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Larry Kudlow's "New Bull Market" claim being particularly offensive

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Ponzi Scheme: a fraudulent investing scam promising high rates of return with little risk to investors. The Ponzi scheme generates returns for older investors by acquiring new investors. This scam actually yields the promised returns to earlier investors, as long as there are more new investors. These schemes usually collapse on themselves when the new investments stop.

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Hedge Funds and the Financial System
It is essential to understand how the credit crisis came about and created the underlying set of conditions whereby a counterparty run on a relatively small investment bank like Bear Stearns could have threatened the global financial system. More broadly, the answer to this question is important in understanding why the frequency of financial crises has been increasing since the Asian crisis flared in 1997.

A good start toward understanding the difference between ordinary risk and systemic risk is to ask how a hedge fund resembles the banking system--especially with respect to risk management--and how it does not. A generic hedge fund can be seen as a collection of traders, each of whom is charged with earning as much money as possible. To that end, the trader is provided with ceilings on the size of investment positions he or she can take and is given incentives in the form of an agreement whereby he or she retains a percentage of the profits earned for the firm. The fundamental risk-management problem for a hedge fund is related to the fact that traders do not personally share in losses, just in gains. An individual trader therefore has the incentive to take too much risk because he or she captures all of the upside of large winning trades without a downside for net losses. Specifically, if a trader loses over the course of a year, the company has to absorb the loss. The trader receives no bonus and may have to make up the loss in subsequent years, but the company absorbs the loss on a year-by-year basis. The "zero-bound problem" (again, my term) breaks into the headlines when a single trader, having taken far too much risk, loses so much money that the entire company is forced to either close or take a massive loss, while the downside for the trader is limited to dismissal from the company.

Risk management for a hedge fund, given this background, is relatively straightforward. First, traders are given limits on the size of positions they can take, and their activities relative to those limits are monitored. [EXACTLY WHY KARL HAS BEEN RAILING ABOUT THE GLASS-STEAGALL ACT REPEAL AND JAILING THE FRAUDSTERS] (This is true in most cases. There are exceptions, however, as with the spectacular losses by an unsupervised trader at Société Générale at the end of 2007.) Sometimes traders press to exceed their predetermined trading limits. If they do so consistently and their returns become too volatile or too negative, traders are usually asked to take a "timeout." If the excessive risk-taking continues, the offending trader is dismissed. The important point here is that the trader's dismissal and the negative consequences of poor risk management or bad trades do not have systemic consequences. Rather, the losses are absorbed by the hedge fund, which may or may not prosper, depending on its risk management going forward. Further, dismissal of a trader who fails to manage risk is clearly in the interest of the hedge fund owner or manager who has a strong incentive to contain trading losses.

Now consider the statutory and regulatory problems referred to by Chairman Bernanke: risk management of the global financial and banking system. Banks and other financial institutions assume the role of individual traders, while central banks and regulators take on the role of hedge fund management. The incentives for banks and individual financial institutions to assume too much risk are similar to those of traders, especially in institutions deemed "too big to fail." The "Greenspan Put"--in which investors rely on the central bank's claims that it cannot identify market bubbles as they build but can contain the damage to financial markets after bubbles have burst--encourages a buildup of systemic risk. Regular readers of this publication will recall that in July 2007, just before the credit crisis intensified sharply, former Citicorp CEO Charles Prince said "as long as the music is playing, you've got to get up and dance." It is the compulsion for banks to "dance" while a bubble is inflating that creates systemic risk. Individual banks and investment banks know they are taking too much risk--recall the virtual disappearance of risk premiums during 2006 and early 2007--but they lose market share if they stop taking the risks that other institutions are taking to inflate the bubble further. The central banks' silence on a bubble encourages the process, as does its complicity to manage postbubble fallout once the bubble bursts. When the music stops, if you are too big to fail, the Federal Reserve helps to cushion the pain by sharply cutting interest rates, providing liquidity, and otherwise acting to contain systemic damage...

Banks and financial institutions individually strive to maximize profits while counting on the Greenspan Put to minimize the costs on the downside. For the systemic-risk managers who oversee the financial and regulatory framework that governs them, perhaps the trickiest part of their role is how to discipline the bad actors. Bear Stearns was a classic case in point. Bear Stearns behaved very much like a rogue trader, taking on far too much risk in the mortgage sector by starting up hedge funds specifically designed to take such risks even as the real estate bubble began to collapse. Regulators and system managers really had no means available to force Bear Stearns to take a timeout. [BECAUSE OF BANK DEREGULATION, DUH.] When the time came to "fire" them in March 2008, it was not possible simply to let them fail because of the systemic risks entailed by such a step.

Hazy Incentives for Systemic-Risk Managers
The other big breakdown in the analogy between risk management at a hedge fund and risk management in the banking and financial system concerns the incentives of the managers. In the case of a hedge fund, management is highly motivated to discipline traders who take too much risk because the managers have a large stake in the survival and prosperity of the fund itself. They want to weed out irresponsible traders, and they have the means to do so in ways that do not entail risk to other institutions or to the financial system. In fact, their diligent risk management is both in their interest and in the interest of the system at large.

In the case of the banking and financial system, however, the regulators and central banks that manage the financial and regulatory framework do not have the clearly defined self-interest of a hedge fund manager. In the vernacular, they do not have as much "skin in the game"--that is, personal risk and reward at stake--as hedge fund managers when it comes to risk management. In addition, the Greenspan Put framework--whereby bubbles are allowed to rise while central banks try to clean up the damage after the bubbles burst--reinforces the strategy of too much risk-taking by individual institutions run by managers whose compensation may not suffer overall if they can retain huge gains during a bubble buildup while cushioning losses after it bursts, especially if the Greenspan Put provides a successful hedge. Of course, the bursting of the housing bubble has been so violent that some managers have not survived, but most--with the notable exception of managers at Bear Stearns--have managed to hold on to gains accrued while the bubble was inflating.
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http://www.aei.org/outlook/28565

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No, real buying is just that - real buying from real retail investors who believe in the forward prospects for the economy and business, not funny-money Treasury and MBS buying by The Fed from "newly created bank reserves" funneled back into the market via high-speed computers. The latter is nothing more than a manufactured ramp job that will last only until "the boyz" get to the end of their rope(and yes, that rope does have an end)...

Last modified: 2009-08-05 00:41:32 by jstanley01