The Daily Reckoning PRESENTS
The derivatives market has reached a face value of $480 trillion...30 times the size of the U.S. economy...and 12 times the size of the entire world economy. Trading in derivatives has become not merely a huge boom or even a large bubble - but the mother of a whole tribe of bubbles...dripping little big bubbles throughout the entire financial sector. Bill Bonner explores…

On November 27th, a story appeared in the Financial Times telling readers that rich investors were having to resort to ‘underhanded’ means and special favors in order to get into the best hedge funds.

Somewhere in the dark mush of our own brain came a flicker of light...and the ringing of a bell. We recalled how hard it was to get in on the Initial Public Offers of the late ‘90s. All a fellow had to do was to put together a plausible dot.com story and take it to the financial wizards of Wall Street or the City. A few months later, actual shares of this hypothetical business would hit the streets. And since managers found it convenient for the shares to rise quickly following their release, they were normally priced at a level where they were bound to go up, even though they were already selling for far more than they were worth. This meant that getting in on the early stages of the IPO was almost guaranteed money-in-the-bank. And it is why Barbara Streisand, to cite a famous example, would send tickets to her shows to IPO managers, hoping for more than a round of applause.

Of course, the dot.coms blew up in January 2000...and investment bankers stopped getting the free tickets. Now, they’re going to hedge fund managers.

But the average fund has not been doing well; so far in 2006 you could have done better by accident than by hedge fund. The typical fund is up only about 7%. The FTSE has risen 9% and the Dow is up 15%. This seems only to have made investors desperate to get into the tiny group of funds that are doing well.

Well-established and top performing funds are often ‘closed.’ They already have plenty of money. And smart managers know that they cannot accept more without degrading their returns. When too much money chases a limited number of good investment ideas, investments regress to the mean. Still, “people are quite flabbergasted, especially very wealthy people, when you send their money back,” said the FT source.

Last week, another bit of news reached us: the derivatives market, in which hedge funds tend to speculate, has reached a face value of $480 trillion...30 times the size of the U.S. economy...and 12 times the size of the entire world economy. Trading in derivatives has become not merely a huge boom or even a large bubble - but the mother of a whole tribe of bubbles...dripping little big bubbles throughout the entire financial sector.

And now our friend Simon Nixon reports that the hedge fund industry is transforming the “social geography of Britain. Fortunes have been created on a scale and in a timeframe that we have not witnessed for 100 years, if ever before. According to the Daily Telegraph, the average age of buyers of old rectories - those quaint country houses favored by the new-moneyed classes - in Britain has fallen by ten years to people in their early 30s.”

Societies go through major trends and minor ones; small fads and big ones; cute little peccadilloes and major public spectacles. Before the Renaissance, societies were besotted with religion - a passion that burned itself out in the crusades, the wars of religion, and the inquisition. Then, they took up politics - and became so wrapped up in ‘isms’ that, by the 20th century, they were killing each other at the fastest pace in history. More than 100 million people died in the 20th century - victims of bolshevism, national socialism, communism, nationalism or some other excess of political enthusiasm.

And now it is finance that has the world’s attention. China says it is a ‘communist’ country. But it seems not to care. Nor does anyone else care what the Chinese call themselves. The only thing anyone seems to care about is that China is open for business. They could throw vestal virgins into Vesuvius or tear the beating hearts out of their enemies so long as their economy grew at 10% per year. The Chinese are the envy of the entire world. Politics has yielded to money.

The fashion for politics peaked out in the United States during the Kennedy Administration. Kennedy’s inaugural remarks - ‘ask not what your country can do for you...ask what you can do for your country’ - marked the all-time high. That was before the war in Vietnam came a cropper, and before the war on poverty and the war on drugs were launched. People believed in those wars and were sorely disappointed when victories weren’t forthcoming. Now of course, we have a war on terror...but few people talk about it at all...and no thinking-person mentions it without an ironic smirk. In fact, the war on terror is hardly a political war at all - but a campaign designed to protect the flanks of the great financial empire. If it were discovered that it diminished consumer spending or raised mortgage rates, for example, it would be stopped tomorrow.

Now, it is money that counts. And mommas now want their babies to grow up to be hedge fund managers. They know where the money is. There’s no money in religion - unless you’re a TV evangelist...and those slots are hard to get. Besides, they are more business than religion, anyway. A good politician, meanwhile, even if he is slick, can only skim off a certain amount without getting caught with his pants down. The Clintons, for example, were only able to pull off a shady land deal...and operate a penny-ante cattle-trading account - besides the book contracts, of course. It might have been serious money, but it took a whole career of sordid dissembling to pull it off. The Bushes have done better, but it has taken them a couple of generations and a few CIA contracts. And in any case, it is nothing compared to the kind of loot a hedge fund manager takes in while he is still young enough to enjoy it.

In this late, degenerate imperial age, no one gets richer faster than hedge fund managers. Last year, Edward Lampert, of ESL Investments (a hedge fund business), set the pace with $1.02 billion in compensation. Compared to him, James Simons of Renaissance Technologies Corp. must have felt like a charity case, with only a bit more than $600 million in take-home. But he still did better than Bruce Kovner, at Caxton Associates, who earned $550 million.

