June 2005 Newsletter
Issue Six, Volume Six

HEDGE FUND FOLLIES

By Mike Gasior

Although my general nature is that of a teacher, I seem to spend much time each month espousing my views on all sorts of things rather than trying to impart knowledge to my readers. This month's edition will spend at least some time reviewing the state of the hedge fund industry, and I also want to share with you the information necessary to understand how some hedge funds sustained heavy and unexpected losses just over a month ago thanks to positions they held in credit default swaps. Those of you who have attended my seminars in person already know I can get somewhat touchy about how the media portrays the derivatives marketplace and the financial markets in general. My goal for this edition is to not only have you clearly understand the nature of credit derivatives, but to enable you to explain with clarity the strategy that broke the kneecaps of some fund managers when General Motors had their debt downgraded to junk status. Of course, because since I simply help myself, I'll also have a smattering of comments regarding China, the G8, Russia and even the Live8 Concerts.

First let me issue a few reminders.

MY FIRST RADIO SHOW AIRS JULY 6TH SO PLEASE TUNE IN

I have grown extremely excited about this new radio gig as my premier show gets closer and closer. The forum is dynamic and I don't believe there is another program airing anywhere that focuses exclusively on the issues and news affecting the institutional investor marketplace. The show is titled "Big Money with Mike Gasior" for exactly that reason. There are already far too many shows that help individuals investors lose their shirts in the stock markets and elsewhere. My show intends to shed light on how the big boys and girls manage money and you can count on me keeping it real. First and foremost, let me give you the pertinent details:

--The show airs "live" every Wednesday at 8:00 p.m. Eastern Time, 5:00 p.m. Pacific Time. It will also be re-broadcast on Thursdays at 8:00 a.m. Eastern Time, 5:00 a.m. Pacific Time.

--PLEASE feel free to call in with questions for my guest or myself during the live show toll free within the U.S. at 1-866-233-7861.

--To hear the show simply click on the following link:

http://www.business.voiceamerica.com

--We will be posting an archive of all past shows in MP3 format on our website soon and I will give that link as soon as it's available.

To make the show timely and interesting I am enlisting some terrific guests to help me discuss a range of issues.

My first guest, Jim Ware, on July 6th is an old friend and an expert on the skills and mentality exhibited by the world's best money managers. Jim has 20 years experience as a research analyst, portfolio manager, and director of buy-side investment operations. He has authored two fabulous books titled "The Psychology of Money" and "Investment Leadership" both published by Whiley Finance. There is no one on earth better suited to explore the subject of July 6th, "The Psychology of Big Money".

On July 13th I will be tackling an extremely timely subject when I take on hedge funds, and I am once again blessed to have the one person who has seen it all in this complex corner of the financial markets, Gary Linford. Gary is the Head of the Investment & Securities Division for the Cayman Islands Monetary Authority and has spent the past 16 years deeply involved in the global securities markets in Cayman, Hong Kong, South Africa and Jersey. Since the Cayman Islands are home to 6,300 of the world's hedge funds, nobody has a better vantage point than Gary to the trends in this growing industry. This is a show you should not miss.

If you think you might be a good guest, or perhaps know someone who should be on the show, please drop me a note with the suggestion. I trust my readers are some of the most connected in the world and I look forward to hearing from you.

BERMUDA PROGRAMS IN SEPTEMBER

The sessions have been chosen and the dates are definite for two fantastic programs in Bermuda in September.

On September 12th and 13th, 2005 I will be presenting an extremely important program for any accounting, operations, audit or management staff who needs a clear understanding of how the financial markets operate, "Securities Operations, Processing and Accounting". For a complete description of the sessions please click:

http://www.afs-seminars.com/offshore.html

The subjects of my sessions on September 14th and 15th, 2005 will be some of the most complex securities held by investors, "Structured Products & Derivatives". This program will cover in detail these securities, which have become favorites of all types of institutional investors. If you need to gain knowledge about these exotic vehicles then this seminar is a must for you. The details of the two days can be viewed at the following link:

http://www.afs-seminars.com/offshore.html

Both programs will be held at the Fairmont Hamilton Princess Hotel and space is unfortunately limited due to the size of the meeting room. Registrations will be accepted on a "first come, first served" basis, and we will do our best to accommodate everyone. I look forward to seeing you there.

