The Attack on Prosperity: How Speculators Are Causing the Cost of Living to Skyrocket

Part 3: America's Capital Markets Are Run by 29-Year-Olds

Speculators -- and speculation bubbles -- have always existed, as a look back in history shows. What is new is the sheer volume of speculation, numbering in the billions, in recent years.

This has something to do with modern financial markets and their instruments, known as derivatives, which major American investor Warren Buffet has rightfully described as weapons of mass destruction. But these weapons are only effective because the central banks have created the necessary environment. Never before in history has the world been deluged by such a flood of money.

Since the beginning of the 1980s, interest rates in the world's major economies have trended downwards. The volume of money has grown accordingly, initially at about four percent a year and now at more than 10 percent. When more capital produces less interest income, investors automatically seek higher-yielding investments.

It is relatively easy to follow the trail of this money. Whenever a large amount of capital floods a market, it leaves behind a broad riverbed.

First there was the rally in the Asian Tiger nations in the mid-1990s. Billions of dollars in Western investment helped fuel the booming economies of Thailand, South Korea, Malaysia, the Philippines and Indonesia. But then, in the autumn of 1997, came the crash.

The one party had hardly ended before the next one began. In Moscow, Western speculators gambled with short-term Russian government bonds until Russia became insolvent in 1998. This led to the spectacular collapse of Long-Term Capital Management, a giant hedge fund, which almost dragged the international financial system down with it.

In his book "The Trillion Dollar Meltdown: Easy Money, High Rollers and the Great Credit Crash," American author Charles Morris wrote, "No matter what goes wrong, the Fed will rescue you by creating enough cheap money to buy you out of your troubles." He was describing the policies of the Federal Reserve, America's central bank, and it chairman of many years, Alan Greenspan.

After the dot-com crash and Sept. 11, the Fed lowered the prime rate by five percentage points, thus ensuring that the market would be literally inundated with money. At the time Greenspan, who was worshipped and practically treated as a sorcerer, kept rates at only one percent for 12 months. His successor, Ben Bernanke, took exactly the same approach when the American subprime mortgage crisis struck last year. He has reduced interest rates seven times since last September.

"The liquidity available worldwide is a driving factor in speculation and innovation," says one expert at the European Central Bank (ECB). In addition to the US's aggressive low-interest-rate policy, he cites a considerable expansion of the money supply in Asia. Several teams at the ECB are seeking ways to better understand how the financial markets affect changes in the money supply, thereby indirectly influencing inflation.

Out of fear that the markets could collapse, US central bankers have made money cheaper and cheaper, but in doing so they are fighting fire with gasoline instead of water. As capital grows, it seeks increasingly rigorous new sources of return.

Hedge funds are the most aggressive, collecting vast sums of money and investing them in an extremely speculative manner. If all goes well, they can earn extremely high returns for their investors and, for their managers, salaries that would have seemed inconceivable until not too long ago.

John Paulson is a case in point. A former investment banker, he has managed his own group of hedge funds, largely unnoticed, since 1994. In 2006, he was earning an estimated annual income of $100-150 million (€65-97 million). Though certainly a vast sum by ordinary standards, Paulson's income was relatively modest within the industry, and not enough to merit any media attention.

That changed in 2006 when Paulson, 52, decided to place his bets on a crash in the US real estate market, especially in the subprime sector, while the overwhelming majority of speculators were still betting on unbridled growth. Last year one of Paulson's funds, Credit Opportunities II, climbed in value from $130 million (€84 million) to $3.2 billion (€2.1 billion), a 2,362-percent increase. Paulson himself made it to the top of the industry publication Trader Monthly's ranking of the top 100 earners in the industry -- with an estimated annual income of more than $3 billion (€1.9 billion).

The man in the No. 2 slot on that list, Phil Falcone, recognized potential in Australian iron ore. The senior managing director of Harbinger Capital Partners, Falcone invested heavily in one of the key producers in the industry, Fortescue Metals. The investment paid off, earning him a 114-percent return, and contributing to Harbinger's annual earnings of about $1.5 billion (€967 million).

The new rulers of the financial markets look different than their predecessors, the consistently well-dressed bankers of Wall Street. John Burbank, 44, in his beard, fleece vests and dented old SUV, could easily double as a park ranger. His small company is headquartered in a modest building in San Francisco, as far removed from New York's Wall Street as possible, and yet Burbank is Wall Street's latest boy wonder. Last year his hedge fund, Passport Global Strategy, earned a record 219-percent return.

"You can only achieve these kinds of profits if your opinions are well outside the mainstream," says Burbank. One of his investments was in African coalmines.

Recent data generated by the US market analysis firm Barclay Hedge point to the massive influx of hedge fund money into the commodities futures markets in the past few years. Since 2003, these investments have increased by 372 percent, to the most recent figure of roughly $190 billion (€123 billion).

Sometimes, of course, there is more at stake than investments in coal and iron ore. And in some cases speculators, with their lack of transparency, have bet on an entire economy. The drama currently unfolding in Iceland is a case in point.

In the past few years, the small country's three largest banks speculated against their own currency because they had borrowed heavily abroad. A few hedge funds got wind of the banks' move and acted on the speculation that the situation would spin out of control.