The New York Times provides a list: Steven Cohen of SAC Capital Advisors, $450 million; David Tepper of Appaloosa Management, $420 million; George Soros of Soros Fund Management, $305 million (Soros was number one in 2003, with $750 million); Paul Tudor Jones II of Tudor Investment Corp., $300 million; Kenneth Griffin of Citadel Investment Group, $240 million; Raymond Dalio of Bridgewater Associates, $225 million; and Israel Englander of Millennium Partners, $205 million. Poor Richard Fuld; the man earned only a paltry $35,257,099 for his work running Lehman Brothers. And E. Stanley O’Neal, at Merrill Lynch got even less: a miserly $32,134,673.

We do not report those figures out of jealousy, but simply puzzlement and amusement. Every penny had to come from somewhere. And every penny had to come from clients’ money. Investors in leading hedge funds must be among the richest, smartest people in the world. Still, with no gun to their heads, they turned over billions of dollars’ worth of earnings to slick hedge fund promoters.

What do you need to do to get that kind of work? Well, it helps to be good with complicated math. Then, you can join other hedge fund managers who trade derivative contracts that the clients cannot understand, such as the recently launched CPDO, the Constant Proportion Debt Obligation. According to Grant’s Interest Rate Observer, the CPDO may be an innovation, but it is hardly a new idea. It is remarkably similar to the CPPI, or Constant Proportion Portfolio Insurance, which made its debut 20 years earlier.

The CPDO is meant to protect investors against the risk of investment-grade credit defaults. CPPI was meant to protect investors from a stock market crash, using a complex formula that clients also couldn’t quite understand. Then in 1987, only about a year after the CPPI was introduced, the stock market crashed and investors finally figured out how they worked. Sifting through the debris, analysts determined that CPPI had not protected investors; instead its fancy programmed trading features actually magnified the losses.

We don’t know how the CPDO will hold up under pressure, but we can barely wait to find out. Whenever the higher math and the greater greed come together, there are bound to be thrills.

The twitty quants at big investment firms invent the complex derivative contracts...give them a jolt of juice...and then the abominations spring to life. The next thing you know, the hedge fund whizzes are building big houses in Greenwich, Connecticut - and there are billions of dollars...no trillions...in CPDO and other contracts, in the hands of buyers who don’t quite understand the elaborate equations behind the contract...and (here we are just guessing) who will be surprised when they find out.

If you are good with figures, you can at least partially protect your own investments. But it usually means taking a position on the opposite side of the great weight of investment capital. You can also find ways to make more money than your slower-moving peers, again, by doing things a bit differently. But neither financial wizardry...nor any complex instrument...can protect a whole market. The whole market can’t protect itself from itself. The more people climb onto an investment platform - whether it is derivatives, dot.coms, dollars or dirigibles - the more it creaks and cracks, and the more damage it does when it finally gives way.

But buyers of CME (the Chicago Mercantile Exchange) don’t seem to notice. Google, the newest, hottest technology stock of late 2006, trades at a forward P/E of 36...CME trades at an astounding 51. CME is where futures and derivatives trade. The stock came out three years ago at $39. Since then it’s gone up 14 times, to more than $550. In New York, meanwhile, the NYSE gets half its daily volume from hedge fund trading. Its stock too, has been on a roll, now trading at 10 times sales, 119 times trailing earnings, and 46 times forward earnings.

If you want to profit from hedge funds, the best way is to become a hedge fund manager. Or, if you want really want to get into hedge funds, but wish to retain your dignity, you could consider investing in a hedge fund company. At least two hedge fund companies have sold shares to the public on the London market.

But hedge funds are supposed to be able to produce superior returns for both investors and managers. If they could do so, why would they wish to trade their shares for cash? What will they do with the money; invest it in someone else’s hedge fund? But with returns falling...and customers beginning to ask questions...more hedge fund impresarios are likely to want to get out while the getting is good. As the funds become less profitable, in other words, more will probably be sold to strangers who don’t know any better.

And then, someday - perhaps someday soon - a peak in the credit cycle will come. The mother of all bubbles will finally pop and then the ‘little big bubbles’ in the financial industry will pop. The Dow will come down - the dollar too. Junk bonds will sink. Builders in Greenwich will notice that their phones aren’t ringing as often. NYX and CME will crash. And 5,000 hedge fund managers will be on the streets...looking for the next big thing. When will it happen? How? We don’t know. But our guess is that when the history of this bubble cycle is finally written, derivatives will get a special ‘tipping point’ place...like the Hindenburg in the history of the Zeppelin business...or the Little Big Horn in the life of George Armstrong Custer.

© 2006 Bill Bonner
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Bill Bonner is the founder and editor of The Daily Reckoning. He is also the author, with Addison Wiggin, of The Wall Street Journal best seller Financial Reckoning Day: Surviving the Soft Depression of the 21st Century (John Wiley & Sons).

In Bonner and Wiggin’s follow-up book, Empire of Debt: The Rise of an Epic Financial Crisis, they wield their sardonic brand of humor to expose the nation for what it really is - an empire built on delusions. Daily Reckoning readers can buy their copy of Empire of Debt - now available in paperback - just click on the link below:

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