Over the last several months, fear has crept into the investor’s psyche.  While some of that might be just prudence, the kind of fear that grips most of the folks who take the time to drop me a line is based on the role hedge funds play in the current economic cycle.

It is understandable.  These are a somewhat mysterious entity that fascinates those of us that report on their comings and goings and frighten those that believe they are manipulating the system for the benefit of the few.

One note, received just last week struck me as typical.  

Carl writes:

“What you think of their (hedge funds) role in artificially keeping mortgage interest rates low by intervening in the short-term treasuries market (2-year notes) in order to flatten the yield curve with return on the 10-year notes low?  I suspect there is massive collusion between the banks and the hedge funds to keep the real estate bubble from bursting at the expense of small and institutional investors, who may not be aware that housing has been the engine of the recovery which began back in 2001.  What are your thoughts on this and the prospect for an economic/stock market collapse?”

Whether or not is fear is well-founded remains to be seen but I did answer his question and with any luck, many similar ones.

I replied:

To answer your question about hedge funds and their role in the housing market you have to consider two questions.  The first: is it necessarily a bad thing for hedge funds to play the flattened yield curve to their best advantage?  And second: Are these instruments of risk actually predicting risk with their back room involvement with housing?

Playing the flattened yield curve by trading off two-year Treasuries in favor of the price rally in the ten-year is just good a fixed income strategy.  The Fed has given fixed income investors a good deal of problems especially when it comes to predicting what their next move will be.  

Inflation is still a problem and could be reason enough to keep tightening in spite of the obvious slowdown in consumer spending.  With core inflation running ahead of the Fed's comfort zone, hedge funds are only doing what you would want them to do if they were investing your money.

Hedge funds have been buying up mortgage-backed securities at a good clip recently, which does appear to be suspicious at first glance.  Do they know something that we don't?  The housing market's cool down is based on the assumption that the riskiest loans issued over the last several years will lead to a wave of defaults and those houses will detract from the sale of new housing.

There are a lot of unfortunate homeowners sitting on property whose value has dropped significantly.  Whether these mortgages turn negative (the loan is worth more than the underlying property - a purely paper situation that might affect about $500 billion in outstanding loans and I emphasize the word "might"), remains to be seen.

There is an awful lot of talk about wage increases even as personal spending slows and that could, if it were true, signal the very slowdown Bernanke wants without bursting the misnamed bubble.  Consumers are resilient and resourceful and should they be confronted with their own personal economic slowdown, they will react rationally.  This is evidenced in the lack of borrowing in the most recent months. 

I'm fairly certain that homeowners will pay the bills first, starting with the mortgage and keep a losing property rather than admit their mistake.  

If that is the case, mortgage-backed securities are not as risky as they would appear to be and hedge funds that realize this are being rewarded with higher yields than Treasuries of any maturity can offer.  

The only evidence I can offer for this argument is the recent move by Moody's to begin some sort of rating system for the lightly regulated business of hedge funds.  In order to do this, Moody's is offering a grade of one through five with the best ranking going to the fund with the lowest number.  But to get a one rating, the service has changed how it views debt.  No longer will it be perceived as a risk of default or even on the ability of the fund to produce returns.  Instead, the rating will be based on operational risk.

Operational risk will encompass a wider variety of variables than just the underlying investments and could find funds that use instruments such as mortgage-backed securities more favorable than those that take a decidedly more adventurous approach.  Ratings will offer institutional investors such as pension funds a better picture of how the fund is run, their regulatory compliance all while eliminating many of the concerns that the fund will change course.

Houses will still be built even as the marketplace slows demand to a more normal production level.  I believe that demand is running around 1.75 million per year and the recent job numbers showed construction hiring is still brisk - all things considered.  

Those homes will need mortgages and banks will issue them with somewhat tighter guidelines.  And those mortgages will continue to be bundled and sold to investors like hedge funds.  Is it collusion?  I don't think so.

As to the last question Carl dropped concerning economic and equity collapse in the near future, I can only be certain of one thing.  Those trade deficits you hear about so often actually relate to real dollars in the hands of our suppliers, who turn right around and lend it back to us.  These foreign investors have a vested interest in keeping our economy propped up in the near-term as they await a better buyer for their goods.  That could be decades in the future or it might not come at all but for now, we are still the consumer of choice even if our star has diminished somewhat.

We could, with the right leadership, change the economic direction of this country without jeopardizing the current consumptive lifestyle of the American public and achieve the comfort zone that surpluses provide.  That would rely, however, on a changing of the guard starting this fall.  

We do have a vibrant economy from 40,000 feet as one economist noted.  Whether closer scrutiny at ground level will benefit the marketplace, the consumer and ultimately the investor relies on a crystal ball prediction.  Unfortunately, that crystal ball would need only one good shake to make it resemble a snow globe.

Personally, I wouldn't worry about the big picture.  If your house is in order, your retirement funded and your overall outlook remains positive, I have no doubt that most of us could weather any sort of economic storm.  Rather than concern yourself with the investment strategies of the hedge funds, which have been applying a good deal of pressure of late on companies to provide better governance, worry about those that are less prepared than you or I for any change in the economy.  

Hope this helps!

© 2006 Paul Petillo
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Blue Collar Dollar.com
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