Tantamount to financial terrorism

26 April 2008

Neil Barnett says hedge funds should be forced to reveal their trading secrets, to deter them from the kind of market manipulation that has recently hit Icelandic banks

As the Financial Times has reported, in January 2008 managers from Bear Stearns and four funds (named by the FT as DA Capital Europe, King Street Capital Management, Merrill Lynch GSRG and Sandelman Partners) visited Reykjavik. According to an Icelandic banker who spoke to one of the managers, they had all decided to go short on Iceland and expected a payout comparable to ‘the second coming of Christ’. Iceland’s equivalent of our Financial Services Authority is now investigating the visit and subsequent trading.

Numerous funds around this time started to short Iceland’s currency and bank stocks, at the same time as holding credit default swaps (CDS) — tradeable instruments which provide insurance cover against the possibility of default — relating to bonds issued by Icelandic banks. The CDS rate moves according to the market’s perception of risk, and the bond issuer is obliged to pay it. Moreover, the CDS market has become speculative: CDS contracts overall are worth $45 to $60 trillion against a total underlying value of bonds that is less than a quarter of that figure.

Professor Richard Portes of London Business School, a close observer of the arcane Icelandic economy, explained how this worked. ‘The way a fund would play Iceland is to short both the currency and the equity markets simultaneously. This forces the monetary authorities to raise interest rates, which in turn pushes down the equity markets. In this latest Iceland episode there is a new wrinkle, the CDS market, which is highly distorted.’

He went on, ‘CDS rates are at ridiculous levels. For Icelandic banks at one stage they were at 1,000 basis points, so that insuring $1 million of bonds cost $100,000. This implies that all of the Icelandic banks would go under over a five-year period, which most of the market doesn’t believe. The explanation is that the credit crisis means no one wants to insure debt, so the market is very susceptible to rumour and manipulation. You can push up spreads on pretty much any target this way.’ And this in turn piles yet more pressure on the banks’ liquidity.

Previous page 1 | 2 | 3 | 4 Next page

More articles from: Neil Barnett | this section

Print this article | Email to a friend | Permalink | Comments (2)

Post this entry to: del.icio.us | Digg | Newsvine | NowPublic | Reddit

Post comment

Chris De Vere

May 2nd, 2008 10:37pm Report this comment

Neil Barnett describes the behaviour of Hedge funds in shorting Iceland's currency and banking stocks as "financial terrorism". In doing so, he is missing the real culprits.

Bank deposits were originally treated as deposits for safekeeping and to be one hundred percent available, just as if goods were being stored in a warehouse. In other words, the funds on deposit could not be lent out to others in a process of credit expansion. Laws going back to Greek and Roman times have upheld this.

However, laws in more recent times have broken this principle by obscuring the difference between deposits for safekeeping and loans, legalizing fractional reserve banking and credit expansion. The great beneficiaries of this have been the banks themselves which have been able to greatly increase their profitability and governments which have been amongst the first and biggest beneficiaries of that credit expansion. Indeed, fractional reserve banking can only exist as partnership between the banks and governments, the governments having a monopoly on the issue of currency and a central bank to bail the banks out as a lender of last resort.

The Hedge Funds are therefore only pointing out what is essentially true: that in a fractional reserve banking system, the banks are technically insolvent; and the ability to trade in this way was only made possible by the legalizing of fraudulent activity.

I draw one’s attention to Jesus Huerta de Soto’s book, “Money, Bank Credit and Economic Cycles”.

David Jones

May 17th, 2008 5:34pm Report this comment

Chris De Vere makes a very noble post, but misses the point entirely, that the reason people deposit their money with banks in modern times is not only for safe keeping but to ensure a rate of return.

A bank that is required to keep funds '100% available' cannot produce a rate of return much higher than that of the depositor that chooses to store his banknotes under the bed.

Indeed a depositor who has done his homework, would weigh up in advance the level of risk/return that is acceptable before he chooses the institution that he places his funds with.

It is a brave cause to campaign against the evils of fractional banking, but much like the man spending his life in the street wearing the 'end of the world is nigh' sandwich board, the rest of the world is going to carry on around you regardless.

As for the hedge funds, they have been betting against Iceland in one way or another for the past decade... and they are still waiting for the collapse.

Post comment