Corporations Are Not Humans: Not Even Close---Episode 40

                   CREATING UNCERTAINTY AND RISK 

   There would be little opportunity for speculative profit in a stable financial market. In most instances, the extractive investor is taking advantage of price fluctuations to claim a portion of the value created by productive investors and by people doing real work --- a private tax levied on the productive output of others. It is difficult to see, for example, how arbitraging electronically linked markets to reduce two-second differentials in price adjustments serves any public purpose. The greater the volatility of financial markets, the greater the opportunity for these forms of extraction.

   The riskier and more destabilizing forms of extractive investments have received a major boost from the formation of a new breed of mutual funds --- called hedge funds --- that specialize in high-risk, short-term speculation and require a minimum initial investment of $1 million. The biggest of these, Quantum Fund headed by George Soros, controls more than $11 billion of investor money. Since aggressive hedge funds may leverage investor money to borrow $25 or more for every investor dollar, this would give a fund with $10 billion in equity potential control over as much as $250 billion. Many of the largest hedge funds produced a return of more than 50 percent for their shareholders in 1993. The downside risks are also substantial, however. One small hedge fund lost $600 million in two months in the mortgage markets and went out of business. 
   The fact that hedge funds are generally highly leveraged greatly increases both the potential gains and the risks. It also ties up banking system funds in activities that are of questionable benefit to society when the credit needs of home buyers, farmers, and productive businesses go unmet. 
   The claim that speculators increase price stability by moving markets more quickly toward their equilibrium was recently debunked by George Soros himself in testimony before the Banking Committee of the U.S. House of Representatives. Soros told the committee that when a speculator bets that a price will rise and it falls instead, he is forced to protect himself by selling, which accelerates the price drop and increases market volatility. Soros, however, told the committee that price volatility is not a problem unless everyone rushes to sell at the same time and a "discontinuity" is created, meaning there are no buyers. In that case, those with positions in the market are unable to bail out and may suffer "catastrophic losses." His testimony clearly revealed the perspective of the professional speculator, for whom volatility is a source of profits. If he were involved in productive forms of investment, he would surely have had a different opinion about price volatility. 
   Soros speaks from experience when he claims that speculators can shape the directions of market prices and create instability. He has developed such a legendary reputation as a shaper of of financial markets that a New York Times article, "When Soros Speaks, World Markets Listen" credited him with being able to increase the price of his investment simply by revealing that he has made them. After placing bets against the German mark, he published a letter in Times (London) saying, "I would expect the mark to fall against all major currencies." According to the New York Times, it immediately did just that "as traders in the United States and Europe agreed that it was a Soros market." On November 5, 1993, the New York Times business pages included the story, "Rumors of Buying by Soros Send Gold Prices Surging." 
  In September 1992, Soros sold $10 billion worth of British pounds in a bet against the success of British Prime Minister John Major's effort to maintain the pound's value. In so doing, he was credited with a major role in forcing a devaluation of the pound that contributed to breaking up the system of fixed exchange rates that governments were trying to put into place in the European union. Fixed exchange rates are anathema for speculators because they eliminate the volatility on which speculators depend. For his role in protecting the opportunity for speculative profits, Soros extracted an estimated $1 billion from the financial system for his investment funds. The resulting gyrations in the money markets caused the British pound to fall 41 percent against the Japanese yen over eleven months. These are the kinds of volatility that speculators considered a source of opportunity. 
   There is a substantial and growing basis for the conclusion of Felix Rohatyn, a senior partner with Lazard Freres & Co., that : 

     In many cases hedge funds, and speculative activity in general, may now be more responsible for foreign exchange and interest-rate movements than interventions by the central banks.
   . . . Derivatives . . . create a chain of risks linking financial institutions and corporations throughout the world ; any weakness or break in that chain (such as the failure of a large institution heavily invested in derivatives) could create a problem of serious proportions for the international financial system.

   The fact that many major corporations, banks, and even local governments have become active players in the derivatives markets as a means of boosting their profits began to attract the attention of the business press in 1994. The The risks can be substantial, yet the institutions that have been major players generally do not disclose their financial exposure in derivatives in their public financial statements, preferring to treat them as "off-balance-sheet" transactions. This makes it impossible for investors and the public to properly assess the real risks involved. 
   The truth becomes known only as major losses are reported, as when Proctor & Gamble announced a $102 million derivatives loss after interest rates rose more sharply than anticipated, or when bad real estate loans required a federal bailout of of the Bank of New England. The bank's balance sheet showed about $33 billion in total assets. Regulators, however, found that it had off-balance-sheet commitments of $36 billion in various derivatives instruments. 
   The Paine Webber Group announced in July 1994 that it would spend $268 million to bail out one of its money market funds, which had been marketed as a safe and secure investment, when it came up short on derivatives speculation. In 1994, BankAmerica and PiperJaffray Companies took similar actions. 
   The most publicized derivatives shock of 1994 came in December when California's Orange County announced that its investment fund of $7.4 billion in public monies from 187 school districts, transportation authorities, and cities faced losses of $1.5 billion. It had borrowed $14 billion to invest in interest-sensitive derivatives and lost its bet when interest rates rose. As a result, Orange County faced a severe cutback in public services, including its schools, and the possibility of sharp tax increases.