Previous Columns
8:00 AM EST, Tuesday, September 23, 2008: Anyone still in stocks is being slaughtered. The big gainers yesterday were gold and oil -- oil "enjoyed" its biggest one-day gain yesterday since the the early 1980s. But most hedge funds are short gold and oil.

Anyone jumping in, thinking they can make a profitable short-term trade (or even buy something for the long-term) is being slaughtered. No one can handle (or predict) the present Washington-induced insanity and its zillions of unintended consequences.

There's an old saying that (I think it's from Milton Friedman) that "If you put the Federal Government in charge of the Sahara Desert, there'd be a shortage of sand within five years."

The SEC banned short selling on about 800 financial or financially related stocks. Instead of calming the market, it roiled it. Many traders knowing that these 800 stocks would be protected from short selling, sold them -- instead of waiting until the stocks could be sold short in the future. Unintended consequence #1.

This is the past few days. Yesterday the Dow fell 372.75 -- 3.3%. Traders became apparently leery that Congress could actually pass the $700 billion bailout before it goes on break shortly.

Everyone's leery of what might be in the legislation. Everyone knows that the bailout will tighten the bank's capital requirements. Everyone is afraid that many banks won't be able to meet those requirements, will scramble for new capital, won't find it and will go bust. Another unintended consequence.

There's more. Let's say Congress passes the bailout. A bank sells $100 million of toxic mortgages to the new government entity. Is that good or bad for the bank? Depends on what the bank valued those mortgages on its balance sheet. If it valued them at $50 million, it just made a $50 million "profit" -- good for shareholders. What happens if it had valued them at $200 million (even though it may have taken a $100 million writedown), then it's just incurred a $100 million "loss."

Even better, now the banks know Congress is buying their bad loans, it makes no sense to write the toxic mortgages down -- since Congress may choose to buy them at the written-down prices. This would be the classic case of being hoisted on one's own petard. Better to sell Congress a pig in the poke. ... Without the writedowns, we, as dumb investors, are left in the dark as to what one bank may or may not be worth. Since we won't know what one bank is worth, we'll assume that they're all bad and sell them all. I bet there's a way to short them. Off-shore?

Washington's unintended consequences get better. This was posted by someone called Yves Smith on a financial blog yesterday:

We have said more than once that a terribly misguided aspect of the Freddie and Fannie conservatorship was the elimination of dividends on the GSEs' preferred stock. Preferred was the best vehicle that struggling financial firms had for raising new capital. Eliminating the dividend lead to big losses in all financial preferred stocks, since investors assumed any bailout would similarly trash the preferred. Indeed, it is quite possible that this move accelerated Lehman's demise, since it closed off its best funding option.

A second reason for taking a dim view of this move was that the Treasury had encouraged banks to buy Fannie and Freddie preferred stocks, so any losses on these holdings would reduce the equity of banks that owned the stock. Paulson alluded to the issue in his statement announcing the conservatorship, and claimed very few banks would be affected, and the impact would not be significant:

The agencies believe that, while many institutions hold common or preferred shares of these two GSEs, only a limited number of smaller institutions have holdings that are significant compared to their capital.

It looks like they were wrong. From the Financial Times:

US regulators have underestimated potential bank losses on preferred stock issued by Fannie Mae and Freddie Mac, the American Bankers Association said on Monday.

Nearly a third of US banks hold preferred stock issued by the two mortgage financiers that were taken into conservatorship this month, according to an industry survey conducted by the ABA. The average bank exposure to such securities relative to core equity capital was 11 per cent.

“The negative impact on banks – particularly Main Street community banks – is far greater than regulators first thought,” wrote Edward Yingling, chief executive of the ABA in a letter to the Treasury, the Federal Reserve and other banking regulators.

The government takeover of Fannie and Freddie all but wiped out the value of $36 billion of their preferred shares. This would force exposed banks to take writedowns at the end of the third quarter that could impede future lending, the ABA warned. ...

The ABA’s letter called for regulators to reconsider the suspension of dividend payments on Fannie and Freddie preferred stock to alleviate the capital impact on banks and avoid a multi-billion dollar decline in lending.