"Unscrupulous dealers" from abroad were trying to drive Iceland's financial system to collapse, said David Oddsson, the head of the country's central bank. He raised interest rates to a record high of 15.5 percent in an effort to save the Icelandic currency, the krone. Since the beginning of 2008, the krone has lost 20 percent of its value against the euro, partly as a result of the actions of the Icelandic banks.

The investors have another trick up their sleeve, though. Now they are speculating that the Icelandic banks will go under. But the Icelanders are fighting back. To raise fresh cash one of the institutions, Kaupthing Bank, is attracting German investors with a record 5.65-percent interest rate on money market accounts.

Meanwhile, the central banks are preparing for the worst. The Scandinavian countries have pledged to provide Iceland with up to €4.3 billion ($6.7 billion) in emergency cash if its central bank ends up having to bail out the banks. The ECB has also been made aware of the problem. It looks as though it is time for the hedge funds to admit defeat, at least for now, in their battle for the island nation.

It is not unusual for hedge funds to speculate and lose, and many have already failed as a result. Although there has been no major meltdown yet, the possibility cannot be ruled out. It will happen if several of these funds bet on the same horse, lose and then drag their lenders down with them. This is because hedge funds operate primarily with borrowed money, which makes them both highly promising and risky at the same time.

Of course, speculation is not a business reserved exclusively for these major financial jugglers. Millions of small investors are part of the game, consciously or not. Commodities speculation secures their retirement pensions (unless something goes wrong), and it is part of the diversification strategy of their life insurance companies and investment plans. Small investors are now also able to invest directly in oil and grain futures.

"A lot of money can be made in this business if you properly utilize growing worldwide demand," Charles Valdes said enthusiastically less than two years ago. He is in charge of investments for America's largest pension fund, the California Public Employees' Retirement System (Calpers).

Valdes has already invested more than $1.1 billion (€710 million), compared with $450 million (€290 million) in the commodities markets on behalf of the pensions of 2.5 million California public employees. The money is intended to "diversify our portfolio and reduce our risk," says Valdes.

Powerful investment fund companies are also jumping on the bandwagon. In the last 12 months, they introduced 52 index funds specializing in commodities in the United States alone. These instruments mirror the industry indices issued by Standard & Poor's and Goldman Sachs, in the expectation that prices will continue to rise.

Germany's booming certificate industry operates in a very similar way. With more than 300,000 securities being traded daily on the world's exchanges, any ordinary investor can bet on changes in the price of Super Unleaded gasoline, zinc or soybean meal. The price of these debentures issued by banks also follows the fever charts of international quotations, such as those on the Chicago Board of Trade and the London Metal Exchange. German private investors have already bought shares worth more than €130 billion ($202 billion). The banks are hedging their investments by buying the corresponding futures, thereby driving up prices.

Because the stock markets are no longer as attractive an investment as they once were, many banks are also betting on commodities. Ethical qualms are generally not mentioned in their promotional literature, nor do they note that private investors pay for their investments elsewhere, at the supermarket or when filling up their gas tanks, for example. And hardly a banker is likely to point out that lucrative fund prices translate into rising food prices in places like Burkina Faso.

Be a part of the rally in oil prices but at little risk, the US bank JP Morgan tells its customers. Merrill Lynch even offers an investment product called the "Emerging Markets Fertilizer Basket."

Speculators pricked up their ears a few weeks ago, when leading agricultural experts warned officials at the United Nations Educational, Scientific and Cultural Organization (UNESCO) that they could expect to see more and more people going hungry in the future. Rice, once a niche product on commodities futures exchanges that attracted little notice, had caught their attention. Before long, figures were being circulated and the speculators realized that rice is the main staple food for more than half of mankind, especially in Asia and West Africa.

The Dutch bank ABN Amro was the quickest to react, issuing a certificate that made it "possible, for the first time, to participate in the top food product in Asia." Now that India has imposed a ban on rice exports, "worldwide reserves will decline to minimum levels," writes the bank, implying that rice is a hot investment opportunity.

The certificate has been so successful among small investors that other banks are now considering issuing rice certificates, as well. However, the rice price has since dropped significantly again. Ironically DWS, German bank Deutsche Bank's fund subsidiary, advertised a new global agricultural fund on the bags German bakeries use to wrap bread and other products.

The commodities issue comes just at the right time for the certificates industry, providing it with a new and effective tool to attract customers. Until June 29, investors in Germany will not be liable to pay taxes on profits from speculative investments. Those who invest after the cutoff date, though, will have to pay a 25-percent speculation tax on capital gains, which, before the new rules come into effect, are tax-free if held for at least a year.

The mood is heated and opportunities abound, bringing back memories of the best of times in the New Economy (shortly before the worst of times began). Some analysts at investment banks have acquired cult status once again -- just like Henry Blodget and Mary Meeker, analysts at Merrill Lynch and Morgan Stanley, respectively, who fueled the dot-com boom for years with their optimistic prognoses.