THE JULY VIDEO CLIP IS UP

The topic of this month's video commentary is corporate bonds, but I decided to FINALLY throw in the mini-tour of Bermuda I've been promising for so long. If the tour is too boring for you, please feel free to fast forward through it to get to the meaty part at the end where I discuss the important features of the corporate debt markets. You will find the links for both hi-speed and lo-speed versions of the video on the right-hand side of the homepage at:

http://www.afs-seminars.com

Also, I told you last month about a hysterical video that was done on The Daily Show with Jon Stewart by correspondent, Ed Helms about the Cayman Islands titled "Gimmie Shelter". Unfortunately Comedy Central had taken the clip off of their website, but a terrific reader sent me a link where you can view the video. Simply cut and paste this address into your browser and the video will play for you. Enjoy.

mms://a386.v99506.c9950.g.vm.akamaistream.net/7/386/9950/v001/comedystor.download.akamai.com/9951/dailyshow/helms/helms_10055.wmv

Now let's get on with the newsletter.

HEDGE FUND FOLLIES

The hedge fund industry has literally exploded in size in the past three years; going from about $500 billion U.S. just back in 2003 to over a $1 trillion U.S. last year, and it also continues to be a constant source of entertainment for me. I got my first hedge fund client over 20 years ago, and I used to have to explain to my colleagues what the heck one even was since they were relatively few in number and received no mainstream press at all. Nowadays, they are buying a $270 million dollar, Michael Jackson loan package from Bank of America and voting to oust the head of Germany's largest stock market. It has been intriguing for me to observe firsthand the maturation and acceptance of this once clandestine group of money managers.

To be truthful, some of the statistics I have observed in the past few months have been staggering. Let me share a few of them with you:

--On an average day, between 18% and 22% of ALL trading on the New York Stock Exchange is hedge fund related.

--On an average day, between 30% and 35% of ALL trading on the London Stock Exchange is hedge fund related.

--It is estimated that in excess of 75% of quoted, convertible bonds are now held by hedge funds.

What has also been remarkable are the types of investors who I have personally observed putting their money into hedge funds. Sometimes with less than stellar results too. I was just in Bermuda last week and read an article in The Royal Gazette about the Ohio Bureau of Worker's Compensation managing to lose $215 million in a hedge fund that only invested in U.S. Treasury securities. If you cannot help but wonder how one manages to lose $215 million in U.S. Treasuries, you might find it even MORE interesting that the Bureau of Worker's Compensation had only invested a total of $225 million in the fund in the first place, so the loss is actually an unfathomable 95% of their total investment. Welcome to the world of extreme leverage and to the world of hedge funds where performance numbers tend to be eye popping whether the numbers are positive or negative ones.

There were also widely circulated rumors of hedge funds that suffered massive losses on positions they held that were linked to General Motors a short time ago. Even I received whispered phone calls about funds that might be liquidated out. I'm going to tell their story for the purposes of teaching a little bit about the use of derivatives, but also to illustrate how things often occur in the financial markets that no amount of rocket science can predict.

First let me remind you of what happened with General Motors a short time back. It started to become obvious to many observers in the markets that there was a decent chance that the rating agencies may downgrade GM debt to a "junk" status. This, of course, would drop the value of the bonds significantly, and increase the yield on them a commensurate amount. In anticipation of this possible downgrade investors immediately began demanding higher returns on GM bonds in comparison to U.S. Treasuries, which investors consider to be "riskless".

