Thursday, June 16, 2005


Major flaw in BWC MDL reporting

[Edited 6/17 to improve clarityl]

We have heard from, and talked with, several people about what appears to be a significant flaw in the reporting on BWC/MDL debacle. We think they are right

It has to do with a point we have raised a few days ago, but the significance of the flaw is growing given the stories in the Dispatch and Blade about the release of the weekly BWC memos from Conrad to Taft.

The flaw is this: There is a big, big difference between investing in "hedge funds" and "hedging" (what MDL and Terry Gasper did). On a consumer's level, its like the difference between putting some savings into a 401k versus taking your savings to Vegas for a game of Hold 'Em, if you get our drift.

Allow us to explain this more. Over the last few years, many so-called hedge funds have been created and operated more or less successfully. Originally these were marketed to the extremely wealthy as another way to diversify their personal investments and maybe make higher returns than the average investor.

These funds were called hedge funds because they invested in more exotic types of investments than ordinary stocks. They invested in a wide-range of instruments that the financial world has used for hedging (or insurance purposes). These might include foreign currency contracts, futures, forward contracts, weather futures, swaps, etc. They have holdings in a diversified set of hedging instruments, and in a sense they are just specialized mutual funds. The point is that hedge funds don't engage in hedging - they only invest in the kind of securities that various business use to hedge.

A lot of people, even investment experts are leery of investing in hedge funds. They are leery of them not because of their risk (they do tend to be riskier than typical equity investment funds) but because the regulations and disclosure requirements are too weak. In other words, it's hard to tell what you are "buying". Nevertheless, if someone is willing to spend extra time investigating and monitoring a hedge fund investment, it might be worthwhile.

Back to BWC. Clearly, the reports show that there was a discussion at a meeting of the Oversight Committee about hedge funds, and ultimately they agreed to invest in some of these funds. As today's stories reveal, there was a proposal to make investments in several established (and diversified) hedge funds: FrontPoint Partners, Clinton Group Multistrategy Fund, Laurus Master Fund Ltd., and KBW Asset Management.

That would have probably been okay, but because of its nature, the Oversight Commission would have had to have clearly approved a new policy allowing this type of investment - and apparently it did.

What the Drew Crew and the reporters at the Dispatch and PD don't seem to get is that the MDL affair had NOTHING to do with an investment in a hedge fund of they type discussed above.

The MDL affair was about a risky attempt to "hedge" BWC's Insurance Fund. It had nothing to do with diversifying BWC's investment holdings (as an investment in an established hedge fund would have done). Yes, MDL purpose was to hedge, and, yes, it created a fund. But that by itself doesn't make MDL a hedge fund. It was a fund used to hedge, but it wasn't a "hedge fund" in the normally accepted use of the term.

Why do we say that MDL was NOT a hedge fund? First and foremost, it wasn't a true hedge fund because there was no diversification. True hedge funds (and other funds) diversify so that if one type of their holdings starts to have losses, the chances are that other holdings are making gains. Diversification balances things out.

But MDL was PURELY a scheme to engage in short-selling of bonds. It was an attempt cooked up by BWC staff and Mark Lay to either hedge against losses in the BWC portfolio that were occurring because of rising interest rates, or it was just an enormous gamble in a field where they had no experience gambling. There was no diversification. And, as the facts have shown, when things went bad, the entire investment went bad.

The point of all this is:
  1. The discussions about approving investments in "hedge funds" is a red herring. It has NOTHING to do with MDL. It is a distraction from getting to the bottom of what happened with MDL and who was responsible.

  2. The real question is whether Conrad, McLean, Gasper or the members of the Oversight Commission had any discussion or created any policies that permitted significant short-selling and/or hedging.


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