Hedge Funds, Politics, and the Market Crash

There are several culprits in the recent market crash, but one key source of the problem has hitherto escaped attention: an economic index that can be easily manipulated by hedge funds and whose gyrations have shaken the foundation of Wall Street: the ABX index, launched in 2007 by the Markit Group, a London-based company that specializes in credit derivative pricing and that administers the index.

The collapse in the American stock markets was a calamity for the campaign of John McCain. In September, McCain was running strongly against Barack Obama. Some polls had him leading Barack Obama by 3 percent before the market broke. By October 7th, Obama had taken the lead across America. What changed in one month? The trigger was the market crash. Who pulled the trigger and why? Who benefited?

At the heart of the mortgage mess is uncertainty regarding the value of subprime securities held by banks, saving and loans, Fannie Mae, Freddie Mac and a wide range of financial firms across America. However, the impact has spread beyond the value of just those mortgages. A supermarket of financial products has been created using the "raw material" of the mortgages themselves (recall the adage about everything from a pig being used but the squeal?). Mortgages can be packaged into securities called collateralized debt obligations (CDOs) and sold in slices with varying levels of risk. Furthermore, for buyers of these slices who wanted to insure against the debt going bad, Wall Street created a new instrument, called "credit-default swaps" (CDSs).

The value of all of these "products" pivots on the underlying value of the mortgages themselves.

Image an inverted pyramid. At the bottom are subprime mortgages and everything above is a type of financial family tree spawned by the mortgages themselves. An inverted pyramid is inherently unstable. A kick at the bottom can collapse the whole structure. And so it has.

The Role of the ABX Index

The heart of the mortgage mess is uncertainty regarding the value of subprime securities. The ABX Index is used to determine the value of these securities: it is a benchmark of the market for all the home loans issued to borrowers with weak credit . A collapse of this index leads to these home loans being marked down in value. The advent of the so-called mark-to-market accounting rule requires firms to slash the value of their holdings. This rule has magnified the problem: weakened balance sheets restrain lending, risk-taking, and may ultimately lead to bankruptcy.

The problem is that it looks like the ABX can be manipulated. The Wall Street Journal has noted that there is criticism "that the ABX is manipulated by hedge funds, or fails to represent the overall subprime or housing market"

As the ABX subprime mortgage index crashed, so did much of our economy.

Some investors benefited handsomely. Hedge fund manager John Paulson personally has made billions of dollars over the last two years from the collapse of the subprime mortgage market. How he did this can be found in this superb Wall Street Journal article.

Who else may have benefited? Indeed, who may have helped precipitate the crisis by taking actions that would weaken the ABX Index? We don't know, but there are some obvious suspects.

George Soros for one. Soros (the "owner of the Democratic Party" according to Saturday Night Live) is a legendary hedge fund manager who has become a political powerbroker of unrivaled influence within the Democratic Party (see The Shadow Party: How George Soros, Hillary Clinton and Sixties Radicals Seized Control of the Democratic Party) and who has an empire of politically active 527 groups, of which he is the number one donor, by far, in America.

Soros's hedge fund -- like most hedge funds -- is based overseas and escapes much scrutiny and regulation (more on this later). Word of Paulson's early success got "around in the world of hedge funds and Soros invited Paulson for lunch, "asking for details of how he laid his bets, with instruments that didn't exist a few years ago" 

Paulson made billions betting against the ABX Index. When you bet against the value of an index it exerts pressure on it -- hastening a decline and thus a decline in the value of the products that are priced using this index.

Did George Soros profit from such machinations, too? A relative, Peter Soros, directly invested with Paulson. Others also listened to Paulson and went off on their own to independently follow the same strategy and have reaped vast fortunes in doing so. Soros has refused to answer questions from the Wall Street Journal about his now infamous lunch with Paulson .

This is somewhat surprising silence from a man well known for his loquaciousness. He certainly has not been reticent the last couple of years as he trash-talked down the American economy. As a man whose investment prowess is legendary, his words alone could have harmed the stock market.

