When will this party finally end?
By
Bill Bonner Aug 06, 2007
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“The Party’s Over,” said the FT, rushing to judgement. July was the worst month for US stocks in three years. Problems in subprime lending seem to be weakening the entire credit market. Maybe it is time to turn out the lights and go home. Or should we have another drink? “Risk is being re-priced,” said US Treasury Secretary Henry Paulson. Nothing to worry about, says he; there is “no threat to the overall economy”.
Economic forecasting is a métier of the damned, we conclude. The greatest of them all – at least by reputation – was miserable at it. When Alan Greenspan was confronted by Congress after his nomination to head up the US Federal Reserve, Senator William Proxmire was ready for him. He’d done his homework. He noted Greenspan’s “dismal forecasting record” when he was chair of the Council of Economic Advisers. He had, for example, forecast a rise in consumer price inflation of 4.5% for 1978. Instead, it rose over 9%. He was further off-the-mark than any CEA chairman before, or since. “You broke all records,” said Proxmire. Proxmire turned to a copy of Forbes magazine, which described Greenspan’s efforts at forecasting when he was in the private sector: “Greenspan and O’Neil turned in one of the least impressive records of all pension fund advisers”. Proxmire said: “I hope… when you get to the Federal Reserve Board everything will come up roses. You can’t always be wrong.”
The 20th anniversary of those hearings passed last week. Nobody bothered to recall how the former chairman of the Federal Reserve surprised all observers; he was almost always wrong. First, he mistakenly put up interest rates in the early 1990s – probably causing a recession and almost certainly costing George Bush Sr. his bid for re-election. And in early 2000, by holding rates too low for too long, he almost single-handedly created the global credit bubble we watch today. It’s a bubble that has made many rich – and humbled others.
When it comes to guessing about the future, investment professionals are no better than economists. Take Mr. John Devaney. Poor Devaney is selling his 142 foot yacht for $23.5m. Word is, he’s put his house in Aspen up for sale too. At $16.25m, all 16,000 square feet can be yours. There are only two happy moments in a boat-owner’s life, or so it is said – the day he buys his boat, and the day he sells it. Devaney may be especially happy to get rid of his tub; its name – Positive Carry – must strike him like a curse. The boat is on the market precisely because his carry went negative – and his hedge fund, United Capital Markets, went into losses. This is not the first time Devaney has made the news. Previously, he was quoted describing people who took out subprime mortgages as “big idiots”. At the same time, Devaney was buying up the big idiots’ collateralised debt obligations.
Devaney highlights the problem with trying to figure out when this bash will end. A bubble party usually ends only when the greatest fool finally arrives. But they keep coming! Surely, the fellow who buys a trashy barrack in a bad part of town using a subprime loan is asking for trouble. He’s a fool to buy more house than he can afford. But so is the fellow who buys a whole inventory of these packaged mortgages. If they were bad for the borrower, sooner or later they’re going to be bad for the lender too. The typical hedge-fund buyer also leverages his purchase – just like the subprime mortgagee. For example, he might borrow yen or Swiss francs at a low rate and use the money to buy high-yielding subprime debt. He’ll have ‘positive carry’ until the idiots stop making mortgage payments.
And what do you make of the investor who pays fees of ‘2 & 20’ to take part in this mad gamble? What do they expect? Also in the news this week was Sowood Capital, where Mr. Jeffrey Larson has lost half his clients’ money. Larson was making more than $17m a year managing money for Harvard University. In 2004, he decided he could make even more by setting up his own hedge fund. He and his partners raised $2bn from investors, including Harvard, which put up $500m. As of this past Wednesday, more than $350m of Harvard’s money was gone.
What happens to these guys when they fail so badly? Our friend, Nassim Taleb, took up the question recently. “Don’t worry about them,” he said. “A hedge fund manager who blows up his fund isn’t out of work for long. He just takes a vacation. The bigger the blow-up, the longer the vacation. Maybe he goes for a hike in the Alps if it is a small fund. A medium-sized fund manager who blows up goes to climb Kilimanjaro. And a really big fund manager has to go to the Himalayas. But he has already sent out his resume, telling of all the great success he has had… blemished by only one mistake. Usually, he gets a call to come back to work at another fund before he ever leaves the base camp.”
So don’t worry about the idiots. As long as the credit boom is still going on, Greenspan, Devaney and the others will be all right. Until the party really ends.
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