The same would appear to hold in
Russia, where the oligarchs can steal without compunction or
interference from the state -- unless the state's power is
challenged. Then it reacts like any other capo, squashing opponents
and cutting them out of the business. And woe to reporters who stick
their nose in where they shouldn't.
But for the economies and the stock
markets of the civilized world, a belief in hell, or at the minimum
the consequences for one's actions, does seem to go with good times.
And, more recently, vice versa. The bursting of the bubble has been
accompanied by the downfall of corporate miscreants who clearly
weren't inhibited by any fear they might face eternal damnation for
their deeds. Among these, of course, are Enron, Tyco and WorldCom in
the U.S., and Parmalat and Ahold in Europe.
There is nothing unique about this
rogues' gallery. The peak of every big economic and market cycle
invariably produces a crop of crooks whose deeds are exposed when
the market starts to buckle. Who can forget those characters from
the 'Eighties -- Ivan Boesky, the Drexel crowd, the savings-and-loan
bandits? Bernie Cornfeld and Robert Vesco from the 'Seventies? Ivan
Krueger and Richard Whitney and all the rest after the Great Crash
of '29?
And, of course, add Martha Stewart.
The domestic diva Friday received the lightest possible sentence for
her conviction for lying to the feds about her dumping of ImClone
stock just before the Food and Drug Administration was about to
deliver bad news about the company's cancer drug. Stewart got five
months in jail and five more months under house arrest, plus a fine
of $30,000. Shares of her company, Martha Stewart Living Omnimedia,
popped 40% on news of the decision, lifting its stock-market value
by some $160 million, to $585 million. That's still a far cry from
its peak of $1.9 billion, which is the true penalty exacted for her
transgressions. All to save $51,000 by dumping ImClone before the
hoi polloi.
Scandals that emerge after booms go
bust have historically elicited a reaction from regulators and the
general public. Now that the mutual-fund horses have been stolen, of
course the Securities and Exchange Commission is busily locking the
barn door. And, finally, Ken Lay has been indicted more than two
years after Enron's collapse and just before it was about to emerge
from Chapter 11.
For the public, there hasn't been the
sort of revulsion toward stocks and investing that has been seen at
the ultimate bottom of a major bear market. Judging by the cheers
that greeted Ms. Stewart as she held forth on the courthouse steps
following her sentencing, there seems to be little public opprobrium
for her behavior, which has cost her com-pany's shareholders and
employees dearly. Marketing mavens even speculated about ways she
could use her time in the hoosegow to burnish her reputation.
If you've any doubt that the public is
ready to renounce these rascals, know that the devil remains among
us, garnering boffo ratings. Satan can take on an pleasant
appearance, or at least surround himself with attractive associates.
He can build great, gold- plated structures, to be idolized by the
masses. He will tell you that if you follow him, all this can be
yours. But he needs new disciples, or in this case, The Apprentice.
Oh, what the hell.
What the financial markets have been
stuck in recently has been a kind of purgatory marked by a lack of
investment opportunities. For veteran value buyers, that's meant
piling up great mounds of cash for lack of anything worth buying;
the Clipper Fund has more than 30% in cash. Or they've taken the
painful step of shutting their doors to new investors, as the
Longleaf Partners fund did last week (with cash up to about 25% at
that point), following the lead of FPA Capital, which had amassed
40% in cash.
But for hedge funds, they can't just
stand there, they have to do something. And what's gotten to them is
the lack of volatility in the markets. Stocks, as Mike Santoli
deftly details on page 19, have been drifting in the doldrums. But
equities aren't the only things in irons; bonds, currencies,
convertibles, the whole array of playthings tossed around by hedge
funds are in the same boat.
What's to blame for this soggy state
of affairs? Clearly, a lot has to do with the uncertainty that
besets all manner of things, from the election to the war to the
economy, all of which combine to make sticking your neck out on
anything a distinctly uncomfortable position.
