The government must get a grip on large private investors

(The article below argues on the basis of Michael Spence and Joseph Stiglitz asymmetric information markets theory and Gresham’s law that:

1. Large private investors (e.g. hedge funds, private equity, venture capital firms) must be regulated so their activities are completely transparent.

2. Short selling of shares of companies must be banned.

Whilst it is completely understandable that the editors of mainstream financial media such as the FT, due to their educational background, are unable to deal with technicalities of the current crisis, the article below presents a type of arguments that must be within their grasp and must have been published by them in the interest of debate on the state of the financial system. The fact that such arguments have not been published - regardless whether one agrees with them or not - raises further questions about competence and also about vested interests. Readers of this blog are invited to draw their own conclusions.)

Last week London Mayor, Boris Johnson, visited Brussels. He was openly lobbying the European Union MP’s and officials for non-introduction of tighter regulation on large private investors operating under various hedge funds, private equity firms and venture capital firms. Johnson’s argument was that these firms pay so much in taxes that it would be significantly damaging to London and the UK, if tight regulation forced them to relocate abroad. Johnson however did not address a question whether there are any costs to London, the UK economy and indeed the entire world of these private investors’ entrepreneurial exploits.

“Secrets of trade”

Investors who can bring returns on investment in good and bad economic times are widely admired. Hedge fund managers are legendary for such abilities. They never explain what makes them so successful: what kind of investment strategies they deploy. Jeeves’ “secrets of trade” is a typical response, implying deep sophistication.

Let us examine then a possible successful investment strategy based on short selling. Short selling is a relatively old strategy. If it is deployed on a macro level, like currencies or commodities, it brings balance and improvement into economic growth.

A classic example was British Black Wednesday in 1992. The government hoped to keep the value of the pound higher than the markets thought that it was worth. The investors were short selling the pound. Eventually the markets won. Although this was a defining moment of the last Conservative government, it was also arguably the turning point during the previous economic downturn. Whilst the Major’s government completely lost credibility for economic competence, devaluation of the pound made British economy more competitive encouraging exports and discouraging imports. From that point “things only got better” but despite that Conservatives lost the elections in 1997. (Conservatives’ economic electoral misfortunes were also exacerbated by a long sequence of events that went into history under the “sleaze” headlines.)

Another example of short selling was a crude oil market collapse in 1997 – 1998 when a price of a barrel dropped below $10. This curtailed exploration activities, drove less efficient players from the market and forced consolidation. In effect the price of oil rose again with remaining oil companies being more efficient. However at the time there were concerns, one voiced by The Economist, that the price of oil could collapse to $5 per barrel driving all but a handful of huge producers with low operating costs (like Saudi Arabia and the Persian Gulf states), who could have monopolised the market and then could have started dictating high prices. Fortunately it did not happen and indeed was not very likely to happen. On macro level it is rather impossible to get a control of the market.

The story is different on an individual company level. If an investor buys a stake in a company it is in his interest to ensure its growth. And it is not an easy task, but at the end of this process, through competition amongst companies, there are benefits to the entire economy. If an investor is short selling a company shares it is in his interest to drive the company down, even to bankruptcy so his return is maximised. Although for a small investor buying shares in a huge company it is rather impossible to have such impact, the story is different if a multi billion hedge fund is short selling small and medium size publicly quoted companies or even large corporations at a time of either such corporation’s trouble or general economic uncertainty.

Not a rocket science

Returning to a sample hedge fund investment strategy which is based upon the observation of the market activities in the last decade. A fund buys a significant stake and invests in a successful medium size publicly quoted company (or it does so with a private company and takes it to floatation). The share price goes up: this is a point of the first return on investment. But any rational investor knows that there is a limit to short term growth of company value. Large private investors are famous for their short term investment windows. Further growth involves more competition, mergers and acquisition, dilution of ownership and high uncertainty. So the time comes for profitable exit whilst a company is still doing well. A fund lends, for example through some offshore entity technically not even associated with the fund, significant amounts of monies to a company. Offshore holdings in non-transparent jurisdictions, non-direct association through large individual investors and trust funds with confidential structures, make such operations at present absolutely non-traceable. A fund also buys credit defaults swaps against the money it lent (possibly many times over the amount lent) and when the share price is still up it sells the shares and starts short selling. The success is achieved by a company making some “unwise” investment decisions or a fund calling back the loans. Such heavily leveraged company quickly ends up in trouble and a fund makes a nice exit return on investment: making money on short selling shares and cashing on default swaps.

The perverse nature of short selling on individual company level stems from the fact that significant investors, like hedge funds, are capable of bringing down a company that they are short selling on their shares. This came clear last autumn when even the largest banks shares were short sold to the extent that it threatened the entire financial system. Rather than banning short selling altogether, the government only temporarily suspended it.

No wonder short selling became a very popular way of making money. It is not a rocket science. At present there is a massive crowd of very powerful and influential investors in whose interest is driving the economy down. The share market is turned asymmetric, with shares of the companies being short sold by large private investors being turned into “lemons”. It is also tantamount to Gresham’s law “bad money drives out good”: since it is far easier to drive company down than to grow it, the interest in short selling will only increase, especially during downturns or times of uncertainty, with potentially disastrous effect to the economy. This goes to show that indeed markets behave rationally when it comes to immediate beneficiaries of an investment decision-making process. This however can be a parasitical arrangement at massive costs to the society at large.

Rooting out the pathology

It appears that Boris Johnson’s views on hedge funds are rather naïve. The recent scandal of MP’s expenses taught us that even amongst the most trusted individuals of the highest integrity if there is any opportunity or loophole left to make money it will be ruthlessly exploited to its limits and beyond. The current crisis showed us that the exploits of the financial sector can cost economy trillions of dollars. Whilst from free market standpoint there is a case for passive short selling even on individual shares of companies (i.e. on condition that an investor short selling shares of a company cannot influence it at all), in practice, in a global market with non-transparent offshore financial centres and multi billion pounds investors it is a breeding ground for pathology. The risk, in practice certainty, of costs of market abuse massively outweighs any possible benefits therefore short selling of shares must be banned.

Not only must the government regulate private investors, like hedge funds, and scrutinise their investment strategies and actions, it must also examine them retrospectively in detail in methodical way. The transparency of the entire financial industry practices, retrospective and current, is the key. There will be a lot of interesting lessons learnt about the “sophistication” of large private investors. Little doubt they will tell us a lot about the background of the current financial crisis.