Thursday, October 12, 2006

Concerns over financial ‘weapons of mass destruction’

Some of those who claim to know are getting nervous about the record growth of hedge funds. There is concern at the European Central Bank and the Financial Services Authority in Britain. Those who don’t seem to be worried - and are investing heavily - include the people managing the pension funds for the staff of Sainsbury’s, the railways, and British Telecom. But what are hedge funds, I hear you asking? Well, you could say that they are a way of rich people – and pension funds - giving huge sums to someone called a hedge fund manager, who claims special expertise, to place bets on movements in the financial markets.

There are an estimated 10,000 hedge managers in charge of an estimated $1.5 trillion of assets, trading in global markets. They borrow against their assets so that their investments – and commitments - multiply in value. Pretty much what these hedge fund managers do is to guess which way a particular market is moving and bet accordingly. A lot of the managers place each-way bets. They charge their clients huge sums to do this, and the successful ones make obscene amounts of money. When they aren’t so successful, the rich folks lose out. Brian Hunter, a 32-year-old Canadian was, until recently, the golden boy at Connecticut-based hedge fund, Amaranth. He was said to have been $2bn ahead for the year by the end of August, having taken risky bets on the way natural gas prices were heading. Things then went badly wrong. The market didn’t perform according to forecasts and Amaranth told investors that Hunter had lost $5bn in just one week.

Most of the bets are placed on "derivatives". But what are derivatives, I hear you asking? Well, in the world of finance, "derivatives are financial instruments that have no intrinsic value, but derive their value from something else". In 1997 the Nobel Prize for economics went to Professor Robert C. Merton of Harvard University and Professor Myron S. Scholes of Stanford University, for their method of determining the value of derivatives. A year later, Long Term Capital Management, a hedge fund in which they were among the principal shareholders, had to be rescued at a cost of $3.5 billion because the authorities feared its collapse could bring down financial institutions around the world.

Warren Buffett, the world’s most successful stock market investor, and the second richest man in the world after Bill Gates has said: "We view them as time bombs both for the parties that deal in them and the economic system... In our view... derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal." No wonder the regulators are getting nervous, although the sums involved are now so enormous it’s difficult to see what they could do when the casino side of capitalism unravels.

Gerry Gold, economics editor

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