There also may be another culprit,
ironically one that until now has nurtured the growth of the hedge
funds: the Fed. By providing boatloads of free money to play with,
Greenspan & Co. has staked the funds with the kind of leverage
they live on. But by so carefully telegraphing their intentions to
raise the overnight money rate at a gradual, almost glacial pace,
the monetary authorities have flattened all the waves in the market.
"The Fed's stage-management deserves a lot of credit for the lack of
volatility," says David Goldman, head of fixed-income research at
Banc of America Securities. But that has taken away opportunities
for the hedge funds.
With high valuations, and thus low
prospective returns in equities and the array of fixed-income
instruments, hedge funds have been "selling volatility" to generate
income, for they're desperate in this environment. That is, they're
selling options to collect the premium income. And so long as the
markets stay quiescent, they can collect those premiums without
those options being exercised. Think of a writer of flood insurance
in a drought.
As a result, Goldman says, all these
sellers of volatility have driven down the price of options to
where, in his words, they're "stupid cheap." And that's extended to
the VIX, the CBOE's benchmark of volatility, which has dropped to
the lowest since early 1996, he adds.
But Mark Turner, chief investment
officer of Pentagram Investment Partners, a Boston hedge fund,
likens this tactic of selling depressed options to "to picking up
pennies in front of a steamroller." While your luck holds out, you
can grab them; if not, you're flattened.
To be sure, volatility has been
depressed by all these funds seeking to exploit it, adds Douglas
Greenig, managing director of RBS Greenwich Capital Markets. There
are a lot of talented people trying to make money the same way. And
there shouldn't be any free money.
There used to be free money in the
arcane strategy of convertible arbitrage, Greenig adds, but that's
been squeezed out. Convertibles have implicit options embedded in
their structure; you can exchange the bond for shares at a certain
price for a certain period, just as with an option. But the prices
of those embedded options were inexplicably lower than the price of
regular options. So you simply bought the cheap converts and sold
expensive calls. Of course, that's been too good to last as hedge
funds latched onto the arbitrage. And without demand from hedge
funds, convertible issuance is down sharply, which also takes money
out of the game.
The mortgage market, Greenig's
specialty, also has been a big source of volatility in the past, and
a reason for the present placidity. Mortgages, to review, also have
an embedded option, that is, to let the homeowner refinance almost
any time. So mortgage investors, who are short those options, have
to hedge them. The simple way is with Treasury notes, which aren't
callable. Or with other options.
Among the biggest mortgage investors
are Fannie Mae and Freddie Mac, which to their critics amount to
federally subsidized hedge funds. The Wall Street Journal Friday
reported the Treasury may be able to rein in Fannie's and Freddie's
growth, based on an opinion the Bush Administration has obtained
from the Justice Department. Greenig says the mortgage giants
already have throttled back their portfolio growth, and in tandem,
reduced their options-buying to hedge their holdings. With the
biggest buyers buying less options, their prices have eased. He
notes that with Fannie and Freddie less of a factor, options
volatilities have dipped in line with European markets, which don't
have such government behemoths.
That still leaves the problem for
hedge funds to make their "point- a-month" bogey to collect their
fat fees. The simple answer, according to observers who want to
remain anonymous, is to leverage further by exploiting rules that,
ironically, are meant to limit risk. "Value at risk" is supposed to
describe a fund's or bank's exposure resulting from the size and the
riskiness of their positions. If volatilities have been cut in half,
the risk is similarly halved. That means the position can be doubled
without changing VAR. But if something bad happens and the market
spikes, the VAR shoots up, and positions have to be slashed.
There doesn't seem to be a hedge fund
like the monster Long Term Capital Management, which blew up in
1998, out there, but there are more numerous smaller funds. The Fed
arranged for a bailout of LTCM by the major banks. But if an
offshore fund collapsed, would the Fed step in? Turner recalls that
the Bank of England let Barings in 1995 fail when its Japanese stock
and bond options went against it.
E-mail:
randall.forsyth@barrons.com
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