LBO's and Hedge Funds...a working paper


The United States economy is swooning right now. We are facing a rather critical issue coming up that really has not been discussed too much. A lot of people say that the housing market is really the culprit here but I do not believe this at all. There are several reasons for believing this also.

The things that are concerning me about the economy are a dry capital market, a falling Dow Jones and inflationary pressures across the economy that cannot all be accounted for by food and energy including oil. The culprit for the combination of these issues cannot be the housing market. Since the housing market it declining across the board from prices to costs, it would add no inflationary pressure at all to the overall economy and yet it is ever present.

I have felt for a long time that LBO's and Hedge Funds are rather foul but I am going to contend, even so, that they are the culprits behind the latest economic swoon facing the United States economy.

When considering the inflationary pressures on the United States, one reason for this is monetary creation. How the money is created is the tricky question to answer. In most cases massive inflationary pressure is due to the central bank or the government printing money with no due regard to the effects and paying debt by this. Another aspect to this is moneatary creation through the capital markets. This is what I believe to be the culprit behind the latest inflationary pressures on the economy today and this is due to the recent spasm in LBO's and hedge fund activity with the main activity laying on the side of the LBO's.

Over the past several years, LBO's have shot up dramatically. In a leveraged buyout of course is the leverage which is derived from loans. In any loan, money is created in the form of interest from the loan itself. The coupling of increased activity in LBO's and lowered interest rates, created a miasma in that the LBO's were only spurred to continue. Like any bubble, activity slowly increased and then over a shortened period shot up dramatically as profits were present and more entities got into the sector with profit seeking motivation. The credit market, as of recent has actually maxed out as the over-valuation in the credit market has been realized.

This is what is creating the inflationary pressure on the economy. It could be contended that the housing market failures are counter-acting the LBO and hedge fund sectors and can be easily believed. As the money is being created from the loans given for the leveaged buyouts, for not it is being counter-acted by the failings of loans in the housing sector and so the inflation in not completely realized and so lies in just pressure on the economy instead of actual inlation across the ecoonomy, but this cannot be proven, at least at the moment by me.

How can we see that the capital markets are overvalued? Tightening in the lending practices are a definite way for the banks to signal that the believe that they markets are reaching their maximum capacity. This was not realized in the housing market and so we are seeing a collapse in lending and businesses while others are being dramatically hurt. In the LBO market the funding has been in essence completely cut off as businesses are realizing the their money is overly exposed in the market. As a result of this, comparing the housing market to the LBO market, we should start to see calls on loans and various other ways for the banks to draw out the overvaluation so as not to be hurt on their own.

The differnece between the markets is going to lie in the on-going concern of a business versus and personal home. If the banks believe that the businesses are going to be on-going concerns, the emphasis is not on calling on the loans but in the housing market with an increasing rate of failures on the back end of the loans, they were called. When the businesses were called, they called on the home owners if the had the liquidity to cover, otherwise the bagan their failings.

So far we have detailed part of the market so lets look at this from a different aspect.

Bail Out

Jim Cramer from CNBC, I think, recently spazed out because he seems to think that the Fed should cut rates. Why is this a bad idea if it will help the tightened lending markets?

The idea proposed by Cramer is a bailout for idiotic decisions by some. The essential idea behind market corrections is that you make a mistake in the market and you pay for it later. The essence of the market forces are behind this action/reaction.

The bailout would come in the form of the Fed lowering the lending rate which would indeed loosen the lending market making it cheaper for people to borrow money. This was the essence of the problem to begin with. Whether or not the LBO binge is going to be consequetial to the market, is really a moot point...the fact remains that they are a bubble of some sort. It may burst or it may not but the fact that the bubble actaully exists, coupled with the fact that no one really knows how big of a total effect the subprime debacle is going to have on the econmy, has extremely cautioned those lending money on the market.

There needs to be corrections to the markets from time to time otherwise bubble would hyper-infalte and lead to a total collapse in whatever area of the economy they are present in, similar to The Great Depression...however The Great Depression was a little more complex then that.

Bailing out the market will not lead to a proper correction in the market and will leave overvaluation in the lending area perhaps leading to later problems that will have to be confronted.

Issues in the Market

There are several issues in the markets as I see them that lead to diseconomies. One of them is the valuation of bonds and securities. One big issue with the valuation of securities right now is that no one really knows exactly what securities they hold.

When a mortgage enters the market initially, it is bundled with hundred to thousands of others. A rating agency...Moody's, Standard and Poors...look at the security and give it a rating based on its compilation.

When this is done it is usually all that the buyers may know about what they are dealing with. The ratings agency need to be correct on their valuations. A little while ago, Moody's announced that it was going to change the way securities are valued. The other agencies were going to stand pat. Businesses that compile the securities decided because it was going to lower the ratings of subprime mortagages, they would take their business elsewhere in order to get a better rating and thus get more money for their securities.

This is a loss of information in the market leading to mis-valuation. Whenever information is lacking or incorrect in the market, it leads to diseconomies. There was rampant greed in many parts of this swoon. It was greed on the lenders part in that they were giving off the ARMS like they were going out of style. They were doing it because they were making more and more money and since the values of houses kept on going up they could just refinance the loan if any issues came up. They came up but unfortuantley housing prices did not keep on rising. This should have been caught as a bubble a long time ago but was ignored because there was a lot of money in it.

There was greed on the Hedge Funds part because the did not do due diligence in looking into the securities they were pilling on because money was moving to freely on the market. Their investment decisions were so damn poor that they are losing currently massive values in overnight periods. Goldman Sachs loses 1.4 billion dollars over night. Bears Sterns loses 2 billion dollars in a combined two Hedge Funds. Why should everyone in the economy cover their loses? The easy answer is we should not! They made the mistakes based on greed.

Futher On

There is an underlying inflationary pressure right now that needs to be further recognized. With this pressure, lowering productivity and increasing wage rates, it points to a definite inflationary pressure. Letting loose the money supply right now will increase the inflationary pressure and lead to definite nasty inflation. The economy needs to work its issues out without adding monetary moves to help it out and that is why the latest move by the Fed and ECB was so brilliant. They did not let money out into the economy, the increased lending. They did not inflate the money supply, they just "primed the lending". If the Fed had just let the money into the economy, this would have lead to inflation in the economy but instead they put the money out into the economy to be borrowed.

This will have two effects. One is that it will increase borrowing in the economy and some of the necessary bonds and securities that need to be sold will now have money to get at a good interest rate. The second is that it is not adding to but taking away infaltionary pressure in that the money is not just free in the economy. The issue is in lending and not in other areas of the economy right now so just putting loose money into the economy the Fed put the money into the area that it needs to the lending market. There will also be a third psychological effect in that the lenders will find it easier to lend money if more money is available on the market. It will be hugely disasterous if all lending including necessary municipal lendind cannot find money in the economy.