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Hedge Funds Out of Excuses?


The market sets the value of any security via the price discovery mechanism. Some things are only worth what someone else is willing to pay for them.

"The complete absence of liquidity in certain market segments of the U.S. securitization market has made it impossible to value certain assets fairly regardless of their quality or credit rating," said BNP Paribas last week regarding the freezing of redemptions in certain of its funds.

For its own part, Goldman Sachs (GS) says "current values that the market is assigning to the assets underlying various funds represent a discount that is not supported by the fundamentals" in its Global Equities Opportunities Fund.

And a report from Lehman Brothers (LEH), dated August 9, notes that quant funds' negative performance is not due to "model mis-specification" but rather something more systematic. "Model misbehavior" is, alas, the causa proxima of its losses.

"Value certain assets fairly"? "Not supported by fundamentals"? "Model misbehavior"?

Many keystrokes have been logged over the last several weeks regarding the Federal Reserve's role in creating moral hazard in financial markets; about whether Bernanake's helicopter will continue its only known flight pattern of taking off from the East 34th Street heliport, flying to Wall Street, dumping its cargo, and returning to the East Side lighter by tens of billions of dollars. But moral hazard has a front line; it has its aggressors and its victims. And the various investors in BNP's asset-back funds or in Goldman's GEO fund – well heeled they may be – now know viscerally what moral hazard feels like. And various financial institutions are giving them moral hazard good and hard.

You would be excused for assuming that a hedge fund might actually hedge its bets. What else are you getting for that 2 and 20 if not some downside protection? But apparently its hedging activities are confined to the English language rather than the financial markets: "fairly"?, "fundamentals"?, "misbehavior"? These are the financial world's equivalent to a student's "the dog ate my homework" excuse: apropos in grade school rather than the boardroom.

So let's call a spade a spade; let's not hedge. Asset pricing models that don't take into account the fact that markets are non-linear, are not Gaussian, are not efficient, and are not rational; are not misbehaving. They are behaving exactly as markets do. And what precisely is fairly valued?

The market sets the value of any security via the price discovery mechanism. Some things – ice cream, paper towels, collateralized debt obligations – are only worth what someone else is willing to pay for them.

To agree to that particular arrangement when buyers are lined up in the sweltering heat of August 14 and you can sell a cone for $4, but then come December complain that ice cream isn't "fairly valued" is not just grossly hypocritical; it's also stupid. And you'd be out of the ice cream selling business in short order to boot.

Precisely how many times do investors have to learn the lesson that fundamentals are only one part (and sometimes not even one) of the analysis for an asset's price? Wasn't 1987 enough? How about 1998? Or 2000? Or Japan from 1991 to 2003? Or Hong Kong or...? Sisyphus' curse has nothing on Wall Street's.

Robert Louis Stevenson once wrote that "sooner or later, everyone sits down to a banquet of consequences." Anyone that tells you that markets are misbehaving here is about to eat a lot of consequence.
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