Hedge Funds: Maybe The Safest Place To Play?

Nicholas Vause at the Bank of International Settlements released a paper this week which highlights some interesting activity in the credit default swap markets.  The graphs below are from said paper.

What do supposedly smart risk managers know about the future of select financial vehicles that the common man does not?  Have hedge funds become less risky over the past year-and-a-half?  In reality risk is not being eliminated but just shifted from one counter-party to the next; they in turn will shift their risk to another counter-party until we make a complete circle and realize that everyone is so interconnected that systemic risk has actually been magnified instead of diminished... just like last time.

Notional Value Of Derivatives At All Time High

The Bank of International Settlements released its most recent statistics in November.  Information on OTC derivatives only covers up to June 2011, but what is quickly evident is that after a few down years of derivatives uses during the crises, financial instruments are back into growth mode.  The total notional value of derivatives traded as of June 2011 was an astounding $707.5 trillion.  Keep in mind that the total world GDP in 2010 was only $63.044 trillion according to the World Bank.

Miller & Modigliani Circular Reasoning

In the paper "Dividend Policy, Growth, and the Valuation of Shares" Miller & Modigliani present the idea that dividend policy is irrelevant to firm value.  More specifically they are addressing the payout policy of the firm.  As in most financial academic papers they make some pretty unrealistic assumptions of markets along the lines of the efficient market hypothesis.  However later in the paper they make a startlying address to rationality in the markets:

"For if an ordinarily rational investor had good reason to believe that other investors would not behave rationally, then it might well be rational for him to adopt a strategy he would otherwise have rejected as irrational.  Our postulate thus rules out, among other things, the possibility of speculative "bubbles" wherein an individually rational investor buys a security he knows to be overpriced... in the expectation that he can resell it at a still more inflated price before the bubble bursts." 

They add to this bold statement with a footnote:
"We recognize, of course, that such speculative bubbles have actually arisen in the past... We feel, however, that is also not of universal applicability since from our observation, speculative bubbles, tough well publicized whey they occur, do not seem to us to be a dominant, or even a fundamental, feature of actual market behavior under uncertainty."

I would respond to the footnote by suggesting a look at the book "This Time Is Different."
What i found amusing while reading the main text of the paper was the similarity or the circular reasoning i believe the authors unwittingly present with that of a famous scene from the movie The Princess Bride.  In the scene where the Man in Black and Vizzini face off in a battle of wits, Vizzini is trying to determine in which of the two goblets the Man in Black has placed some deathly iocane powder.  
Vizzini: "But it's so simple. All I have to do is divine from what I know of you: are you the sort of man who would put the poison into his own goblet or his enemy's? Now, a clever man would put the poison into his own goblet, because he would know that only a great fool would reach for what he was given. I am not a great fool, so I can clearly not choose the wine in front of you. But you must have known I was not a great fool, you would have counted on it, so I can clearly not choose the wine in front of me."

Derivatives Market

Data: Bank of International Settlements

Despite the fervent opposition from market purists, the picture above shows the need for market regulation.  Keep in mind these are OTC, which means all the private contracts entered into between parties are not included.  I also believe this picture speaks to an even larger issue in society today: the end of the law of the harvest.  People are removing themselves more and more from the physical assets that produce wealth, and instead are profiting from a derivative which appears to add wealth to the economy, but when closely analyzed, has no economic substance.

Private Sector Contribution to GDP

Once upon a time the United States rivaled only with Germany for manufacturing superiority.  However, the American economy over the past 63 years has evolved from a country who's economy was driven by manufacturing to a country that is now largely a service nation.  Another fundamental shift is taking place in the economy again as the U.S. moves towards a predominately financialized  economy, but that is a discussion for a different day.

The data displayed below depicts three broad industry categorizations.  Finance, Insurance, and Real Estate include all companies that engage in financial transactions for the sole means of profits.  Manufacturing firms include all firms that produce durable and non-durable goods.  Services does not include any government transactions or public utilities as is often included in this account.  I have not included government services as to only display the private sectors contribution to GDP.  In measuring GDP i have also excluded from the aggregate number any government contributions, again to isolate the private sector. 

Data: BEA's Gross Product Origination

The three sectors shown above account for the largest contributions to GDP.  Since 1947 the average combined contribution to GDP is 61.63% with a standard deviation of 3.54%.