‘For every long there’s a short.’
That is one of the comforting myths of the present credit bubble.
Yes, there are more derivatives than there are people…but no, they are
not supposed to pose a threat to the world economy. Why not? Because there
is always someone on the other side of the trade, say the experts.
Every dollar lost by one trader in London is recovered by a trader, say,
in New York or Berlin. The total amount of ‘money’ or ‘liquidity’ remains
constant. One man’s loss is another man’s gain.
But is it true? Is liquidity like water? Does every drop lost to
evaporation come back as rain? Is it like energy and matter, of which the
world supply is constant, unchanging and irreducible?
There’s the problem, isn’t it? We know very well that the world’s supply
of liquidity has recently grown at the fastest rate ever recorded. If it
can increase, isn’t it obvious that it can decrease too? And when it does
go down, who gains?
One of the remarkable features of this entire remarkable period is the
disappearance of what is called ‘short’ interest – interest in selling. We
mentioned yesterday that the people who are supposed to have shorts –
hedge funds and young, female celebrities – have been forgetting to put
them on. Life is so pleasant…so safe…they don’t think they need them
What was supposed to make hedge funds different from mutual funds or other
collective investments was that they ‘hedged.’ They went short in order to
protect themselves on the downside…thus trying to achieve decent returns
even when the broad market went up. Time goes on and hedge fund managers –
like hikers and husbands – lose track of where they are and how they got
Today, a ‘hedge fund’ is merely an unregulated pool of money in search of
investors’ cash. This desire is driven, not by a love of investors, but a
love of investors’ money. Warren Buffett describes hedge funds as a
compensation plan disguised as an asset class. By that he means that hedge
fund managers pay themselves so richly – typically, 2% of assets and 20%
of profits – that is it unlikely there will be much left for investors. We
have said so often ourselves.
But the burthen of today’s comments is not to curse the darkness of the
hedge fund industry but to light a small candle…hold it up…and burn
their fat derrieres!
We are only joking, of course. Instead, we hold up our flickering lamp in
order to try to see who is on the other side of these massive bets…and
what will happen to all this ‘liquidity’ when the bets go bad. We have
faith, dear reader…faith in the eternal verities…including this: Every
dollar created out of thin air eventually goes back from whence it came.
But let us return to our first question: if there is a buyer for every
seller, how come the world’s supply of riches – cash, credit, liquidity –
doesn’t remain constant? First, it is worth pointing out that as a credit
bubble expands, short interest does not expand with it; instead it
shrinks. Look at the hedge funds themselves. They dropped their shorts
because, as prices rose, short-selling became unnecessary…and chances to
do it became harder to find.
“We’re having a tremendous amount of trouble finding short ideas,” says
Paul Mampilly, managing director of investment group Kinetics Advisers
LLC. “We prefer to be more long than short.”
Who wants to short prices when they are going up? Only someone who is
worried that they might go down. But the longer prices continue to go up,
the less concerned about a reversal investors become. A hedge fund that
actually hedges has a disadvantage in the marketplace; its short positions
– though adding greatly to investors’ security – depress the performance
numbers. The fund managers may not be geniuses, but they can do simple
math. ‘Two and twenty’ works a lot better on $50 million at 20% growth
than on $25 million at 10%.
The other thing that happens in a big, long expansion of liquidity is that
as the interest in hedging goes down so does the price of it. Thus, there
are fewer and fewer actual dollars on the short side. Yes, if the market
goes down, a few short sellers will make a lot of money, but nowhere near
as much as the bulls will lose when their asset prices collapse.