Unintended consequence #4 or 5: Also posted by Yves Smith:

"Hedge funds suffer mass redemptions"
One sign that the credit crisis is accelerating: Nouriel Roubini's forecasts are coming to fruition faster. In the past, Roubini has too often played the role of seemingly mad prophet in the wilderness until he is proven correct. His calls that the housing bubble would collapse in a nasty way, that subprime was most certainly not contained, that Freddie and Fannie would get in trouble, that total credit crunch losses would reach $2 trillion, all sounded apocalyptic and were generally ignored, to the detriment of those who failed to take heed.

The time between Roubini making a dire forecast and it coming to pass has just collapsed. From yesterday's Financial Times: The next stage will be a run on thousands of highly leveraged hedge funds. After a brief lock-up period, investors in such funds can redeem their investments on a quarterly basis; thus a bank-like run on hedge funds is highly possible. Hundreds of smaller, younger funds that have taken excessive risks with high leverage and are poorly managed may collapse. A massive shake-out of the bloated hedge fund industry is likely in the next two years.

In today's Independent (recall that London is an even bigger hedge fund center than New York/Fairfield County): Hedge funds could have an unprecedented level of cash pulled out by investors this quarter, according to insiders, just as they faced millions of pounds of losses from last week's shock regulation of short selling. It has been a tough year for the industry with high-profile funds blowing up, clients increasing redemptions, as well as public fury over short selling and increased threats of regulation.

One hedge fund expert pointed to The Hedge Fund Implode-O-Meter (HFI) as how he judges the state of the industry. The HFI was set up online in the wake of the credit crunch "to track as hedge funds learn the double-edged-sword nature of the often extreme leverage they use".

The group's "imploded funds" list has hit 51 companies.....It has 34 stocks on its "ailing/watch list" of those that have suffered significant value declines or temporarily halted redemptions. According to EuroHedge, a hedge fund data provider, 272 individual funds strategies were launched during the first six months of 2008, the lowest for nine years. In the same time, 243 funds have been liquidated, the highest in a six-month period...

The redemptions seem to have started in earnest, although currently the evidence is mainly anecdotal. One UK hedge fund manager confided that last week had the highest number of investors rushing to withdraw funds that he has known. The industry will know for sure whether it is a drip or a deluge when the data providers release their statistics for the third quarter, next month. One market analyst said: "I know even the good hedge funds have been suffering withdrawals recently. Investors are very nervous."

Performance numbers are also under pressure. Some have done well out of the market disturbance, but on average the performance numbers are at a low ebb. Andrew Baker, the deputy head of Aima, the hedge fund trade body, said: "The performance is undoubtedly soggy. There are not many strategies that stand out."

Yves here. Note that short strategies had been a lone bright spot, But now that short sellers are being pursued with a vehemence that would warm Torquemada's heart, let's just say that their past results may not be indicative of future performance.

EuroHedge revealed that strategies that have done particularly badly this year include several run by Naissance Capital, once bankrolled by the Habsburg families, which are down a fifth and Pico Fund, which is down 32 per cent. At Endeavour Fund, set up by former Salomon Smith Barney traders, the second fund has fallen by 40 per cent, while its third fund is down 38.79 per cent in 2008. In the emerging markets, PharmaInvest Fund's investments in emerging markets are 38.16 per cent down.

Other funds have sought to lock in investors by halting redemptions. The latest example was RAB, with its flagship Special Situations Fund, as it was so desperate to prevent exits after a 22 per cent drop in performance that it offered vastly reduced fees in return for a lock-in period of three years.

One of the main problems experienced by hedge funds is the extent of leverage in the industry. The funds were able to take on huge amounts of debt, with little capital needed as security, to boost returns. One observer said some of the leveraged strategies were like "picking up pennies in front of a steamroller, and that only takes a turn in the market to cause severe problems".....

At the same time, hedge funds, like the banks, have had to write down exposures to investments in risky instruments including collateralised debt obligations and asset backed securities, and also been exposed to the huge swings in the market.

Another issue is the regulators sniffing around. There have been wider calls for transparency and official controls of the industry, which has already been stung by the shock short-selling rules...

Stuart McLaren, financial services partner at Deloitte, said: "When the dust has settled, I expect the regulators to look at the role that hedge funds have played in the current issues. I expect there will be increased calls for regulation, but I doubt much will come from it."

