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If Hedge Funds are the good child of Capitalism, are Banking Institutions their Evil Twin?

July 12, 2011 1 comment

First published on BBeyond Magazine blog – an ultra niche publisher that caters exclusively for the global UNHW market and community: http://bbpublications.org/BBblogs/if-hedge-funds-are-the-good-child-of-capitalism-are-banking-institutions-their-evil-twin/

Give me control of a nation’s money supply, and I care not who makes its laws.

– Mayer Amschel Rothschild

Post-credit crisis, the spotlight was already trained on large ‘unregulated’ investment vehicles. Then we had the Bernie Madoff ponzi scandal. This was followed closely by one of the largest insider trading cases worthy of a Hollywood script – the Raj Rajaratnam Galleon case, which snared senior management from some of the most prestigious Wall Street and consultancy firms.

Main Street was hit with a triple whammy – reeling from the fact that taxpayers’ money is being used to bail out banks that took on too much risk, against a backdrop of the steepest recession since the Great Depression of the 1930s, which was further exacerbated by the unpopular war on two fronts. Obama said he did not run for president to bail out a bunch of fat cat bankers. A witch-hunt was inevitable.

The opaque nature of the hedge fund industry proved an easy target. In theory, hedge funds are just capitalist. They will tear a firm down if it makes money and build it back up if it makes even more. Capitalism at its very best – hedge funds help allocate capital more efficiently by punishing inefficient firms (through short-selling) and rewarding the well-managed ones (by purchasing their stocks). As part of a group of international private investors with a sizeable war chest measuring hundreds of billions, hedge funds can significantly affect global markets and the economies of nations. As such, hedge fund failures are often well documented as their strategies are laid bare for the ensuing media scrutiny.

Long Term Capital Management’s spectacular implosion destroyed $4.6 billion. Most of it belonged to the firm’s partners. Despite its trillion dollar off-balance sheet derivative positions (due to leverage), no taxpayers’ money was used to bail them out. Subsequent academic studies noted that the Fed’s intervention, despite its good intentions, was misguided and unnecessary as it set precedence for regulating hedge fund activity. The Fed may have helped shareholders and managers of LTCM to get a better deal than they would have otherwise obtained in a rescue effort that involved a consortium of Wall Street and international banks.

When Amaranth blew up in a $6 billon bet on natural gas that went bad, another hedge fund, Citadel, stepped in and took over Amaranth’s books. This time, the markets barely flinched. As Sebastian Mallaby, author of More Money than God, puts it: “hedge funds can be a fire-starter as well as a fire-fighter”.

The global financial system and banking institutions are so intertwined that recent events have shown some banks are clearly too big to fail. Hedge funds, on the other hand, are generally small enough to fail. When hedge funds blow up, taxpayers do not foot the bill. The same cannot be said for banking institutions.

During the recent credit crisis triggered by the bursting of the US housing bubble, two of the most hallowed investment banks on Wall Street converted to bank holding companies to take advantage of a lifeline from the Fed. The rest either went bankrupt, got taken over or got bailed out. Beyond the euphemisms, firms like Citigroup, JP Morgan, Wells Fargo, Bank of America, Goldman Sachs, Merill Lynch, and Morgan Stanley were bailed out by the American taxpayers through the Troubled Assets Relief Program (TARP).  In the UK, the Royal Bank of Scotland and Northern Rock ran into the arms of the British government. Northern Rock became the first bank in 150 years to suffer a bank run. Images of the public queuing up to withdraw their money from the branches were plastered on national newspapers and will forever be seared in the minds of Northern Rock’s customers.

Whilst Hedge Funds and Banking Institutions can both be guilty of gambling with OPM (other people’s money), the hedge fund captain is more likely to go down with the ship. Hedge funds go to great lengths to justify their management and performance fees in order to align their interest with that of their investors. Fund partners often (though not always) have a significant proportion of their personal wealth invested in their own funds. In banking, on the other hand, there is a clear dislocation between management incentives and accountability. With the benefit of hindsight, incredulously, the system is essentially rigged to encourage excessive risk taking. Couple that with deregulation and the repeal of the Glass-Steagall Act and we have ourselves a recipe for disaster. History has shown that given enough rope, some of us have a tendency to hang ourselves. The problem then arises when ‘some of us’ (that may hang ourselves i.e. banks) happen to possess enormous financial power by virtue of their control of other people’s money.

The recent credit crisis may have provided ammunition to opponents of the laissez-faire approach to managing economies. One of the basic tenets of the free-market capitalist approach is that firms should be allowed to fail. Like Social Darwinism, only the strong survive and the weak die out. On the other hand, ideas of socialism, while appealing, begin a slippery slope down into communism. The problem with capitalism is the inherent disparity of wealth that creates fault lines between the ‘haves and the have nots’. The problem with socialism is that it undoubtedly leads to ‘free riding and slacking’, or as Margaret Thatcher once said: “The problem with socialism is that eventually you run out of other people’s money [to spend]”. Recent financial events have drawn parallels with a common joke that begins:

A beautiful and shallow woman said to an intelligent and ugly man: “We should get married, so our children will be as beautiful as me and as smart as you”. The man replied: “What if our children turn out to be dumb like you and ugly like me?”