For example; General Motors has a bond outstanding right now that matures in 2031 and investors are demanding almost 5.00% (500 basis points) more return on it then they would on a U.S. Treasury Bond of comparable maturity. If these bonds were to be downgraded yet again, investors would begin to demand even MORE return to compensate them for the increased risk of default and that increase in spread over Treasuries would show up almost immediately and probably prior to the downgrade even happening.

Now let me explain to you the concept of a "Credit Default Swap". To set this story up, let's pretend that you currently have $100 million to invest and you've examined these General Motors bonds and think that everything is actually going to work out fine. You also think that the 5.00% spread that the bonds are paying compared to Treasuries is quite handsome and you decide to take your $100 million out of Treasuries and invest it into the GM bonds.

Not so fast.

As your broker who is always trying to "add value" for his clients, I call you with a wonderful idea. "Leave the $100 million in those Treasuries," I say, but I suggest that you might want to enter into a credit default swap. Here's how it goes:

--The swap will be on a "notional" value of $100 million. The $100 million is more truthfully a fictional amount of principal that we are going to use to decide who owes whom money. Neither of us actually pays $100 million, and we are likely to never be exposed to that much total risk either. On day one, when we enter into this swap agreement, no money changes hands. We just sign the contract and we're on our way.

What we are going to "swap" is simply this:

--I am going to pay YOU the 5.00% (500 basis points) difference between those GM bonds and the comparable Treasuries. And I mean just PAY you the 5.00% on $100 million, which when combined with your investment in the real Treasuries brings your rate of return up to the level of the GM bonds themselves.

--What you are going to pay ME is any decline in price that occurs should GM default on those bonds, or if a rating agency downgrades them. That means if the bonds have their ratings reduced and decline in price by 10%, then you will owe me that 10% x $100,000,000, or simply $10 million. Basically, I am paying you the 5.00% to take the GM credit risk off of my shoulders and onto yours, and the $10 million loss you suffered there was exactly the loss you would have realized if you'd just went out and bought the General Motors bonds you'd wanted to in the first place.

If you can't help but wonder why someone would be willing to pay 5.00%, as I suggest, instead of just selling the bonds; what if I'm a big mutual fund company or insurance company with a substantial business relationship with GM? How would it look if I suddenly began selling all the GM debt that I hold? By paying you the 5.00%, I have simply reduced MY return to the level of U.S. Treasuries and brought YOUR return up to the level of the General Motors bonds.

As the rumors circulated that GM might be getting downgraded, the credit spreads that were getting paid to accept this risk in a credit default swap became bigger and bigger; to the point where it was so juicy that many hedge fund managers couldn't resist themselves any longer. By simply agreeing to accept the General Motors credit risk they would immediately begin receiving cashflows without tying up ANY money at all during a year when hedge fund managers have found it increasingly difficult to find profits.

Now keep in mind that hedge fund managers tend to be some of the most sophisticated and intelligent money managers on the face of the earth, and I'm stating this with total earnest. They knew full well the risk they were taking on and they immediately knew they would need to find a way to hedge themselves to protect if a downgrade were to actually take place on the debt. Sure, they were enjoying a fat stream of payments for accepting such a risk, but if the debt did really get downgraded they would be facing substantial losses.

What caught their eye was the level of General Motors stock, which has dropped to around the $26 level. Surely, if the corporation's debt were downgraded, the stock would have to get its clock cleaned as well, so the decision was made to short sell the stock.

Remember that the concept of short selling would be to borrow some GM shares from someone (rent the shares actually) and then sell the borrowed shares at the $26 price. If the downgrade comes, let's say that the stock collapses further to perhaps $20 per share, and at this point the hedge fund buys the shares back and pockets the $6 difference between the $26 they sold the stock for and the $20 they had to spend to repurchase it. The hedge funds would need these profits on the short sale to reimburse themselves for the losses they would suffer on the credit default swap. If the downgrade never comes, they enjoy the huge cashflows on the swap, and the renting of the stock for the short sale ends up being a cheap insurance policy.