But, there's more. This may be good for me. Remember I bought all those Australian dollars a few months ago, only to watch their value crater as the American dollar rose. From Barrons:

Dollar May Get 'Crushed' as Traders Weigh Up Bailout (Update5)

Sept. 22 (Bloomberg) -- Treasury Secretary Henry Paulson's plan to end the rout in U.S. financial markets may derail the dollar's three-month rally as investors weigh the costs of the rescue.

The combination of spending $700 billion on soured mortgage-related assets and providing $400 billion to guarantee money-market mutual funds will boost U.S. borrowing as much as $1 trillion, according to Barclays Capital interest-rate strategist Michael Pond in New York. While the rescue may restore investor confidence to battered financial markets, traders will again focus on the twin budget and current-account deficits and negative real U.S. interest rates.

"As we get to the other side of this, the dollar will get crushed,'' said John Taylor, chairman of New York-based International Foreign Exchange Concepts Inc., the world's biggest currency hedge-fund firm, which manages about $15 billion.

The dollar fell against 14 of the world's most-traded currencies on Sept. 19, including the euro, as Paulson unveiled the plan, while the Standard & Poor's 500 Index rose 4 percent. The plan may end the rally that began in June and drove the U.S. currency up 10 percent versus the euro, 2 percent against the yen and almost 13 percent compared with Brazil's real, strategists said.

Paulson's plan, sent to Congress Sept. 20, would mark an unprecedented government intrusion into markets and increase the nation's debt ceiling by 6.6 percent to $11.315 trillion. Officials may also start a $400 billion Federal Deposit Insurance Corp. pool to insure investors in money-market funds.

"The downdraft on the dollar from the hit to the balance sheet of the U.S. government will dwarf the short-term gains from solving the banking crisis,'' said David Woo, London-based global head of foreign-exchange strategy at Barclays, the third- biggest currency trader, according to a 2008 survey by Euromoney Institutional Investor Plc.

Paulson and Federal Reserve Chairman Ben S. Bernanke began plotting the rescue last week after New York-based Lehman Brothers Holdings Inc. filed for bankruptcy, the government seized control of American International Group Inc. and Merrill Lynch & Co. was forced into the arms of Charlotte, North Carolina-based Bank of America Corp.

Morgan Stanley dropped as much as 44 percent Sept. 17, the biggest one-day decline in its history, and Goldman Sachs Group Inc., where Paulson was chief executive officer from 1998 to 2006, lost 26 percent. Both are based in New York.

The dollar fell 2.5 percent to $1.4831 per euro as of 4:05 p.m. in New York, after dropping 1.7 percent in the week to Sept. 19. It slid 2.1 percent to 105.24 yen, extending last week's 0.5 percent decline.

In the four days following Lehman's bankruptcy, the ICE future exchange's Dollar Index, which measures the currency's performance against the U.S.'s six biggest trading partners, dropped 1.2 percent. It fell 2 percent today, leaving it little changed this year.

"After years of doubting the hegemonic status of the dollar, this proves it's still there,'' said Stephen Jen, London-based head of research at Morgan Stanley. "But of course this situation is definitely not stable. The capital leaving the emerging markets is only going into the dollar and that's a powerful force. It's a very uncomfortable balance.''

By the end of the year, the euro will weaken to $1.43 and the yen will trade at 108 to the dollar, according to analyst surveys by Bloomberg. The dollar will depreciate to 1.65 against the real, compared with 1.83 on Sept. 19.

Although the dollar may suffer short-term, at least one analyst says the U.S. government's planned rescue will strengthen the currency before long. Paulson's proposals will return foreign-exchange markets to the trend of the past months, according to Adam Boyton, senior currency strategist at Frankfurt-based Deutsche Bank AG, the world's biggest currency- trading bank. Since the end of June, the Dollar Index has gained 5 percent.

"It's a positive plan that's ultimately good for the dollar,'' said New York-based Boyton. "It reduces risk and volatility and gets the focus back on macroeconomic fundamentals, which suggest weakness throughout the rest of the globe next year, with returning strength in the U.S.''

The U.S. economy may expand 1.5 percent next year, according to the median estimate of 80 analysts surveyed by Bloomberg. That compares with 1.1 percent for the euro-region and 1.15 percent for Japan, the world's second-largest economy.

The rescue comes as the U.S. budget deficit and the current-account balance, the broadest measure of trade, grow. The Congressional Budget Office projects the spending shortfall will increase to $438 billion next year from $407 billion. The current account deficit is up from $167.24 billion in December.