Soros is, after all, the man who famously broke the Bank of England decades ago and made a billion dollars in doing so. George Soros probably has made billions over the last couple of years. Paulson and Soros both shared the "honor" of being the highest earning hedge fund managers last year  and will probably do so again this year.

George Soros, not so incidentally, was a very early and influential backer of Barack Obama. He is a very prescient investor.

Now how does this play in the election?

Hedge funds have been a big source of the problems besetting the market. Heavily leveraged, they have had to sell vast quantities of securities to meet margin calls as well as fund withdrawals from investors.

But could hedge funds such as those run by Mr. Soros also have precipitated the crisis, a crisis that has literally in the span of a few weeks upended the political race for the White House? Short-selling can drive down the market.

Hedge funds are the biggest practitioners of short-selling. Other big institutional investors, including mutual funds and pensions funds, are barred from the risky practice.

Hedge fund short-sellers in recent weeks have targeted financial stocks such as the now-defunct Lehman Brothers and Washington Mutual as well as troubled firms such as Morgan Stanley to try to restore the double-digit returns that endeared them to wealthy investors.

The most dangerous are the hedge funds based overseas, such as the one run by George Soros, that escape scrutiny and a range of regulations.

The Washington Times:

Hedge funds through the years lobbied hard to escape regulation....Legislators and regulators in Europe and the United States are considering much stricter regulations. Italian Finance Minister Giulio Tremonti recently proposed abolishing hedge funds entirely. But the huge sums that hedge funds contribute to political candidates and lobbying in Washington make it unlikely that would happen in the United States.

Robert Morgenthau, the legendary district attorney for Manhattan, penned an op-ed for the Wall Street Journal recently highlighting the dangers of overseas hedge funds (Too Much Money is Beyond Legal Reach):

A major factor in the current financial crisis is the lack of transparency in the activities of the principal players in the financial markets. This opaqueness is compounded by vast sums of money that lie outside the jurisdiction of U.S. regulators and other supervisory authorities.

The $700 billion in Treasury Secretary Henry Paulson's current proposed rescue plan pales in comparison to the volume of dollars that now escape the watchful eye, not only of U.S. regulators, but from the media and the general public as well.

There is $1.9 trillion, almost all of it run out of the New York metropolitan area, that sits in the Cayman Islands, a secrecy jurisdiction. Another $1.5 trillion is lodged in four other secrecy jurisdictions.

Following the Great Depression, we bragged about a newly installed safety net that was suppose[d] to save us from such a hard economic fall in the future. However, the Securities and Exchange Commission, the Federal Reserve System, the Comptroller of the Currency and others have ignored trillions of dollars that have migrated to offshore jurisdictions that are secretive.

We have to learn from our mistakes. Any significant infusion to the financial system must carry assurances that it will not add to the pool of money beyond the safety net and supervisory authority of the United States. Moreover, the trillions of dollars currently offshore and invested in funds that could impact the American economy must be brought under appropriate supervision.

Morgenthau was particularly brave in issuing such a warning since the Democratic Senators of New York have been in the forefront of protecting hedge funds. Senator Schumer was among the Senate Democrats who recently led the fight against taxing hedge funds at a higher rate. The Democrats are far from alone, however. The effort to rein in hedge funds was led by Republican Senator Charles Grassley.

Hedge funds are a major source of donations for Democrats. The Democratic Senatorial Campaign Committee, which Schumer heads, received $779,100 from employees of private-equity head funds in June 2007 (as the tax battle was heating up in the Senate), far exceeding the $60,000 received by the Republican Senate Committee.

Senator Chris Dodd (D-Connecticut)) is a "beloved advocate of many of the hedge funds housed in his state" and has benefited mightily from donations from these hedge fund managers. . He is the head of the Senate's powerful Banking Committee that helps draft (or not) legislation regulating hedge funds.