Well, as you may remember, the downgrade on GM debt DID happen and those fund managers sustained heavy losses on the credit default swaps and felt one of their kneecaps shatter. Thank God they'd entered into the short sale on the stock since they will badly need those profits to help offset the huge hickie they just incurred.

Oh oh. Who could have ever imagined that during such a dark chapter in General Motors history, some 88 year-old billionaire would honestly launch a $31 per share tender offer to buy as many GM shares as possible, causing the stock price to immediately jump to $32 and it is currently residing above $34. Ouch!! For those same hedge fund managers who had just gotten one kneecap broken on the credit default swap, they were suddenly feeling the other kneecap bursting as their "insurance" of a short sale of stock blew up completely on them. I do suppose it could have been worse though. It could have been my money.

But such is life in the fast lane of the world's financial markets. How often are tender offers made for the stock of companies who seem to be limping slowly into the dustbin of corporate history? I can't honestly remember a comparable incident, but it doesn't matter really. What I can vividly remember is the hundreds and hundreds of times that things have occurred in the financial markets that nobody could have ever anticipated, but managed to happen anyway. Ultimately, the markets always have a way of showing even the best and the brightest that they are nowhere as smart as they sometimes think they are.

So another dollar is transferred from one investor to another. Somebody wins. Somebody loses. Wealth seldom just disappears but more often changes ownership, and another day in the life of an investor passes by only to begin again the next morning. I think that's why I love this business so much. You can never be bored, nor can you ever adequately anticipate what might happen the next day. Life doesn't get better than that. Lately I find myself constantly thinking to myself that "now I've seen everything", and every single time that thought has crossed my mind, something happens that proves once again that I was wrong. There still is much to see. And no doubt, next month I will have an equally incredible story to share with you.

JUST AN OBSERVATION ON THE EVE OF THE G8 MEETING

As you have no doubt heard, the G8 is about to begin their meeting in Scotland to discuss a variety of topics.

The G8 member nations are Canada, France, Germany, Italy, Japan, Russia, the United Kingdom and the United States. The European Union also attends the Summit, represented by the Leader of the country holding the Presidency of the European Council and the President of the European Commission. The G7 was originally formed back in 1976 and Russia was invited to join in 1998.

My observation is simply this: What the heck is Russia doing being a member of this group?

Without taking a precise inventory, I would likely wager that I have a product in my household produced by every single member of this group EXCEPT Russia.

The reason for my lament is the fact that my house brims with products produced in China (who now has the world's second largest economy) and yet China has never even been discussed for membership, while Russia has managed to muscle its way into this influential group. This I cannot figure out, and no doubt many of you will write to me about China's political issues. Well you can say what you will about the problems that China's government possesses, but I doubt you can illustrate how Putin's reign looks particularly better.

This was just something I felt compelled to mention.

TWO MORE QUICK VIEWPOINTS ON CHINA

Viewpoint number one is that I am completely against the Chinese oil company CNOOC (China National Offshore Oil Corporation) taking over U.S. oil company Unocal. While you will seldom find anyone more open to free trade and capitalism than myself, this is not a free market deal. With the Chinese government the 70.6% owner of CNOOC, I can only view this transaction as a foreign government acquiring a major U.S. oil company, and at some point America must protect American interests. I have told my readers many times that China is already the second largest importer of oil after the U.S., and in eight years will be importing as much oil as the U.S. imports right now. Every year that passes from now on will showcase an increasing competition for every barrel of oil produced in every corner of the world. My opinion is let China go start its own oil companies.

With all of that said, it probably remains entirely probable that this deal will be consummated. With the massive trade imbalance that exists between China and the U.S., and the enormous amount of dollars floating around China these days, if they really want to buy Unocal, they probably will. I just wish our moron politicians would pick better battles to fight. This brings me to viewpoint number two.