"Investors may start to worry about the amount of debt the U.S. is taking on and its impact on the dollar,'' said Geoffrey Yu, a currency strategist in London at UBS AG, the second- largest foreign-exchange trader. "The fact that they mentioned taxpayer money implies that they're going to issue debt. If there's going to be a huge new supply of Treasuries, this will be dollar negative. It's too much for the dollar to take.''

Traders are also concerned the bank bailout will spread to other U.S. industries suffering from the credit crunch that's holding back an economy growing at its slowest pace since 2001. Detroit-based General Motors Corp., the world's biggest automaker, said last week it will tap the remaining $3.5 billion of a $4.5 billion credit line to pay for restructuring costs.

Lower interest rates may also weigh on the dollar. Futures on the Chicago Board of Trade show there's a 45 percent chance policy makers will lower their target rate for overnight lending between banks to at least 1.75 percent by January from 2 percent currently. A month ago, they showed a 50 percent chance of an increase to 2.25 percent.

Rates in the U.S. are already the lowest of any Group of 10 industrialized nations except Japan, where they are 0.5 percent. The European Central Bank's benchmark is 4.25 percent.

Another drawback for the dollar is that the Fed's key rate is 3.4 percentage points less than the rate of inflation, the most since 1980, so investors lose money by investing in short- term U.S. fixed-income assets.

"People thought that the Fed was done cutting,'' said Andrew Balls, an executive vice president and member of the investment committee of Newport, California-based Pacific Investment Management Co., which oversees almost $830 billion. "In the longer term the diversification away from the dollar will remain intact. The U.S. hasn't done itself any favors in making its assets attractive to foreign investors.''

The biggest beneficiaries may be Brazil's real and Australia's dollar, as demand for higher-yielding assets rebounds, according to Goldman Sachs. The two currencies, the biggest losers versus the dollar since July, may rebound 7.7 percent and 4.6 percent, respectively, in the next two weeks, Goldman Sachs forecasts.

"The currencies that have been damaged the most have the best growth,'' said Jens Nordvig, a strategist with Goldman Sachs in New York. "You're going to see a lot of flows back into these currencies now.''

Meantime, the guys running the CFTC are newly afraid of their jobs (remember McCain says he'd fire the head of the SEC). Another Bloomberg story this morning focused on more Washington madness:

Oil Short Squeeze Prompts Call to Curtail Speculators (Update1)

Sept. 23 (Bloomberg) -- U.S. lawmakers may seek to include commodity speculation limits in legislation designed to rescue banks from bad mortgage investments after a squeeze in oil trading sent crude to a record gain.

Crude oil for October delivery yesterday climbed more than $25 a barrel in New York Mercantile Exchange trading, before settling 16 percent higher at $120.92 as the contract expired. The fluctuation, the biggest since Nymex crude trading started in 1983, prompted the Commodity Futures Trading Commission to say it was ``closely monitoring'' prices for manipulation.

``I know for a fact that some members of Congress are working to include speculation legislation in the financial markets legislation,'' CFTC Commissioner Bart Chilton said yesterday in an e-mail. ``Those efforts, I think, may get fueled by the large spike in oil prices.''

Any move to include commodity limits in the legislation to rescue Wall Street risks encountering opposition from the administration and delaying the law. President George W. Bush called on Congress not to load the $700 billion legislative rescue plan with ``unrelated provisions.''

Oil soared yesterday as traders who had sold the October contract had to buy the futures back on the last day of trading, rather than try to make delivery from inventories that had declined in the wake of Hurricane Ike. Oil for November delivery rose just 6.4 percent to $109.37 yesterday. November crude, which is the most active contract, was trading at $106.99 at 10:49 a.m. London time today, 2.2 percent down.

Curbing Speculation

The House of Representatives approved legislation last week aimed at curbing speculation in commodities after prices of oil, copper and corn reached records. The Senate has failed to hold a final vote on legislation that would give the commission authority to rein in hedge funds, securities firms and pension funds.

``As Congress prepares a proposal to restore public confidence in financial markets, giving CFTC the authority it needs would be a relevant and important set of provisions, which should be included,'' Senator Tom Harkin, an Iowa Democrat and chairman of the Senate Agriculture Committee, said in an e-mail yesterday.

