You sport a huge beard and a towel on your head and in the name of Allah you try to bring down the computer infrastructure on which the world depends. You are, in contemporary argot, a ‘cyber-terrorist’. You wear a button-down shirt and chinos, and in the name of turning a profit you deliberately set out to wreck a pillar of the financial system, or a country’s economy. In this case you are, it appears, a ‘market manipulator’. Can you spot the difference? Aside from motive, little separates the two: one wants to create a global caliphate, the other to make billions, but neither employs violence and both are indifferent to the chaos they cause. Is it time for hedge-fund managers to be subjected to extreme rendition from their Mayfair offices? Alas probably not, but the case for some equally firm application of justice is compelling.
Take the Icelandic crisis earlier this month. The frozen island in the north Atlantic undoubtedly has a puzzling economy. Once almost entirely based on fish, it has been enjoying a boom that brought with it a high current-account deficit and high inflation; and Iceland must surely lead the world in Range Rovers per capita. Its three leading banks are famous for their aggressive expansion and relatively heavy reliance on market funding rather than retail deposits — something superficially reminiscent of the dreaded Northern Rock. The banks’ assets are a vast eight times Iceland’s GDP, yet they are in some respects conservative, apparently avoiding, for example, the dodgy debt instruments that have caused so much trouble elsewhere. The overall picture has the elliptical and sometimes gnomic quality of the lyrics of that most famous of modern Icelandic exports, Björk.
Such obscurity provides the perfect grounds for market manipulation in tandem with short selling. For the uninitiated, this phenomenon allows institutions to take negative positions on stocks or currency; the more they fall, the more you profit. The value of the technique usually lies in its use as a hedge against risk — a means of minimising losses or maximising profits whichever way the market goes. Shorting is in itself a legal and long-accepted market activity. Illegality only comes in when an institution or trader shorts a stock, let’s say, then spreads false rumours intended to drive that stock down. In this respect it is a dystopian, postmodern successor to old- fashioned stock ramping.
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.
‘Now Icelandic CDS spreads are back down to around 800 basis points, but that’s still too high: in the summer of 2007 they were at 30 basis points. So what the speculators do is short the currency and equities and talk up CDS rates. It’s a triple whammy.’
The point is that the triple whammy is only dubious if market manipulation can be proven. It is interesting, then, to note the actions of one fund (not one of those present on the January trip to Reykjavik) around the end of March. The Spectator has learned that a partner of the fund telephoned at least two individuals with market influence and helpfully informed them that Icelandic banks were about to tank. He suggested that the famous Landsbanki IceSave and Kaupthing Edge internet savings accounts, currently beloved of British savers, were vulnerable to a run if Northern Rock-esque trouble were revealed — as, he suggested, inevitably it would be. Coming at a time when bank shares and the currency were already in freefall and CDS rates were going through the roof, this was calculated to turn a reverse into a rout.
A source in the British FSA confirms that it has received several reports of calls by this fund, but that the FSA has yet to launch an investigation. The ultra-litigious habits of the funds prevent naming the perpetrator at this point. But there are other instances of packs of funds attacking institutions through shorting and false rumour, which at any time would be criminal. In the present credit crunch, when the financial system is wobbling, it is tantamount to financial terrorism.
The most notorious case is the collapse of Bear Stearns in March. According to a banker with direct knowledge of the matter, who insists on anonymity, ‘Bear Stearns was prime broker for several hedge funds. A number of these funds started shorting Bear stock, and at the same time creating uncertainty over its liquidity. At the same time they also withdrew their business from Bear’s brokerage desk. They created a run on the bank using black propaganda and abusing their client status.’
Of course there was little sympathy for the vaguely thuggish Bear Stearns. Few on Wall Street had forgotten how the investment bank had walked out of talks on rescuing the stricken hedge fund Long Term Capital Management (LTCM) in 1998. There was, therefore, considerable schadenfreude, not only among the hedge funds, when Bear in turn was denied a bail-out and eaten up by JPMorgan.
But the next day Lehman Brothers, a far more blue-blooded institution, came under similar speculative attack from hedge funds. A storm of rumours about the bank’s health caused its stock price to dive by 50 per cent. More seriously, some Lehman clients were panicked by specific — but false — rumours that both Merrill Lynch and the government of Singapore had broken their relationships with Lehman because it was in trouble. Had the bank not been able to reassure its clients, this rumour could easily have proven self-fulfilling. Lehman survived by a whisker, and has now filed the details of the episode with the Securities and Exchange Commission. Whispers of illiquidity, while profitable for short sellers, are poison for a bank.
arrogance, aggression and secrecy of the hedge funds which participate in this kind of activity is off the scale. Some appear to believe that they exist in a realm removed from social, moral and legal responsibility. Many do not publicly list addresses or contact details and will not interact with the press if they are reachable at all — although evidently some are also happy to retail unattributable lies to journalists when it suits them.
Free financial markets are desirable in order to mobilise capital and increase standards of living and wealth. It is stretching the definition of free markets to include the liberty to vandalise financial institutions, attack sovereign countries and deliberately destroy value on a huge scale.
It is surprising that after the US Federal Reserve organised the rescue of LTCM, it and the SEC failed to create a regulatory architecture that would rein in hedge funds. Banks, for example, are quite happy to submit regular reports of their loan exposure to their central bank or regulator. Why, then, cannot hedge funds be compelled to make confidential declarations of their positions — especially short positions — to the same authorities? This would, at the very least, aid retrospective investigation where market manipulation is suspected, and would serve as a deterrent. Failing that, the last resort in the face of such terrorism might be extreme rendition to the sun-baked cages of Guantanamo Bay — or perhaps, more appropriately, to a chillier island prison in the North Atlantic.