Why the world's new rules will punish us all

Out of the thousands of hedge funds in existence, hundreds are closing up shop and liquidating, if the latest trading action was any indication. Many of these hedge funds should never have been started to begin with, because their illusory gains during the credit bubble were too often made with leverage, rather than analytical talent.

Yet their demise hurts anyone trying to manage an investment portfolio in a prudent manner - similar to how Bear Stearns and Lehman Brothers permanently stained the entire investment banking industry. It's a case of a few bad apples spoiling the whole barrel. Unfortunately, it remains to be seen how regulators and politicians will punish every investor, including those who have acted prudently.

For example, I just read a publicly released copy of a letter dated Oct. 2, sent from the US Congress to Harbinger Capital Partners. It asks Phil Falcone of Harbinger Capital to reveal practically everything that's confidential about his funds and to testify before a committee. Let's hope US regulators don't take action to drive even more investment talent overseas, because we need them here to help keep our markets efficient.

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It amazes me how long this environment of panic has lasted. Last Thursday was one of the most violent days I've ever experienced in the markets, including the bursting of the tech bubble, and the turmoil continues this week. Quality companies in the oil services, coal, steel, and agriculture sectors were liquidated in violent fashion - many of them down 20% in a day and 50% over the past month. These are real companies performing vital functions necessary to keep the lights on and food on shelves, not speculative Internet stocks.

The list of victims includes companies that are very likely to deliver good earnings over the next few years. The list includes several of the stocks I've recommended in past issues of Strategic Investment, and still follow closely. If you're a long investor, there are some screaming bargains out there - unless, of course, half of the world's population stops using food, electricity, and oil. I doubt that will happen in a world of unfettered deficits and central banks, but anything's possible. I'll have more to say about this in an upcoming issue of Strategic Investment.

For immediate ideas, I strongly recommend considering the long list of bargains that my colleague Chris Mayer has recommended in Capital & Crisis and Mayer's Special Situations. It's mind-boggling how cheap some of them have become. Chris is an excellent stock picker. He goes to great lengths to find safe, cheap investments.

Government inflation vs. private deflation

The money managers that survive this environment will probably look to own some of the dirt-cheap stocks in the energy, commodity, and agriculture sectors, rather than expensive stocks that thrived on spending from home equity loans. Once this credit market panic subsides, I expect we'll see this shift in sector focus. Fund managers will have to start distinguishing between earnings that resulted from fake, bubble-induced consumption, and earnings that resulted from real, sustainable demand. I'm looking forward to earnings season, when analysts and fund managers can finally get some guidance about which companies' earnings will hold up best during this recession.

Even the best fund managers and stock pickers in the world are down for the year. A few of these managers saw the credit crisis coming, and made nice profits shorting financial stocks. But the SEC's totally arbitrary rule changes in recent weeks have created an environment that's very difficult to navigate.

The SEC's short-selling ban has not changed much, other than taking efficiency and liquidity out of the market. For example, Allied Capital was on the 'do not short' list. Yet it crashed earlier this week upon announcing the bankruptcy of Ciena Capital. That was a case of long investors all trying to squeeze out of a narrow door of liquidity. It was not a 'short attack'.

Uncertainty about the banking system is causing this panic in the credit markets. Innocent bystanders are suffering from the fallout from this credit bubble.

For example, I've read several accounts of hedge funds whose assets are stuck in the black hole that is Lehman Brothers' balance sheet. I'm not referring to people who own Lehman bonds, I'm referring to funds that had custodial agreements with Lehman. Custodial agreements are supposed to ensure that Lehman could only execute trades for the pool of assets under its custody - not take actual possession of the assets.

It seems that in the days and hours before declaring bankruptcy, Lehman moved certain assets - many of which it did not own - to its subsidiaries all around the globe. Now, hedge funds with no perceived credit exposure to Lehman are joining the line of creditors, fighting to get their clients' assets back in bankruptcy court.

This total destruction of confidence in counterparty risk is the reason why credit is drying up. So what has the Federal Reserve been doing as the lender of last resort?

It has nearly doubled the size of its balance sheet in the past few weeks. The Oct. 3 issue of Grant's Interest Rate Observer describes:

"After a flat-footed start, [the Fed] had shown its ability to degrade its balance sheet by selling off its Treasuries and acquiring dubious mortgages. But it had not really put its back into dollar debasement. The sum total of its earning assets, i.e., Reserve Bank credit, was rising at year-over-year rates of just 3% to 4%. Where was the push to print up enough dollar bills to smother the debt crisis of 2007-8 - assuming the problem was susceptible to smothering through money printing?

"Mystery solved: Reserve Bank credit is suddenly flying. It surged by $203.6 billion, to $1.135 trillion, in the banking week ended Sept. 24. And if Merrill Lynch's guess is on the mark, it has soared to $1.730 trillion in only the past few days, a near doubling since May 2007 [emphasis added], when the latent crisis became manifest."

After the panic subsides, the Fed will rein in much of this new money. Right now, banks are 'stuffing it under the mattress,' so to speak. Banks and individuals are crowding into the perceived safety of Treasury bonds. That's why consumer prices aren't immediately rising; private market credit is contracting as fast as the Fed's balance sheet is expanding. The Fed will always lend when no one else is willing to do so. "The US government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many US dollars as it wishes at essentially no cost," said Fed Chairman Bernanke in November 2002. This means that there will always be paper money available to lend. However, the US dollar is getting debased on an unprecedented scale.

The printing press may be the only way to prevent a self-sustaining credit panic, but it doesn't come without a price; it lowers the US dollar's stature even further in the eyes of our foreign creditors.

I'm betting that government inflation will defeat private market deflation. However, when the dust settles, I expect the Treasury and Fed to have its own set of negotiations with foreign creditors. The obligations they are assuming and monetising are simply too enormous without inciting a potential panic among our generous foreign creditors. Maybe we'll see a Bretton Woods-type agreement in 2009 - one where the US dollar is devalued by 50% against certain foreign currencies overnight.

This article was written by Dan Amoss, CFA, for Whiskey and Gunpowder