David Stockman: Hedge Funds, Prime Brokers, And The Whirligig of Wall Street Finance
As David Stockman, Reagan's infamous Budget Director, writes in his bestseller, The Great Deformation: The Corruption Of Capitalism In America – "the last thing hedge funds do is hedge." The hedge fund complex is "not so much a conventional industry as it is a giant moveable trade": Wall Street trading desks frequently morph into independent hedge fund partnerships, and senior hedge funds often sire “cubs” and then sons of cubs. The protean ability of this arrangement to spawn, fund, and replicate successful momentum trades cannot be overstated, and has "generated trillions of permanent momentum-chasing capital." Ultimately, he warns, "apologists for the Fed’s evisceration of the capital markets could not see... they had unleashed the financial furies in the violent momentum trading modus operandi of the hedge fund casino."
Until winning trades finally finish their run and reverse direction, copycat replication is low risk because it is facilitated by the prime brokerage desks of the Wall Street banks. These desks keep their hedge fund clients posted on “what’s working” for the hottest funds and, mirabile dictu, the flavor-of- the-moment bandwagon rapidly gains riders.
To be sure, Wall Street prime brokerage operations perform valid services such as margin lending, consolidated reporting, trade execution, and clearing and settlement. Indeed, it is the independent clearing functions of the prime brokers which safeguard against the Bernie Madoff style of self-cleared “trades” that were actually not all that.
In this independent trading and clearing function, however, Wall Street banking houses take in each other’s laundry, unlike Madoff’s in-house method. This means that the hedge funds embedded in each of the big banks—operations which are otherwise pleased to characterize themselves with meaningless distinctions such as “prop,” “flow,” and “hedge” traders—use one of the other banks as their prime broker.
JPMorgan’s now infamous “London Whale” trading operation, for example, used Goldman Sachs as its prime broker. It would require a heavy dose of naïveté to believe that the invisible Chinese walls maintained by these two banking behemoths actually stop any useful trading and position information from circulating throughout the hedge fund complex.
Besides a steady diet of tips about hot trades, the hedge fund complex also needs incremental cash, preferably from low cost loans, in order to pile into rising trades. This, too, the prime brokers provide in abundance through what amounts to a variation of fractional reserve banking. The mechanism here is “rehypothecation,” and it amounts to a miracle of modern finance.
Prime brokers are essentially in the business of selling used cars twice, or even multiple times. When they execute trades for a hot hand among their hedge fund customers, for example, they retain custody of the securities purchased on behalf of the customer. But under typical arrangements, the prime broker promptly posts these securities as collateral for its own borrowings; that is, it hocks its customer’s property and uses the cash proceeds for its own benefit.
The precise benefit is that the prime broker relends the proceeds to another client who is advised to jump on the same trade with the new money. The resulting purchase of securities by the second customer begets even more collateral, which triggers another round of rehypothecation. Needless to say, this enables the prime broker to lend and whisper yet a third time, imparting even more momentum into the original trade. In this manner, financial rocket ships are born.
It is not surprising, therefore, that the hedge fund industry remains arrayed tightly around the brand name prime brokers: Goldman, Morgan Stanley, JPMorgan, Merrill Lynch, and Barclays (nee Lehman). Indeed, the whole nexus of the Wall Street–hedge fund arena is cut from a single cloth.
The Wall Street investment banking departments supply financial engineering catalysts for the momentum trades, while their prime brokerages supply back-office services, cash, and inside tips to hedge fund customers, including prop traders and “hedging” desks within the Wall Street banks. The hallmark of this vast momentum trading arrangement, therefore, is that it is both incestuous and so highly fluid as to resemble a giant, undulating financial amoeba rather than a classic atomized marketplace of independent firms.