Barack Obama has now eclipsed Dodd's fundraising record from hedge fund titans. Indeed, Barack Obama-after an initial promising stance regarding taxing hedge funds-backed away from the issue after briefly raising it last year.

The investors in these overseas hedge funds are secret. One cannot find out who they are because their identity is protected in these "secrecy jurisdictions". However, only the world's richest invest in hedge funds. So who have become rich over the last few years? Have you pumped gas, lately? Are Russia and China, and Arab oil nations, the only countries with vast reserves of cash? Are these the very nations vying with America on the geopolitical stage?

Can these hedge funds -- some of which have benefited from the mortgage crisis -- also taken steps to pressure the American stock market (a decline that has also affected markets around the world)? Have they been short-selling the market? This practice has been made much easier and more potent by the abolition of the "uptick rule and by the prevalence of "naked short selling"?

During the collapse of the stock market, noted Wall Street commentator and CNBC star James Cramer noted that traditional short-sellers were not as active as one might expected ("regular short sellers are not doing this" and "traditional short sellers are not active" and "are not so patriotic that they would be doing this"), and said that his sources have mentioned that "financial terrorism" may be at work. 

Is this all just speculation? Yes.

There is a range of problems affecting the American economy. Over-leveraged companies, excessive speculation, loosely written regulations, natural business cycles, over-consumption driven by an addiction to credit. A weakening economy after years of growth. The house of cards was bound to collapse at some point.

Barack Obama may be the luckiest politician ever. This tailspin might just be one in a long chain of "lucky" breaks.

There is no evidence of any conspiracy. No smoking guns. Hedge funds are in the business of making money, not shifting geopolitics. If the market is undervalued now, investors will start scooping bargains. It all might have just been a once in a decade (or two) perfect storm that sent the market into a tailspin (along with the rest of us)

It seems that Obama was just lucky that a market slide seems to have decisively swung the campaign in his favor. That Obama was again lucky that the meltdown occurred just as John McCain was overtaking him in the polls. And that Obama simply lucked out that one of his most influential supporters, one of the world's most adept fund managers (as the Bank of England learned the hard way) also benefited from the meltdown in the markets.

This financial tsunami, and its timing, like the election-eve sex-scandal exposés of his opponents during his Illinois races, might just be one in a long chain of Barack Obama's "lucky" breaks.

If so, Barack Obama must be the luckiest politician, ever.

There is an old salesman's saying that goes: "I'd rather be lucky than good." It may behoove voters to remember this adage before pulling the lever in November.

Washington Post columnist Anne Applebaum has an intriguing column in today's edition titled "The Iceland Syndrome."  She notes that various nations in Europe have seen their stock markets collapse with consequent political changes.  She speculates that certain machinations by players, internal and external to that nation, wishing to destabilize countries may have led to these declines. Market manipulations to achieve geopolitical ends. Is it beyond the realm of possibility?

All governments have enemies, internal and external, or at least are faced with elements that do not wish them well: the political opposition, the country next door, the former imperial power. For someone, there will always be the temptation to bring down the government, destabilize the country and thus create political chaos.

Even when there hasn't been political meddling, someone else will suspect that it has occurred, anyway. Here, then, is a prediction: Political instability will follow economic instability like night follows day. Iceland is not alone. Serbia, the Baltic states, Kazakhstan, Indonesia, South Korea and Argentina are all in financial trouble; so, too, are Russia and Brazil.

And here's a final, unpleasant thought: Pakistan. This is a country with 25 percent inflation and a currency in free fall; a country with a jihadist insurgency on its border with Afghanistan, permanent hostility on its border with India, nuclear weapons and a tradition of street demonstrations in response to suspect newspaper articles. Dozens of people, with all kinds of agendas, have an interest in using financial markets to destabilize Pakistan, and Afghanistan along with it. Eventually, one of them will.

Ed Lasky is news editor of American Thinker.
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