This worst of both worlds approach seems to caricaturize the recent tumultuous events of our financial markets post-2007. When we have ‘too big to fail’ in a supposedly capitalistic economy, we end up with the problems of capitalism (huge disparity of wealth) AND the problems of socialism (spending other people’s money) BUT with NONE of their benefits.

Thomas Jefferson, principal author of the Declaration of Independence and Founding Father of the United States of America, the last bastion of free-market capitalism once said that “banking institutions are more dangerous to our liberties than standing armies”.

What about hedge funds that take on excessive risk through high leverage and speculation? Hedge fund luminary George Soros is infamous for being “the Man Who Broke the Bank of England” when his currency trade forced the United Kingdom out of the Exchange Rate Mechanism (a precursor to the Euro). He netted $1bn by betting on the devaluation of the pound sterling in 1992. The total cost to British taxpayers by the botched attempt to prop up the pound was put at $6.1bn (£3.3bn). Subsequent information obtained through the Freedom of Information Act noted that “if the British government had maintained $24bn foreign currency reserves and the pound had fallen by the same amount, the UK would have made a £2.4bn profit on sterling’s devaluation”.

During the 1997 Asian financial crisis, former Malaysian prime minister Dr Mahatir Mohamad publicly criticized Soros as an ‘immoral financial speculator’ while Soros described Mahatir as a ‘menace to his country’ (Mahatir later accepted that Soros was not responsible for the 1997 Asian Financial Crisis). The crisis started in Thailand when the Thai baht collapsed. Thailand had already acquired a burden of foreign debt that effectively made the country bankrupt before the collapse of its currency. Soros defended his actions by saying “speculation could benefit poor societies if it serves as a signal, not a sledgehammer”. It is worth noting that Soros held back from an all-out attack on the Thai baht. In 1992, Soros sold $10bn worth of sterling at around 2.5x the firm’s capital. The $2bn Thai trade was only one-fifth of the firm’s capital. An all-out attack would have precipitated a crisis rather than encourage the Thai government to avoid one.

In the wake of the Thai baht devaluation, Soros funds gained about $750m whilst Thailand’s economic output plunged 17% and millions fell into poverty. Hedge funds were inevitably vilified. But in a larger context, the roots of the crisis stretched back several years where ‘hot money’ pushed the Thai economy into bubble territory. The Soros team had indeed led the short selling but the actions of hedge funds were in part vindicated when the crisis spilled over to other Asian countries that engaged in ‘crony capitalism’ like Indonesia and Malaysia. What is not usually cited is the fact that Soros lost $800m buying the rupiah as he wrongly believed the turmoil in Thailand had spilled over to neighboring Indonesia without justification. This essentially wiped out all the gains he made in Thailand.  President Suharto and his cronies who controlled Indonesia’s banks drove the country to a crisis, which resulted in his own downfall. Hedge funds may have triggered the avalanche, but it was the government officials who allowed snow to build up to such dangerous levels in the first place.

Hedge funds reap the rewards when they are right and pay the price when they are wrong. Banks reap the rewards when they are right but taxpayers pay the price when they (banks) are wrong. This case of ‘heads I win, tails you lose’ has played a key role in precipitating the recent capricious events resulting from the credit crunch.

 

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Part 2: Epistemological Grounding of Thesis

December 27, 2009 Leave a comment

In line with all scientific research, this study adopts certain philosophical assumptions. Four sets of assumption about the nature of social science will be considered (Burrell & Morgan, 1979). At an ontological level, this research leans towards a realism approach, which believes in an external world that consists of structures that can be examined and understood through empirical research. In common with realism, the author, and therefore this research, is concerned with factors that lead to particular outcomes and tend to avoid generality by accepting temporal, spatial and organisational uniqueness. At an epistemological level, this research adopts an intermediate position between positivism and anti-positivism. This is because the author believes knowledge is a cumulative process (positivism) but rejects the (positivist) notion that a set of generalised laws can be developed to explain the social world.

As for the human nature debate, the research settles for a compromise between voluntarism and determinism. Implicit in this belief is a view that social science is too young to understand and untangle the complex nature of isolating the voluntary and situational factors that affect human activities (i.e. are humans determined by their environment or do they have free will?). Given our present understanding and knowledge (or the lack of it), which as previously set forth (in this research) is biased towards realism, it is therefore prudent to assume that humans do exercise ‘free will’ but at the same time we are, to a certain extent at least, a product of our environment. If, however, advancement in sociology provides new evidence regarding the influence of ‘environment’ over the autonomy of humans, the author would be happy to realign his position on the voluntarism-determinism scale. This is a difficult topic because at one extreme end voluntarism implies that humans are completely autonomous and our decisions are never affected by the environment or situation we are in; at the other extreme, determinism summits that all human actions are determined and can be explained by our environment and we do not have ‘free will’.

