It's been a while since my last entry, and in our current climate, two weeks seems like an eternity! We've had the botched attempt by the US government to secure their auto industry, the fall of Woolworths and Entertainment UK, the release of more terrible economic data - especially unemployment - exemplified by the announcement of massive redundancies and spending cuts at Rio Tinto. We have seen the German chancellor feud with Gordon Brown over their different approaches to the financial crisis - the Germans do not believe more debt is the answer and are refusing to burden future generations with high taxes (endure the pain now so that things will be better in the future - very prudent thinking). And let's not forget the pound hitting new lows against the Euro following fresh concerns over the health of the British economy and hints by the BoE that interest rates will be cut again soon.
This week has seen one of the largest ever financial fraud cases come to light. Bernard Madoff, the former chairman of the Nasdaq stock exchange and hedge fund big man (!), was arrested after running the world's largest yet least intricate pyramid scheme ever. Those who are not familiar with the world of funds may be interested to hear how simple it was too do. Obviously being a person with a credible record, he convinced people to invest in his fund with promises of high returns. When it came to the end of the year, he claimed that he successfully made said returns which convinced existing investors to keep their money in the funds and attracted new investment. The new investment money was used to pay the existing investor's returns. All was fine until the credit crunch hit and investors wanted their money back. Incredibly, it is not until such circumstances arose and his own admission of guilt, that he has been caught.
I assign the blame on two parties. First, and most importantly, the regulators (in this case the SEC) failed to spot the massive irregularities between the returns Madoff claimed to have made and the manner in which they are made. There is a common misconception that hedge funds are unregulated. In the UK they are constrained by MiFID - all trades have to be reported to the FSA and independent administrators have to be hired for valuation and audit purposes. By the sounds of it, US hedge funds are not constrained by the same rules - which begs the question, what is the point in having a regulator in place if it is not there to catch such irregularities? The situation is made worse by the suggestion that the SEC had been warned about the possibility of fraud in 1999. Rather than obtain a subpoena to obtain information themselves, the SEC relied upon data voluntarily provided by the firm. Literally, one independent audit would have uncovered the scheme. Many people, funds and companies have lost a great deal of money through this guy simply because it looks like his firm were treated with somewhat preferential treatment by the SEC.
The other portion of blame goes to the investors themselves. During the good times, investors simply could not say no to the offering of 10% interest a year. They failed to ask the necessary questions and evidence. All they did was follow in the footsteps of other investors and relied upon the integrity of a former big chief on Wall Street. And these investors aren't the "get rich quick" type - they are major corporations - including HSBC ($1bn), RBS ($601m), Santander ($23m) , BNP Paribas ($460m) and Natixis ($605m) - funds, individual investors and even charities. When you put it in perspective, both individuals and firms gave this guy hundreds of millions of dollars to invest simply because other people had done - what the BBC have coined "Irrational Euphoria." I bet they aren't feeling so euphoric now!
In a world where hedge funds are quickly disappearing the collapse of Madoff is likely to to accelerate the contraction of the industry - in that it may persuade many investors to demand their money back from even high quality funds and funds of funds. As a result, I would like to personally thank the SEC and Madoff for providing me with even less job security that I had before.
The other piece of major news on the radar is the rate cut by the FED to a range between zero and 0.25% (from a high of 5.25% in Sept 2007) to try to stimulate the economy. Great news for people with debt, although as an attempt to revive the credit markets it will fall short. More bad news for people with savings. It also brings the risk of deflation to the surface once again - people put off spending money now (a further hit to consumer spending) due to the belief that prices are going to fall in the future. The implications of this move are massive for the US as they now have no monetary tools left at their disposal apart from changing the money supply which is a dangerous game. By printing off and pumping more cash into the system they risk further devaluing the dollar. It will be interesting to see the road they take now. I suspect a glut of chat from the Obama camp about increasing public spending and more public initiatives.
There are also implications for the UK. The BoE released the minutes of their last meeting where they cut the base rate to 2% - the board discussed the option of reducing rates further which sent the pound tumbling against the euro and the dollar. We should expect the BoE to act like the proverbial sheep and follow in the FED's footsteps and lower rates in the near future. I would go so far as to suggest that we will soon be enduring a 0% base rate. Not because it's the best thing to do for our economy or the pound, but because our own economists like to follow those in the US but a little bit later. A case of lets see what happens to them before we do it ourselves.
The problem for the UK is that if we lose the tool of monetary control of interest rates and with the possibility of deflation looming over our heads, letting Gordon Brown and his sidekick Alastair Darling play games with the money supply could lead to a run on the pound and further economic strain. Let me remind you that these two genius's think that getting into more debt is the answer to getting out of this recession - nice one guys!
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