My second viewpoint is my actual surprise at the extraordinary depth of stupidity and lack of historic perspective that is exhibited by U.S. politicians of both parties. The reason for this particular bent was the recent proposal by Democratic Senator Chuck Schumer and Republican Lindsey Graham proposed instituting a 27.5% tariff on all good imported from China and had scheduled a vote on the matter for late July.

The only two words I can think to mention at this juncture are:

Smoot-Hawley

Maybe these wayward politicians never studied the Smoot-Hawley Tariff Act of 1930 in school, which managed to amplify the Great Depression to historic levels of agony, but perhaps it's not too late for these two morons to crack open the history books now. Instituting tariffs always seems like easy rhetoric for politicians to serve up for their own political gain, but it's about the most ridiculous notion I've heard out of a politician's mouth in a very long time. If such a measure were ever passed, the effect on the U.S. economy would be instantaneous and devastating. For all those "Be American, Buy American" bumper stickers that adorn U.S. vehicles, it is always surprising to me how many of them I see in Wal-Mart parking lots, who sells massive quantities of Chinese made products to thirsty U.S. consumers.

The fact of the matter is that China makes many, many products that the U.S. can no longer produce competitively, and the U.S. makes many things that China cannot. The United States and China need each other very badly, and our economies are inextricably intertwined at this point. Whatever my thoughts may be on the CNOOC takeover of Unocal, China is indeed a very important economic ally to the U.S. and it would be nice if we could become better political friends as well. Obviously, there are strains in the relationship, but politicians should focus on finding common ground with such an important trade partner, instead of cranking up the rhetoric and increasing the level of hostility.

PINK FLOYD

Being the huge music fan that I am, it will come as no surprise to you that I spent a great deal of time watching the Live8 concerts broadcast from the various cities.

I have to say that I thought the coverage of the event on MTV and VH1 was surprisingly weak and spotty, and will truthfully offer that the coverage of LiveAid 20 years ago was far superior. In truth, I spent much of the day watching the live stream from the various cities on AOL via the internet. I did buy the LiveAid DVD the moment it was released, and enjoy it immensely, but I really miss seeing the Led Zeppelin reunion that was omitted from the DVD.

The highlight of the Live8 concerts for me was the reunion of Pink Floyd. While I am a much bigger fan of other bands, I have always carried a deep admiration of Pink Floyd's material and innovation. To think that a band that hadn't performed together for 21 years would suddenly reunite simply because Sir Bob Geldof phones them up and asks them is pretty funny in its own right. But the band seemed to be having a wonderful time playing together again, and they were also incredibly tight in their set. Although now in middle age, and looking somewhat like a group of bankers, they immediately demonstrated clearly why they are one of the finest groups of all time. Roger Waters wore a smile the entire performance that I was certain might cause his face to break.

When the DVD of Live8 is released (and I pray it's faster than the 19 years it took LiveAid to hit the shelves) I hope all the performances, in all the cities, are included. Many of you know my love of concert videos and this would be among one of the best collaborative discs I could imagine owning.

BRAINTEASER

Last month's question resulted in a few people doing a bit of research and letting me know that I was technically wrong in my brainteaser. I had asked what company had been a member of the Dow Jones Industrials from its inception to the present day. The answer I gave was General Electric, but in truth GE had been dropped from the average for two brief periods, although it was a member both at inception and right now. But I accept my error and congratulate those who found my mistake.

I've done an increased amount of research for this brainteaser and there will no denying the answer either. This may very well be my most difficult question yet, and it is just perfectly on-target for my audience to know, so here goes.

This month's question is:

"What is the name of the first bank in the world's history?"

At least try to figure out or research the answer before turning into a weasel and clicking the following link for the answer:

http://www.afs-seminars.com/brainteaser_June2005.html

And the answer to LAST month's brainteaser is:

General Electric

http://www.afs-seminars.com

Copyright 2005, Michael Gasior. All Rights Reserved.

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