Central bankers fear the monsters they created -- hedge funds

The Secret World of Hedge Funds

By Ambrose Evans-Pritchard
The Telegraph, London
Monday, May 14, 2007

http://www.telegraph.co.uk/money/main.jhtml?xml=/money/2007/05/14/ccview...

The world's top 25 hedge fund managers earned an average of $570 million each last year, despite the crush of 8,000 funds all competing for a smidgeon of extra yield in the global marketplace. That much we know.

Dr James Simons, a maths PhD and former cryptanalyst for the Pentagon, netted $1.7 billion at Renaissance Technologies Corp, followed by Citadel's Kenneth Griffin at $1.4 billion.

Less known is how the stars operate, and how they view the world. For a glimpse into their clandestine affairs, try Steven Drobny's book, "Inside The House Of Money," based on long lunches with 13 American, British, and European fund managers, each a legend in his own sector, and each replete with tales of how they nearly "blew up" -- hedge fund parlance for going bust.

Such funds are not new. John Maynard Keynes ran his "Syndicate" for a group of friends, and another for King's College, Cambridge. The "College Chest" made a 13.2 percent annual return from 1928 to 1945, through the Great Depression. Keynes learned the hard way like everyone else, sage though he was. His personal account was wiped out by a margin call in the commodity slide of 1929.

Hedge fund man is by nature a contrarian. He -- rarely she -- bucks consensus as a way of life, profiting whenever the price of any asset, derivative, or country looks out of whack. No surprise that so many view the current blow-off rally in junk bonds and Chinese stocks with deep suspicion, a sign that the cycle is nearing a top.

More unnerving is the number who fear something worse, afraid that governments may have upset the workings of capitalism by holding interest rates too low for too long -- that is, by mispricing credit. The villain of this book is former Fed chief Alan "Easy Al" Greenspan.

"My gut feeling is that there will be a lot of pain because we still have to pay for the 1990s, and that worries me," said Christian Siva-Jothy, founder of SemperMacro. His ordeal by fire came as a cocky trader for Goldman Sachs when he bet $1 billion that sterling would rise against the yen in 1994. Politics intruded, a recurrent theme.

President Clinton threatened Japan with car tariffs over alleged currency manipulation. (Sound familiar? China?) The yen soared. "If that wasn't bad enough, five days later UK inflation numbers were simply awful. Sterling went into a free-fall. It was classic -- the market found me," he said.

"On Day 8 of this episode, when I lost about $40 million in one day, I felt this overwhelming desire to walk out and pretend it wasn't happening. Instead I took a deep breath and liquidated everything. Confidence is a very dangerous thing," he said.

His top trade is to buy eurodollar futures whenever the Fed starts cutting US rates.

It worked like a charm after the Russian crisis in 1998, and again after the dot-com bust in 2001. "It's the most obvious trade in the most liquid market in the world. It's not brain surgery," he said.

Dr Sushil Wadhwani, best known for his stint on the Bank of England's Monetary Policy Committee, also came unstuck on the yen when at Paul Tudor Jones, this time in 1998 as China was threatening devaluation (ironically).

"I got seduced by stories that said dollar/yen was going to 180. I remember one or two people saying they thought the US would intervene because of China's complaints, but I'm afraid I didn't pay enough attention," he said.

"In June the Fed intervened, along with the Bank of Japan, and the dollar dropped like a stone. When something is going up or down in a straight line and you start getting political resistance, you had better pay attention," he said.

Dr Wadhwani politely accused the Fed and old MPC colleagues of fatally ignoring property and asset inflation. "If you take your eye off the ball vis-a-vis asset price misalignments, then you are storing up trouble. What you've got now is huge asset market distortions and one of these days the chickens will come home to roost," he said.

"Alan Greenspan has always argued that it's better to deal with a bubble after it has burst than to worry about pre-empting the bubble. I take a different view," he said.

As for Britain, Mr Wadhwani said that the MPC should have tightened interest rates earlier to cool house prices, even if inflation fell below target.

Like others, Jim Leitner from Falcon Management is waiting pensively for the denouement. "Right now there are a lot of bad things lurking, but I'm just not sure when we're going to fall on the knife," he said.

Or take Scott Bessent from Bessent Capital: "At some point, we will have the Big One. It's out there. I don't know whether it's financial asset depression, or a real depression. Financial assets can't keep doing what they're doing, with so many people rewarded for being imprudent," he said.

Or the anonymous currency guru in the last chapter: "When you look at the whole world and see what it's built on, it is totally, clearly not sustainable. I get so bearish that I think about buying a castle in Scotland and moving up there with a couple of loaded shotguns and a truckload of canned food," he said.

Regulators are now fretting, afraid that the funds have grown too big. They warn that speculators clustered on the same trades might lurch en masse across deck, capsizing the boat.

That is a self-serving critique. Hedge funds have multiplied in a sea of credit, and who is ultimately responsible for that excess credit? Central banks, of course.

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