MONDAY, FEBRUARY 12, 2007

UP AND DOWN WALL STREET

Compound Fantasy

By ALAN ABELSON

President Bush's fabulous vision for the future. Why hedge funds are living dangerously.

SO WHAT'S NEXT FOR GEORGE W. BUSH?

Oh, sure, he's got nearly two years left on his present contract and, from all indications, he'll have plenty to keep him busy. But, chances are, every now and then, while savoring a rare moment of solitude, he slips the awesome burdens of office and dares to imagine life after the presidency.

What makes that rather a daunting enterprise is there's no easy precedent to guide him. There's his old man, of course. But George W., for all his evident filial affection, like a lot of sons, is seemingly inclined at least as much to compete with, as emulate, his father. So we can't quite see him spending his days, รก la George H.W., fishing off Kennebunkport, accepting awards, doing the occasional good deed, catnapping at corporate board meetings and otherwise happily idling his time away.

Nor, obviously, is he the irrepressible baby kisser, backslapper, glad-hander, limelight lover, blarney babbler and all-around world-class extrovert that Bill Clinton is. And to further distinguish him from his immediate predecessor and preclude the necessity of keeping his political charms highly varnished and at the ready, there's not the slightest indication that Laura has designs on the presidency.

We suppose, in light of his background as a sports mogul when he was still a civilian back in Texas, he'd be a logical choice as commissioner of Major League Baseball. The question, of course, is whether his epic tussle with Saddam Hussein quite prepared him to deal with George Steinbrenner.

With all due respect and appropriate diffidence, we'd like to suggest a post-presidential role for Mr. Bush. That of writer. Let us quickly disabuse you of even a suspicion that we're suggesting that he write his memoirs. The world is drowning in vacuous memoirs, as it is, and what could be more boring than a lot of blather about what Rummy said, why Deadeye Dick can't shoot straight, what Putin's soul really looked like (sour borscht)? We mean, who cares?

No, we're absolutely convinced the president has a natural flair for science fiction. And the nice part is that unlike so much of that genre these days, his view of the future is not of a desolate wasteland in the grip of nuclear winter, but a paradise on earth.

Inspiring the epiphany as to Mr. Bush's new vocation was a most unlikely circumstance, to wit: Following the cruel dictates of our trade we took a deep breath, drew our chair closer to our desk and sat down to peruse his brand new, hot-off-the-press budget. To be sure, there was plenty of truly dull stuff about revenues and expenses and all that mind-numbing numerical gibberish. But there was plenty of thrilling fare, too, and especially when the president rubbed his crystal ball until he brought the vision thing into focus and described what life and finances would be like in this fair land five years yonder.

For, as we say, the president has the makings of a different kind of sci-fi author, eschewing the trendy gloomy Gus approach in favor of a sunny, even glorious prospect. While the near years, the current one and fiscal 2008, are treated in more or less realistic fashion, Mr. Bush's unsuspected powers of imagination are let loose to soar at will when he takes to peering into the years beyond.

And soar, they do. For example, there's no mention of, must less allowance for, any need to fund our presence in Iraq or Afghanistan after 2009, which can only mean he's certain that a few years hence, the bloody wars in both places will be over, for us at least. Nor is war the only infernal pestilence currently inflicting us slated to vanish: Beginning in 2010, the president envisages no deficit, either, but, instead, a small but lovely surplus, one that will grow ever larger thereafter.

To reach this fiscal nirvana, Mr. Bush's projections, as always, are long on bold outcomes and short on tiresome details. We glean, though, some worthwhile hints. His trademark income tax cuts, enacted early in his first term, will be made permanent. On the other hand, there's no mention of repealing the infamous alternative minimum tax, whose bite will soon be felt by another 20 million honest citizens.

Further demonstrating his visionary reach, the president's budget conjures up surges in military spending and slashes in spending for such politically popular programs as Medicare and student lending. In all, it sees growth in so-called discretionary outlays shrinking to 1% a year, from the nearly 3% a year they've been rising with melancholy regularity for upwards of a decade and a half.

Essentially, Mr. Bush in striving to attain financial bliss has cleverly adapted the magic of compound interest to budgeteering -- it might be called, compound fantasy.

