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Mark's Market Blog

11-14-08: Hedge Funds, CDOs, Tarps, and Pensions

By Mark Lawrence

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Another week, another drop in the stock markets. It is proving impossible for any rally to gain any sort of traction at all in the current uncertain environment: the uncertainty is what will Bush and the Republicans do for the next two months, and what will Obama and the Democrats do after that.

S&P 500, Week of 11/14/08

S&P 500, Last 90 days, 11/14/08

There is huge downwards pressure on stock prices from hedge funds. Hedge funds are highly leveraged: for each dollar of investors' money, they typically have another dollar or three of loans. So each time an investor asks for a redemption of a dollar, the hedge fund will be forced to sell $2-$4 of stocks. There's a whole house of cards built based on this: there are hedge funds that do nothing but invest in other hedge funds, again doubling or tripling their investors' money with loans. Finally, it turns out a lot of the investors have, on the advice of their brokers, borrowed money to invest in the hedge funds. As these loans get called, there's a huge multiplier in stock market sales. How big is it? Hedge funds controlled about $1.3 trillion at their peak, roughly 10% of the entire stock market. How bad is it? Las Vegas and Atlantic City have seen their revenues drop by 25% to date. Michael Jackson walked away from Neverland this week. If you're looking for a good deal on a weekend get-away bungalow in the Santa Barbara area. . .

This same leverage effect was a large part of the problem in the stock market crash of '29. Since that crash, the SEC enacted strict rules on buying stocks on margin. Somehow, by a mechanism I don't really understand, the hedge funds have gotten around these rules and done exactly the same thing that investors did in '29. The result of that crash was that stock prices fell and the DOW did not recover to its previous high until November 1954, 25 years later. While I don't expect any such 25 year bear market this time, there's no question that it will take some time to dig out of this rut, and yet more SEC rules are certainly going to happen. If Greed is Good, then last year Wall Street was the Goodest place on the planet.

CDSs (credit default swaps, Warren Buffet's 'Weapons of mass financial destruction') are unwinding, meaning people are paying off more contracts than they are accepting. The total CDS market is now down to $33 trillion. To put this in perspective, this is about 2 times the US GDP.

Senate Republicans and the Bush administration are balking at loans for the auto companies. It now appears that any such loan package will have to wait until after January 20th. The public view of Republicans is that GM is just another badly run business and the tax payer should not be on the hook for their bad decisions. The private agenda is that this is thought to be the moment to weaken Detroit to the point of busting the UAW once and for all: Republicans and unions have had a mutual hate thing going on for 50 years. The bottom line is that Republicans have had their time at the public trough, bailing out their investment buddies to the tune of about $500B. Soon it will be the Democrats turn at the trough, when they can bail our their buddies: organized labor and inner-city beleaguered home owners. Can a Hollywood bailout be far behind? Do your Patriotic Duty and go see Quantum of Solace today - I will.

TARP, the Troubled Asset Relief Program, was originally passed at $700B total. Half of that was given to Sec. Treasury Paulson, he's to return to congress to ask for the second half if and when. The when is now - he's pretty much spent his first $350B. His mandate is to help banks, with the result that everyone is converting to bank status as fast as possible - American Express is now a bank as of last week, for example. GMAC, General Motor's leasing and loan division, was recently turned down by the Fed in their bid to convert to bank status. It's a near certainty that the next congress is going to have to increase the funds to over $1 trillion. Too bad Senator Dirksen is gone - I'm sure an update to his quote "A billion here, a billion there, and pretty soon you're talking real money" would be most entertaining.

The next big crisis on my horizon: Pension funds. These are guaranteed by the Federal Pension Guarantee Corporation. In a recession, things change forever: in Nixon's recession, we saw the end of full-service gasoline (check your oil ma'am?). Bush's recession ('90) saw the end of the large car and its replacement with the SUV. Today we're seeing the end of corporate pensions and health care plans. In Nixon's recession we saw the end of defined-benefit retirement plans for all but government workers and UAW members. Instead, we all started in on defined-contribution plans, aka 401(k)s. Today we're seeing more and more corporations discontinue matching contributions on 401(k) plans, and health care benefits are getting thinner and more rare. Generation X is going to have to learn how to save money, something they will not be learning from their boomer parents. Obama, of course, is going to fix the health care crises. I wonder if he can fix global warming and the common cold too?

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