And often, there really is no one on the other side at all. If the price
of Google shares falls to $50…hundreds of billions of dollars simply
disappear into a black hole. Except for the short interest, everyone is
worse off. The money has gone away…up to ‘money heaven,’ never to be
You can see even more clearly how this works in the residential property
market. A man who has a house worth $500,000 thinks he has a lot more
wealth than the same man when his house falls to only $250,000. He is out
a quarter of a million dollars. And who was on the other side of the
trade? Who made the money he lost? Where is the short interest in the
residential housing market? It didn’t exist. When house prices fall almost
everyone is worse off – except for new buyers. Owners feel poorer. Lenders
make less money from new transactions…and old ones comes back to haunt
them. Realtors make less. Builders make less. Appliance makers,
toolmakers, furniture makers, Home Depot and other retailers – all make
less; people are unwilling to put a lot of money into a house that is
falling in price.
And imagine what happens if the dollar falls. The U.S. national debt is
nearly $9 trillion and growing at $1.24 billion per day. Remember how
Gerald Ford sounded the alarm back in ’74 when the national debt was a
grand total $30 billion. Now, it grows by more than that amount every
Well, imagine that the dollar is suddenly worth only 50 cents. People who
thought they had nearly $9 trillion in assets suddenly realize they have
lost $4.5 trillion. Where did the money go? Who was on the other side? The
lenders are out trillions…while the borrower – the U.S. government – has
achieved debt relief of the same amount. But it never actually had that
amount of money; that is, it never had the money to pay back the
loans…and never would have. In effect, the trillions would just be
‘written off’ like a bad debt. This doesn’t mean people are necessarily
worse off…but they definitely would have less cash and credit – less
liquidity – than they had before. And other asset prices would collapse.
Of course, if the dollar were to fall in half…all of America’s
dollar-based assets would be marked down 50% too. Farms, factories, labor,
stocks, bonds, tools, cars – everything would be reduced in price. The
whole country would be about $35 trillion dollars poorer, at least on
paper. And where is the short interest? A few speculators betting against
the dollar…but what else? Again, the world would not necessarily be a
worse place. U.S. industries would be more competitive…foreigners would
stream in to buy U.S. assets at fire-sale prices…and even the working
man might finally get a real pay increase. But, there would less cash
around…fewer dollars…much less liquidity to flush up asset prices.
No, dear reader, when a credit bubble implodes, it swallows up what people
once mistook for wealth. All of a sudden, they have less money to spend,
less money to lend, and less money to invest. Asset prices go
down…consumer spending goes down…and an economic recession comes up.
What they once took for granted they now take to court – hoping to collect
10 cents on the dollar, if they are lucky.
And more views:
*** Speaking of residential property, the news reports tell us that it
seems to be stabilizing.
Have we reached a bottom? Not according to Hugh Moore of Guerite Advisors,
courtesy of our old friend John Mauldin:
“In the previous [seven] cycles since 1959, housing starts (seasonally
adjusted) have fallen, on average 50.7% from peak to trough. Each time
housing starts have fallen more than 25% from their most recent peak, a
recession has followed (except during the ‘credit crunch’ of 1966-67 that
ended in an economic contraction, but not an ‘official’ recession.)
“Housing starts have dropped 34% so far since their peak in January 2006.
Just to get to the average drop we have another 20% or so drop in the
starts to go.”
Meanwhile, the low end of the mortgage market is beginning to fracture.
Sub-prime mortgage contracts total more than $300 billion. By definition,
many of the borrowers are marginal. Many face higher expenses that they
won’t be able to afford.
*** “Everything happens in sixes and sevens,” our grandmother used to say.
We never understood what she meant by it. But now we find – thanks to
Richard Russell – a study that tells us that the years ending in sixes and
sevens always bring corrections – going all the way back to 1856.
And there it is…that immense bubble of cash, credit, and liquidity
floating through a universe full of pins. What’s more, the gravity of this
Jupiter is so intense it draws the pins towards it…like sharp edged
asteroids attacking from every direction. Will it make it through another
year without exploding?
We don’t know…but it will be fun to find out.
*** Our Christmas vacation is over. We are back at our desk in Paris… It
is a new year. We have another chance…a fresh start…still 361 days
ahead of us before we have to get another calendar. What will we do with