To this end, hedge funds come in and out of existence at dizzying rates, reflecting fluidity not even remotely matched in any other industry. In 2010, for example, 935 new hedge funds came into existence, while in 2009 more than 1,000 hedge funds were liquidated. Using common back-office infrastructure maintained by the prime brokers, the hedge fund complex is not so much a conventional industry as it is a giant moveable trade: Wall Street trading desks frequently morph into independent hedge fund partnerships, and senior hedge funds often sire “cubs” and then sons of cubs. The protean ability of this arrangement to spawn, fund, and replicate successful momentum trades cannot be overstated, and has generated trillions of permanent momentum-chasing capital.
The hedge funds run by John Paulson, the celebrated trader who massively broke the sub-prime mortgage market, demonstrates the manner in which momentum-chasing hot money had come to dominate the Wall Street casino. The one constant illustrated by the Paulson saga is that the pool of hedge fund money lives by the law of relentless reallocation.
The Hot Hands Went Stone Cold
For most of his career Paulson was a steady and astute journeyman who managed a modest-sized hedge fund specializing in merger arbitrage. But in 2005–2006 he chanced upon the “greatest trade ever”—the monumental subprime short—and during the next several years generated astounding investment returns. His fund profits measured out at more than a 300 percent annual rate.
The inflow of new money to the several Paulson hedge funds was astonishing and instantaneous, even by the standards of contemporary Wall Street. Paulson’s AUM (assets under management) went from $4 billion to $40 billion in a financial heartbeat. The inflow of capital was so great, and the timing of his momentum trades so effective, that during 2006–2010 Paulson’s personal share of profits was reputed to be nearly $15 billion, a figure that exceeded the entire AUM of the largest hedge fund as recently as 2001.
Still, these heaving pools of hedge fund capital care only about what managers have done for them lately. The violent unwind of the Paulson funds is dramatic proof. By early 2012 his funds had shrunk to $20 billion and investors had fled in droves.
This breathtaking rise and fall is not about capitalist freedom to succeed and fail, or even a morality play about an investor becoming overconfident in his own genius. Instead, it is evidence that the great financial deformation has spiked the system with opportunities for huge, misshapen speculations that could never arise on the free market.
On the free market uncorrupted by the state—and especially the money-printing and Wall Street coddling policies of its central banking branch—there would have been no reckless boom in mortgage lending nor the resulting rampant inflation of housing prices. In turn, there would also have been no “big short” against bad real estate prices and bad housing debt.
As it happened, however, this wager amounted to the chance of a lifetime to extract billions of windfall profits and attract billions more of momentum-chasing hedge fund capital. Furthermore, these enormous windfalls from busted mortgages enabled the suddenly giant hedge funds run by Paulson to pivot on a dime and place tens of billions of new bets behind highly speculative theories which soon proved to be disastrously wrong.
After early 2009, for example, Paulson wagered that the United States would experience an inflationary boom and therefore bet heavily on gold, banks, home builders, and other sectors that would benefit. John Paulson had no special macroeconomic expertise, but he had chanced upon a dogeared copy of Milton Friedman’s quantity theory of money. When Bernanke flooded the economy with a humongous quantity of money in the fall and winter of 2008–2009, Paulson placed his bets accordingly.
Unsung economic forecasters have been making erroneous bets for decades based on Professor Friedman’s faulty theories about money, but this time upward of $30 billion had been placed on Friedman’s money supply growth equation. So when the inflationary boom didn’t happen, Paulson’s funds experienced shocking losses which amounted to 45 percent by the end of 2011.
Still, apologists for the Fed’s evisceration of the capital markets could not see that the tens of billions flowing first toward the Paulson bets and then in headlong flight from them were evidence of profound financial disorder. Indeed, the apparent view from the Eccles Building was that John Paulson was just some kind of hedge fund Casey—a mighty trader who aimed for the fences and had struck out at the plate.
Yet the truth was more nearly the opposite. The Fed had unleashed the financial furies in the violent momentum trading modus operandi of the hedge fund casino. Paulson was only the most visible practitioner.
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