Exodus In Waiting

The deadline for many investors to get their money back from hedge funds by the end of the year passed this weekend. Now we'll see what happens. Will stocks stop falling now that funds have finished selling to meet redemptions? Keep in mind that hedge fund assets doubled over the last three years to around US$1.7 trillion today.

Let's assume that all those pension funds and college endowments and local councils that rushed into funds because they were hip and cool now rush out. Okay. Not all. Let's say half. You'd have about $800 leaving the fund industry (with all the de-leveraging and equity selling that implies) and looking for a new home.

While hedge fund assets are shrinking, the Fed's balance sheet in the U.S. is growing. The Fed started 2008 with about $890 billion in mostly squeaky clean U.S. Treasuries on its balance sheet. It now has nearly $2 trillion, much of which is "collateral" from banks, prime brokers, and other financial firms who traded assets they could not sell for Treasuries from the Fed.

It's the incredible growing balance sheet. Speaking about the so-called assets on the Fed balance sheet, Dallas Fed President Richard Fisher said, "I would not be surprised to see them aggregate to $3 trillion...by the time we get to the new year." That's 20% of U.S. GDP.

Now we can't guarantee that the Fed will finance its collateral laundering program with new cash from the U.S. Treasury. But one way or the other, the U.S. government is going to have to sell more bonds to finance its portfolio of bailouts. The big question is whether all these hedge fund investors who've redeemed what's left of their capital will stay in cash or switch to short-term bonds (which are admittedly paying below the rate of inflation).

If they move to bonds, it's probably bad news for equities to finish the year. It's also madness. But hey, when you have a lot of cash (other people's money) it has to go somewhere. And the U.S. bond market is as liquid a place as any.

"Landmark Finance Summit Sets New World Order," reports Deutsche Welle. "Summit of lies," countered Italy's La Repubblica. The beauty of integrated global financial regulation is in the eye of he who gets to make the rules, apparently. The G20 summit in Washington on the global crisis has come and gone. What did it leave behind?

More tax cuts. More government spending. Lower interest rates. That seemed to be the gist of things. The group will meet again in London on April 30th to make more rules and to-do lists.

You'd think cutting taxes AND spending more at the same time, would, you know, increase government deficits. But the political imperative across the world is not to balance a nation's books or for a nation to live within its means, but to keep voters employed. Employed voters don't rebel. But you can't have employment without more growth. Thus the stimulating trifecta of tax cuts, lower rates, and more government spending.

The statement the G20 released after its summit is the sort of thing only an accountant (or, perhaps, Kevin Rudd) could love. But G20 statements, like all of God's creatures, need love, too. It made some good points about taking a look at how credit ratings agencies operate (and are regulated), the transparency of the credit default swap market, and accounting standards.

Another worthy point was made about executive compensation, although not in the populist way you'll find in the papers. The real issue isn't how much money executives make. That's up to shareholders and boards of directors, and if they've gone along with it until now, it's their own fault. Executives should make exactly as much as compensation committees and shareholders permit.

The real issue is whether the interests of executives are aligned with the interest of shareholders, or, as the case seems to be in the last few years, directly opposed to them. If executives, or whole entire financial firms, benefit by putting shareholder capital at elevated risk to boost earnings which trigger options compensation targets, then the interest of the executives is not aligned the interest of the firm or its shareholders.

This is true, of course, across the financial services industry. It's a question you should always ask yourself about anyone you choose to do business with. Are their interests aligned with mine? The simplest way to do this is to ask: how do they make money? If they make money through fees and charges that are not related to performance, then there's a pretty good chance their interests are not aligned (and are often opposed) to yours.

Of course it's not realistic to expect that everyone is always going to be on your side. That's not how it works. But what most investors have now realised is that in a bull market, you can get by without having your broker or your fund manager looking out for you. The market takes care of you both. But in a bear market, you find exactly who's been making a living at your expense, without adding anything of value.

If one lasting change comes from the Financial Panic of 2008 (or World Depression One), it's that a business has to be run for the long-term benefit of its customers. If a business takes care of customers, shareholders benefit. But the idea that the shareholders or executives can extract maximum value out of a corporation's balance sheet or earnings in the short-term violates the very legal idea of the concept of the corporation.

The corporation is designed to be a going-concern, a legal entity that survives the comings and goings of those who work inside it. But it can only do this if those who run it operate it to serve the interests of customers. If they operate it to serve their own interests, they'll kill it. Hence, the rising number of corporate casualties.

Back to the G20 quickly. If you had to pick just three points to focus on from the report that could affect investors, they would probably be accounting, the IMF, and pro-cyclicality. You can detect an almost panicked plea by G20 leaders for accounts to figure out a way to value the "toxic collateral" that's poisoning the global financial system.

But guess what? Whether it's fair-value or mark-to-market, accounts already DO have a good way of knowing what it's worth...and either way you add it up, it comes to less than what banks would like to value it at. Still, rather than realising losses, expect more bailouts and capital infusions for a large list of increasingly non-financial firms. We are all Socialists now.

The bit about pro-cyclicality is central bank and economist speak for the fact that financial markets are actually accelerating volatility in the real economy (as if the financial markets were not actually part of real economy.) The idea that somehow cyclicality can be removed from the economy by reforming the financial markets is a central planner's opium dream. It shows you how naive the expectations are for global harmonisation of regulatory, tax, and accounting standards.

What about the IMF? Now that should be interesting. The IMF may emerge as the first powerful institution in the New World Order, whatever that Order ends up looking like. It's worth keeping an eye on.

The emerging market nations (Brazil, India, China, Russia) and the developing world would like more say in how the IMF makes its loans and sets its conditions to the rest of the world. But for years, the IMF has been the tool of dollar hegemony. You get bailout money in exchange for opening your markets to U.S. and European trade.

Today, though, the IMF needs more money to bailout bankrupt governments. Though it is quintessentially an American institution, the IMF has to be funded by people who have money. Americans and Europeans can't fund it at the moment. But others could. Currently, those "others" are Japan, China and Saudi Arabia (the world's savers, traders, and oil exporters, respectively.)

Now ask yourself why these countries would fund the IMF but not get a say in how its loans are made or what rules are used to make them. It's a kind of financial blackmail. "Give us your money or the world's financial system gets it," seems to be the tone of the message coming from Gordon Brown and Henry Paulson. "It's your money or the world's economic life!"

Something to watch for? Rubin's Bane. The growing role of the IMF might come back to haunt the very people and countries who pushed so hard for the expansion of that role.

Under Robert Rubin and the Wall Street-U.S. Treasury alliance, the IMF has been pushing for capital account convertibility for years. While trade barriers in goods and service have come down over the last twenty years, the IMF wants to open up the world's capital markets by removing barriers.

Here's a prediction, though. Capital account convertibility leads to greater capital flows AND increases the likelihood of financial panics and crashes. For example, right now, huge global capital flows are making their way into the U.S. Treasury market. This finances the bailouts in America.

But should these capital flows reverse-as they could under the IMF's push for more liberal capital rules-then they have the ability to generate a tremendous crisis in the American economy. It would be a vast exodus from America's bond market into the global financial wilderness. More on this tomorrow.

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