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How Hedge Funds, Pyromaniacs and Gangsters Caused the Global Financial Crisis

Stock-Markets / Credit Crisis 2009 Jan 29, 2009 - 05:55 AM GMT

By: Money_Morning


Best Financial Markets Analysis ArticleMartin Hutchinson writes: Let's face it: The financial services sector has suffered a severe loss in popularity.

The result is that governments in both the United Kingdom and the United States are looking for lightening rods to absorb all the criticism, and bankers have made for the ideal candidates.

Now Franz Muntefering , chairman of Germany's Social Democrats has joined the pile-on, saying that while many bankers are responsible, many others are “ beatniks, pyromaniacs and gangsters .”

Muntefering has a history of doing this sort of thing. In 2005, he branded U.S. private equity firms – then threatening to take over German companies – as “locusts.” But given the below-market returns achieved by the private equity industry for its investors, and the way-above-market returns achieved by its sponsors, I'd have to say that the “locusts” comment, which looked quite silly at the time, has proved to be pretty accurate.

After all, after what we've seen, it now seems perfectly reasonable to conclude that the modus operandi of many private equity investors is to seize control of valuable corporations, leverage the hell out of them, strip out many of their long-term projects, and leave them horribly vulnerable to the next downturn. Like an attack of locusts, such investors may nourish themselves lavishly, but they destroy value rather than creating it – even though their objective is generally not destruction but simply rearranging that value for their own benefit.

“Pyromaniacs” basically expresses the same thought as “locusts” and is an equally fair comment.  For a German socialist, the free-market Schumpeteran process of “ creative destruction ,” by which old businesses that can no longer compete are broken up and replaced by new businesses in high-tech sectors, is deeply threatening.

In past years, one would have sneered at such worries. It is becoming clear, however, that in the last decade, the process of capitalism has resulted in more destruction than creation.

The hedge fund Paulson & Co. Inc . Tuesday boasted of having made $420 million by short-selling shares of Royal Bank of Scotland PLC (ADR: RBS ), thereby causing a run on the shares and requiring it to be nationalized by the British government. In that case, the $420 million made by Paulson is likely to be far less than the eventual cost of the deal to RBS shareholders, British taxpayers and the financial system in general.

Basically, the global economy suffered a net loss that likely stretches into the billions, so that Paulson & Co. could come away with $420 million.

“Gangsters” also seems to be a pretty appropriate term for bankers. One can imagine certain private equity investors approaching company management, and saying “Nice little company you have here… Pity if anything should happen to it,” in way that would make the Gambino crime family proud.

The tendency of the financial service industry players to hunt in packs, and to rush simultaneously into businesses that appear to promise short-term profits, whatever their long-term costs or economic damage, is every bit a characteristic of organized crime.

By and large, gangsters tend to focus one particular form of illicit economic activity at a time. Whether it's gambling, bootlegging, prostitution or trash collection, they seek to swarm an industry and dominate it all themselves, rather than simply establishing a business bridgehead in a field dominated by non-gangsters.

If you think about it, the subprime mortgage business – with its casual disregard of lending standards, its enormously rapid expansion, and its looting of value – was a very gangster-like activity.

“Beatnik,” on the other hand, doesn't quite seem to fit bankers.

The conventional image of the well-groomed banker in his slick Italian suit is not that of the 1950s Bohemian strumming a guitar in an espresso bar. While many 1960s hippies later grew up to become successful bankers, neatly reversing their proclaimed hostility to material goods, the 1950s beatniks were less likely to do so. In any case, given the rapid turnover in banking, any 1950s beatniks turned bankers would have most likely have left the business in about 1990, at the latest.

Then again, Muntefering may have a point, even here. The beatniks were outlaws, running against the established order, seeking to overturn it in favor of a society they preferred. Likewise, these renegade bankers sought to overturn the established economic order, replacing it with an empire of trading, in which all assets could be exchanged on a trading desk in seconds, and nothing was permanent.

Former Enron Corp. CEO Jeffrey K. Skilling attempted to achieve the same thing in the energy business. When I saw him in 2001, before his fall, he spoke of a world in which all the complex interactions from the oil well and the gas tank could be carried out across trading desks, with intermediation costs removed and the flow of product streamlined to its utmost extent.

Skilling ended up with a 24-year jail sentence, but his essentially nihilist vision, in which trading desks would replace all those who actually built pipelines, drove trucks and manned gas stations, was an important inspiration for the mortgage disaster and the ziggurat-like liability creation of the derivatives business.

Muntefering's solution – to increase government control and implement heavy taxes to remove the rewards from the richest bankers – is the wrong one. But his criticism of the 1995-2007 financial bubble is not entirely unfair.

We must hope that once we dig ourselves out of this economic pit, banking will return to its traditional role as a modest facilitator of economic activity, providing no home for gangsters, pyromaniacs or beatniks.

[ Editor's Note : Overcoming the global-financial-crisis damage that Money Morning columnist Martin Hutchinson describes in this commentary won't be easy; the damage is deep and is certain to last for years to come – years during which uncertainty will hold sway .

But what if you knew – ahead of time – what marketplace changes to expect? Then you'd be in the driver's seat - right? You'd know what to anticipate, could craft a profit strategy to follow, and could then just sit back, watching and waiting - and finally profiting from - the very marketplace events you anticipated.

R. Shah Gilani - a retired hedge fund manager and a nationally known expert on the U.S. credit crisis - has predicted five key financial crisis "aftershocks" that he says will create substantial profit opportunities for investors who know just what these aftershocks are, and how to play them. In the Trigger Event Strategist , Gilani uses these “trigger events," as gateways to massive profits. To find out all about these five financial-crisis aftershocks, and about the trigger-event profit strategy they feed into, check out our latest report .]

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