January 21, 2006

Like the snowball that starts a landslide, small happenings in the stock markets of the world are capable of kicking off major panic.

The recent shutdown of the Tokyo Stock Exchange is an example. Investors panicked when a company named Livedoor, which is substantially and aggressively involved in various Internet businesses, got raided by investigators from the Tokyo District Prosecutors' office and the Securities and Exchange Surveillance Commission.

Livedoor, a favorite of individual Japanese investors, was thought to be cooking its books and the raid caused an avalanche of sell-offs. The Exchange, unable to keep up with sell orders, closed 45 minutes ahead of schedule.

By the time the snow was at the bottom of the mountain, some $300 billion had been wiped off market valuations.

Individual investors in Japan make approximately 40 percent of all trades on Japanese exchanges and account for most of last year’s steep rise in the Nikkei, which recently hit a five-year closing high. But individuals aren’t very sophisticated investors, they panic easily and $300 billion is a lot of yen to watch run over a cliff.

Stockmarkets worldwide rise and fall periodically, which is what they’re supposed to do and most are regulated reasonably well to prevent another ’29 crash. But there’s an exception and the exception is a relatively new investment vehicle and, at least outside the United States, it's largely unregulated.

Hedge Funds have the potential to bring down the mountain, along with the snow.

So far, U. S. regulators have 'seen no need' for further regulation affecting hedge funds, because (they claim) hedge fund investors are high-income individuals or institutions that can fend for themselves. Which is an intriguing point of view, but dead wrong. Just because the entry fee is $2.5 million instead of $25 doesn’t preclude a rich sheep from running off the same cliff as a poor one.

Most hedge funds are operated offshore, outside America, and thus avoid what little U.S. supervision there is. There are tens of thousands of hedge funds, competing for trillions of investor dollars. Because their portfolios are so arcane, their specialties so esoteric, their main (and perhaps only) attraction to investors is return on investment (ROI).

The possibility of fraudulently managed ROI is what caused the cops to raid Livedoor.

Here in the U.S., once upon a time there was a hedge fund called Long Term Capital Management that got in short-term trouble. A lot of it. A mountain of it, suitable for a major financial avalanche.

LTCM required a $3.6 billion private rescue operation, put together under the eye of Alan Greenspan by a consortium of 14 major international financial institutions. Greenspan deemed this calling-out of the financial cavalry necessary to sustain confidence in the financial markets. In essence as well as fact, it was a bailout of the wealthy ‘individuals or institutions that can fend for themselves.’

That was 1998 and memories are short in the investment game. Last week's Tokyo debacle is a warning that greed knows no dollar limitations and the rich as well as the middle-class are equally capable of running off the same cliff.

But the rich are far more likely to drag the world economy over with them.

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