And if by some remote chance his fiscal dreams don't quite come true, he can always find consolation in the fact they were great preparation for his science fiction best-sellers.

NOT THE LEAST ADMIRABLE QUALITY of the stock market this still infant year and, actually, stretching back to last year's closing months, has been the tendency to treat the inevitable bits and pieces of bad news that come its way as mere annoyances. That splendid sang-froid has enabled investors to all but ignore, for example, the rapid recovery in oil, from a hair under $50 a barrel to over $60, which occurred while most onlookers were still chortling over the huge "windfall" of a drop in energy prices.

Shrugged off with something approaching aplomb as well were fair-sized surges in other commodities, including in gold with its nasty implications for inflation, and most ominously, in food, and the continued downward spiral in housing, enlivened by periodic sightings of what inevitably prove to be false bottoms. Until last week that is, when the market's estimable composure began to show unmistakable signs of strain. The most obvious agents of that disquiet were crude finally breaking above $60, a bummer of a report by Micron and warnings on inflation and its potential consequences for interest rates by two members in good standing of the Open Mouth Committee, the presidents of the Dallas and St. Louis Fed banks.

But from our perch on the sidelines a much more compelling reason to get antsy about the market and what might lie in store was the release of an extraordinary analysis of hedge funds. The authors, Stefan-Michael Stalmann and Susanne Knips, grace the research department of Dresdner Kleinwort. We don't know either of them, but after reading their 50-page opus, we've become instant fans of both.

Not the least remarkable thing about the piece, which examines the importance of hedge funds to the investment- banking business (chipping in maybe 15%-20% of revenues), is, in the words of one of the several kind folks who forwarded it to us, that "it's the sort of analysis that, as an investment- banking analyst focusing on the investment- banking sector, might seriously damage your career."

But, notable for its clarity and careful exposition, the analysis has serious import not only for investment banks but for the mushrooming phenomenon of hedge funds, for global financial markets and, by extension, the global economy. What makes this study particularly timely is that for quite a spell we've had a "perfect environment" for the hedge funds, one that has created a slow virtuous circle for their swelling ranks on the way up. But a sea change may be in the wind that could very well turn that slow virtuous circle into a vicious circle on the fast way down.

The authors point out that the roughly $1.3 trillion of assets hedge funds have under management represent over 1% of all the world's financial assets, but with leverage, the proportion may be greater than 3%, or in certain asset classes even higher. Their influence in global markets is much, much greater, thanks to their feverish activity and liberal use of leverage, whether via derivatives or margin.

On the latter score, U.S. hedge funds shoulder two-thirds or so of worldwide margin debt, or something in the neighborhood of $300 billion. Truly staggering, furthermore, is the Dresdner Kleinwort estimate that hedge funds account for between 25% and 60% of the trading in global major markets. And, we're reminded, it's the marginal trader that makes the market.

According to the analytical pair, transaction costs run to a not inconsiderable 4% of the assets managed by hedge funds, while manager salaries and performance fees take another 4%-5%. By any measure, that's one big nut. And it means, Stalmann and Knips reckon, that hedge funds must generate returns that average 20% a year. Which is neither a modest return nor an inevitable one.

Although on the surface, hedge funds seem to use a variety of investing strategies, in fact, an awful lot of them take pretty much the same tack. Which consists of making "a leverage bet on stable or converging risk premia across many assets classes." To Stalmann and Knips, hedge funds resemble leveraged sellers of deep-out-of-the-money put options who are short volatility (a word much in favor in the Street that translates into wide and frequent swings in price). That helps explain, we suppose, why volatility has been so preternaturally subdued. The Dresdner Kleinwort duo estimate that at least 70% of assets managed by hedge funds are "invested in some kind of spread-based long-short strategy."

The fact that so many of the hedgies are doing the same thing and, indeed, conceivably not infrequently are on either side of a trade, combined with the heavy use of leverage and their hyperactive trading add up to a potentially explosive investment mix. As Stalmann and Knips warn, although the timing is impossible to pin down, there's a real and growing risk that some untoward event or sequence of events "could trigger a rapid liquidation (the 'great unwind') across many asset classes, with unpleasant consequences for investment banks, hedge-fund investors and possibly a systemic impact for securities markets."

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