29/10/2008 - 22:00

Crisis analysis offers differing views

29/10/2008 - 22:00


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LIKE many people, I've been bombarded by views on the financial meltdown, some via email and others through the news, offering analysis about what has taken place and what the landscape may look like in the future.

Crisis analysis offers differing views

LIKE many people, I've been bombarded by views on the financial meltdown, some via email and others through the news, offering analysis about what has taken place and what the landscape may look like in the future.

Many of those issues, both past and potential, belong in the realms of high finance, with a level of knowledge rarely required to cover business in WA.

So in recent weeks, I have taken the opportunity to attend as many related functions and interviews as possible. For instance, last week I took up an invitation to interview Chicago-based Dick Elden, the co-founder of Lakeview Partners and, from what I can gather, something of an elder statesman of the hedge fund industry, who was in town as part of his role with fledgling investment group NWQ Capital.

The previous week I also went along to hear Justin Mannolini from Gresham Partners and James McClements from Resources Capital Funds speaking on where capital markets were heading.

I also went along to UWA to hear four of their academics and Patersons analyst Alex Passmore discuss what the financial crisis means for WA. Here are a few of the things that stand out to me:

Credit Default Swaps

There has been much angst reported on these CDS instruments, which effectively brought down Lehman Brothers and insurance giant AIG.

They sound like simple devices to effectively insure standard products such as mortgages and other securities so they can be traded within the banking system. The problem is that they have been unregulated so no-one really knows who has got them and risk is really attached to them.

And they have become a giant market - doubling to around $US55 trillion in the past financial year.

There is a lot of concern out there - Mr Passmore was one who raised this spectre again last week - that we might experience another shock caused by these instruments.

However, not everyone is concerned. Mr Elden, for one, believes the risk from potential CDS contagion is relatively small.

"It would not be a major meltdown, it would most likely be a major institution, but if you have another failure it would be smaller," he said.

Let's hope so. Mr Elden pointed out, as many others have, that the CDS contagion spread because these instruments were unregulated and became very influential in the market very quickly. That begs the question as to why, when regulated exchanges have established on any tradeable item for hundreds of years, some entrepreneurial capitalist didn't figure a $US55 trillion market wasn't worth exploiting in this way, let alone one of the existing securities houses?

You'd have to expect to see one soon, that would be my guess.

Hedge funds

Naturally, Mr Elden was a big believer in hedge funds, given he started the first fund of funds in this sector, investing with the best of the various players.

Mr Elden points out that as much as hedge fund activity has got bad press, there are many different forms and investing in this sector allows great diversification and less volatility.

In fact, he expects there to be more of them as their track record bears witness to their ability to gain in markets moving in both directions.

He believes some forms of hedge funds will do very well in the current period, though he admits his own strategy of investing in activist hedge funds - those that aim to get involved in the management of companies they invest in - are less likely to perform well in this subdued market.

Not everyone is a fan of hedge funds though. James McClements points out that many hedge funds he sees in the market tend to be indiscriminate in the way they act, moving in and out of sectors rapidly rather than stock picking.

Mr McClements believes they lack the patience and are beholden to the short-termism of investors, with many allowing quarterly redemptions. He points to the worst week of the past year occurring in the first full week of October, after hedge funds have had to deal with heavy redemptions at the end of the September quarter and realise significant amounts of assets.

Regulatory system

The regulatory system has proved to be less than robust, with financial engineers and whiz kids outgunning the watchdogs.

Mr Elden believes the system is obsolete and needs a total overhaul, but he is concerned that what could emerge may well be overkill.

"It's hard to tell how that will play out, it could be punitive and counter-productive or it could be sensible," he said.

While there is much conjecture about what will occur, he views a CDS exchange and some form of transparency on short selling as likely and needed.

He believes the shorting should allow market observers and regulators to view the total position of the market or individual securities to offer a workable transparency, rather than try to micro-manage individual investors.

"I doubt there could any active oversight of hedge funds because it's too complicated."

Whatever the case, shorting a stock, and then talking it down, has to be hit as hard as ramping shares up. At least with shorts, there is a physical transaction which marks that it has taken place, unlike the whispers we see here with share-ramping where there is no evidence apart from owning a stock.

It was interesting to hear the views of UWA Business School professors Ray da Silva Rosa and Ken Clements. Both had differing views on regulation's role post-meltdown. Professor da Silva Rosa appeared most keen on the role that government can play to influence market behaviour, whereas Professor Clements seemed to take a more restrained stance, concerned that the rule makers might over-react.

Short-termism - tax and remuneration

What has been disappointing to me is that no-one has yet raised the issue of short-term thinking in our investment community which, in my view, has prompted the current crisis.

With everything based on quarterly and annual cycles, rewards are handed out before the long-term implications of such decisions are borne out. It's hard to blame boards because companies that don't perform in the short-term tend to get savaged by the investment community and suffer for that.

The tax system, reporting rules and hype surrounding so-called market success all seem to be conspiring to create bubbles and offer generous rewards prematurely, not just for CEOs but also the fund managers that back them. Only the very private and very rich can afford to be patient.

Top points for anyone who can offer a solution to this issue.


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