One important argument, which studies that emphasised a voluntaristic view have drawn upon to defend their position on human nature (Pasanen, 2003), relates to the intentionality of humans. For example, voluntaristic theorists argue that human beings can set future goals and objectives to make their present behaviour understandable, yet at the same time an entrepreneur may choose to pursue goals that are not economically rational (i.e. altruistic goals instead of profit maximising). Deterministic theorists will argue the keyword here is choice. Did the entrepreneur really choose altruism or did his upbringing and (therefore environment) play a role? Can his choice be explained by her experiences? Perhaps he was born altruistic with genes that predispose him to such behaviour? In that case, did he really make the choice of setting philanthropic goals for his company or was his choice determined by his experiences/environment?

While it may be difficult for some readers to submit that one’s conscious thoughts are not within the realms of oneself, it is worthwhile to note that a conscious belief of having a ‘choice’ (free will) does not necessarily equate to having one.

Theorists from both camps have yet to determine the line of demarcation between what constitutes autonomous and heteronomous behaviour, therefore this research adopts an intermediate position that considers both situational and voluntary factors when accounting for the activities of an entrepreneur/SME manager.

Lastly, in terms of methodological dimension, this research has a stronger preference for ideographic theory over nomothetic theory. As previously discussed, this research is concerned with factors that lead to a particular outcome (realism) and avoids generality; therefore, in line with that assumption, the author also shies away from nomothetism, which relies more on the scientific method of hypothesis testing (such as quantitative surveys and standardised research tools). The ideographic approaches to social science emphasise the analysis of subjective accounts that one generates by ‘getting inside’ a subject and exploring their background and history. For example, a study of outliers (from scientific and music geniuses to business luminaries and sport stars) ascribes individual success to a sequence of events that occur throughout the subjects’ lives (Gladwell, 2008). Success, according to Gladwell, can be explained by a series of cumulative factors that can be pinpointed to certain historical and biographical occurrences unique to the subjects.

Conventional wisdom would argue the idiographic approach lacks predictive power. It is descriptive/analytical rather than predictive. At a postgraduate or doctoral level, research should always be analytical or predictive as opposed to exploratory or descriptive for undergraduate level (Collis & Hussey, 2009). Such criticisms often originate from researchers of hard sciences who embrace the nomothetic methodology characterised by quantitative techniques. Yet often, such criticisms are also unwarranted, as the complexity and subjectivity of social sciences do not allow for the luxury of statistical significance and confidence intervals that bode well for researchers of natural sciences. As ‘success studies’ have shown, attempts to predict ‘winners’ in the field of management research have failed miserably (in terms of their predictive powers).  For all the criticisms levelled at the ideographic approach and its lack of predictive power, the nomothetic approach and its extrapolative powers have not fared any better in terms of addressing the holy grail of business management – the quest for sustained performance.

While sympathetic to the assumptions of a nomothetic approach, this research, as previously mentioned, rejects the notion that a set of generalised laws can be developed to explain the social world. Accordingly, it adopts the ideographic view that one can understand the social world by ‘getting inside’ and gaining first-hand knowledge of the subject.

In line with the author’s position of straddling both positivism[1] and anti-positivism[2] camps[3], this research also follows Kuhn’s recommendations on theory choice described in his seminal work The Structure of Scientific Revolutions (Kuhn, 1970). According to Kuhn, the five characteristics of any good theory should have: 1) Accuracy – empirically adequate with observations and results, 2) Consistency – internally and externally consistent with other theories, 3) Scope – the theory should be able to explain beyond what it was designed for, 4) Simple – Law of parsimony[4], the simpler of two competing theories is preferred, and 5) Fruitful – discloses new phenomena for research.

Although Kuhn’s work has been famously criticised by Popper, who promotes empirical falsification over inductivism, the author maintains that both verificationists and falsificationsists are essential to the growth of knowledge (in which we previously adopt the position that knowledge is cumulative). The accumulation of knowledge can only happen with new insights added to the stock of knowledge and false hypotheses eliminated (Burrell & Morgan, 1979).

Finally, as a realist, the author maintains that all beliefs are an approximation of reality and every new observation brings us closer to understanding reality (Blackburn, 2005).


[1] Positivism is generally a form of deductive research commonly characterised by the use of (scientific) statistical technique.

[2] Anti-positivism is the view that social sciences should develop different (non) scientific methods from those used in hard sciences.

[3] Kuhn’s work has been accused of blurring the distinction between scientific and non-scientific methods by the likes of Karl Popper, which ironically fits this research’s intermediate position of embracing both positivism and anti-positivism.

[4] Occam Razor is a principle that states: between two competing theories that make exactly the same prediction, the simpler one is preferred.

 

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