``The administration is pushing a narrow proposal focused mainly on residential mortgages, however, so it is not clear what the prospects may be for including anti-speculation provisions,'' Harkin said in an e-mail yesterday.

Hurdles in Congress

While the administration is asking Congress to move swiftly on the mortgage proposal, the measure is already encountering hurdles, after House Financial Services Committee Chairman Barney Frank said the plan must include limits on executive pay. Treasury Secretary Henry Paulson rejected the idea over the weekend, suggesting it would dissuade companies from taking advantage of the law.

Senate Majority Leader Harry Reid is ``not sure at this point'' whether anti-speculation measures will be included in the bailout bill, Rodell Mollineau, a spokesman for the senator, said in an e-mail yesterday.

Oil reached $130 a barrel yesterday, 44 percent more than six days earlier, when it fell as low as $90.51. Gasoline futures gained 4 percent yesterday to about $2.70 a gallon on the Nymex.

``This sharp move reflected extreme tightness in the prompt physical market as participants that were short oil scrambled to find physical oil before expiration,'' Goldman Sachs Group Inc. analysts led by Jeffrey Currie said in a report dated yesterday.

Last week, the Goldman analysts had cut their three-month crude forecast to $115 a barrel from $149.

Scouring Trades

CFTC staff will ``scour'' yesterday's oil trades in search of any illegal activity, Stephen Obie, acting director of the commission's division of enforcement said in a statement. ``No one should be trying to game our nation's commodity futures markets.''

There is ``likely to be a renewed interest in taking some action in light of this price movement,'' said Geoffrey Aronow, former director of enforcement at the agency and now a partner with Bingham McCutcheon LLP in Washington. The price swing yesterday wasn't ``automatically a cause for suspicion,'' he said.

The Nymex declined to comment on whether it was investigating yesterday's trades.

Anti-speculation language ``absolutely should be included because otherwise, the guys who are getting bailed out are going to have free reign over these commodity markets,'' said Michael Masters, of hedge fund Masters Capital Management.

`Cut Off the Heads'

Masters has testified to Congress four times this year that financial-market participants are responsible for doubling the price of oil. He estimates oil should be $65 to $70 a barrel.

"You can't curb short selling and then leave commodities unregulated,'' Masters said in a telephone interview yesterday. "It's like a hydra, you can't just cut off one head, you've got to cut off all the heads.''

Hedge funds and other large speculators amassed commodities in the first half of the year, and prices peaked July 3. Since then, the Reuters/Jefferies CRB Index of 19 raw materials tumbled more than 20 percent. So-called net-long positions, or bets prices will rise, in 17 of its 19 members dropped 72 percent since July 1 to 241,370 contracts on Sept. 16, data from the CFTC in Washington show.

Adding anti-speculation legislation to the financial rescue bill ``could be disastrous for its odds,'' Kevin Book, senior energy analyst with Freidman Billings Ramsey & Co. Inc. in Arlington, Virginia, said in a telephone interview. ``At the same time this is the type of issue that really gets people's attention.''

End notes.
John F. Kennedy is alleged to have said "Washington is eight square miles surrounded by reality."

Mae West said she'd been rich and she'd been poor. Rich was better.

Friends arrived from Australia yesterday. The U.S. Immigration officer told them that in the old days when the Sheriff left town, the people robbed the banks. Now, when the Sheriff leaves town, the banks rob the people.

Welcome to America, fall 2008.

Cash is king. Tennis is sanity.

This column is about my personal search for the perfect investment. I don't give investment advice. For that you have to be registered with regulatory authorities, which I am not. I am a reporter and an investor. I make my daily column -- Monday through Friday -- freely available for three reasons: Writing is good for sorting things out in my brain. Second, the column is research for a book I'm writing called "In Search of the Perfect Investment." Third, I encourage my readers to send me their ideas, concerns and experiences. That way we can all learn together. My email address is . You can't click on my email address. You have to re-type it . This protects me from software scanning the Internet for email addresses to spam. I have no role in choosing the Google ads on this site. Thus I cannot endorse, though some look interesting. If you click on a link, Google may send me money. Please note I'm not suggesting you do. That money, if there is any, may help pay Michael's business school tuition. Read more about Google AdSense, click here and here.