom.

Needless to say, such clients didn’t survive very long, and retail stock brokerage evolved into a volume business, endlessly seeking to replace outgoing suckers with new ones. When one asked “Where are the customers’ yachts”, everyone in the industry new the grim answer.

Since the popping of the dot-com boom in 2000, the individual investor has finally started to smarten up. They bailed en masse from equities, seeking to plow their fortunes into real estate, which everyone knew never went down. Since 2008, the exit from equities has accelerated. There have been over $400 billion in redemptions of equity mutual funds, compared to $800 billion in purchases of bond funds.
Although I don’t have the hard data to back it, I bet the average individual investor is outperforming the average hedge fund in 2011. With such heavy weightings of bonds and cash, how could it be otherwise. While the current yields are miniscule, the capital gains have to be humongous this year, with yields plunging from 4% to 2%.

This takes me back to the Golden Age of hedge funds during the 1980’s. For a start, you could count the number of active funds on your fingers and toes, and we all knew each other. The usual suspects included the owl like Soros, the bombastic Robertson, steely cool Tudor-Jones, the nefarious Bacon, the complicated Steinhart, of course, myself, and a handful of others.
The traditional Wall Street establishment viewed us as outlaws, and believed that if the trades we were doing weren’t illegal, they should be, like short selling. Investigations and audits were a daily fact of life. It wasn’t easy being green.

It was worth it, because in those days, if you did copious research and engaged in enough out of the box thinking, you could bring in enormous profits with almost no risk. I used to call these “free money” trades. To be taken seriously as a manager by the small community of hedge fund investors you had to earn 40% a year, or you weren’t worth the perceived risk. Annual gains of 100% were not unheard of.

Let me give you an example. In 1989, you could buy a warrant on a Japanese stock near parity, for $100 that gave you the right to own $500 worth of stock. You bought the warrant and sold short the underlying stock. Overnight yen yields then were at 6%, so 500% X 6% = 30% a year, your risk free return. If the stock then fell, you also made money on your short stock position. This was not a bad portfolio to have in 1990, when the Nikkei stock index plunged from ¥39,000 to ¥20,000 in three months, and some individual shares dropped by 80%.
Trades like this were possible because only a smaller number of mathematicians and computer geeks, like me, were on the hunt, and collectively, we amounted to no more than a flea on an elephant’s back.

Today, there are over 10,000 hedge funds managing $2.2 trillion, accounting for anywhere from 50% to 70% of the daily volume.

Many of the strategies now can only be executed by multimillion dollar mainframe computers collocated next to the stock exchange floor. Winning or losing trades are often determined by the speed of light. And as the numbers have expanded exponentially from dozens to hundreds of thousands, the quality of the players has gone down dramatically, with copycats and “wanabees” crowding the field.

The problem is that hedge funds are no longer peripheral to the market. They are the market, and therein lies the headache. How are you supposed to outperform the market when it means beating yourself? As a result, hedge fund managers have replaced the individual as the new “dumb money, buying tops and selling bottoms, only to cover at a loss, as we witnessed on Monday.
The big, momentum breakout never happens anymore. This is seen in hedge fund returns that have been declining for a decade. The average hedge fund return this year is a scant 1%. Make 10% now and you are a hero, especially if you are a big fund. That hardly justifies the 2%/20% fee structure that is still common in the industry.

When markets disintegrate into a few big hedge funds slugging it out against each other, no one makes any money. I saw this happen in Tokyo in the 1990’s, when hedge funds took over the bulk of trading. Volumes shrank to a shadow of their former selves, and today, Japan has fallen so far off the radar that no one cares what goes on there. Japanese equity warrants ceased trading by 1995.

How does this end? We have already seen the outcome; that investors flee markets run by hedge funds and migrate to those where they have less of an impact. That explains the meteoric rise of trading volumes of other assets classes, like bonds, foreign exchange, gold, silver, and other hard assets.

Hedge funds are left on their own to play in the mud of the equity markets as they may. This will continue until hedge fund investors start departing in large numbers and taking their capital with them.

The December redemption notices show this is already underway. Just ask John Paulson.