Arjun Murti at Goldman Sachs plays a similar role today. The oil analyst is famous in his industry. His bold predictions have almost always been correct, at least until now -- to the point that his latest reports always trigger minor shock waves in the markets. In the spring of 2005, he predicted that the oil price -- at about $50 (€32) at the time -- would approach $105 (€68) by 2009.

On May 6, Murti said that a price of up to $200 (€129) a barrel was "increasingly likely" within the next 24 months. Prices promptly shot up. "The Goldman report gives fund managers an excuse to push prices up even further," says Michael Fitzpatrick of MF Global, the world's leading brokerage house for futures transactions.

Financial programs on television have also clicked into high gear. Business channels, like CNBC and Bloomberg in the United States, are doing their best to fire up the mood. Where past reports focused on the latest numbers of hits on Amazon's and Netscape's websites, tickers now scroll across the screen, showing the current prices of gold, silver, gas and oil. Talk show hosts, investors and analysts are constantly embroiled in heated discussions of "America's oil crisis" and the "housing bubble." Of course, part of their discussions revolve around the best ways to turn a profit from these calamities.

Jim Cramer is the new mini-speculators' shrillest media personality. The former hedge fund manager has remade himself into an entertainer of sorts for American financial television. On his chaotic show, "Mad Money," he occasionally throws chairs through the bright red studio. He is constantly pressing various red buttons to trigger sound effects -- a Hallelujah chorus, machine gun fire or the sounds of bulls, bears or pigs -- to correspond to his shouted investment tips. Wind turbines are in short supply: drum roll! The container shipping industry is about to experience a major comeback: applause! The oil boom could see an occasional mini-crash: machine gun fire!

There is hardly a better backdrop for the rampant global capitalism of speculators large and small. No wonder even the occasional insider is starting to feel queasy, while more and more people are wondering how the out-of-control markets can be subdued once again.

A lack of regulation has allowed the financial industry "to become far too profitable and much too big," says George Soros. The legendary investment guru has been warning for years of the dangers of the global money business. In a hearing before the US Congress last week, Soros even spoke of a "super-bubble" that he believes has been building over the last 25 years.

The record high oil prices are also the result of a bubble, according to Soros. "Speculators and index funds that follow the trend are only increasing the pressure on prices," he says. For this reason, Soros proposes making it more difficult for pension funds and index funds to trade in futures contracts on the commodities markets. One method would be to impose higher minimum investment requirements for speculative capital.

Kenneth Griffin is also one of the major players in the market. His hedge fund, the Citadel Investment Group, is worth $20 billion (€13 billion) and is one of the most successful in the industry. Nevertheless, he sometimes gets a queasy feeling when he thinks about the business. "Walk across any of the trading floors -- they are full of 29-year-old kids," Griffin recently complained to the New York Times. “The capital markets of America are controlled by a bunch of right-out-of-business-school young guys who haven’t really seen that much. You have a real lack of wisdom.” According to Griffin, bank executives now understand only "part of their business." He believes that the industry needs better regulation.

"We must create a financial system in which there are no perverse incentives, the risks are properly recognized and managed, and there is less borrowing," says Mario Draghi, the head of Banca d'Italia and president of the Financial Stability Forum, a group founded by the seven leading industrialized countries 10 years ago, in the wake of the Asian financial crisis. In April, Draghi presented a 70-page document detailing proposed measures to strengthen the stability of markets.

For instance, Draghi writes, banks should be urged to use far more of their own capital to invest in complex financial products. Hedge funds and other major speculators, he adds, should be forced to finally disclose their activities and risks.

"The proposals are efficient, but they also have to be implemented at some point," says Hans Tietmeyer, the former president of Germany's central bank, the Bundesbank, and a co-founder of the forum. According to Tietmeyer, Americans and Britons are constantly demanding exceptions for their companies the minute acute crises are over.

In addition to tighter regulations, economists are also calling for stricter monetary policy. This means higher interest rates, less inflation and, ultimately, a stronger dollar. "Investors worldwide see commodities as a hedge against inflation," says Ben Steil of the American Council on Foreign Relations. This means that as long as the dollar remains weak, oil prices will not decline. For starters, oil is the world's new reserve currency.

Meanwhile, in the offices of hedge funds, pension funds and investment firms, a feverish search for the next big thing is already underway. Conservative investments -- concrete things that cannot go up in smoke as easily as a futures contract on the Chicago and New York exchanges -- are suddenly back in vogue.

In keeping with the new trend, hedge funds and investment banks have started buying up farms worldwide. Morgan Stanley, for example, already owns several thousands of hectares of agricultural land in Ukraine. An agriculture fund operated by Blackrock, a New York investment group, acquired more than 1,100 hectares (2,717 acres) in Britain's Norfolk County. Others are combing the world, from Russia to South America, for investment opportunities. In Argentina, prices for the most productive fields have increased by 80 percent in recent years.

The British hedge fund Emergent Asset Management is currently collecting €1 billion ($1.55 billion) to buy up African farmland south of the Sahara Desert.

"Hedge fund managers may not be good farmers," says Paul Christie, Emergent's marketing chief, "but with the right partners they can be good farm managers."

MARKUS DETTMER, FRANK HORNIG, ARMIN MAHLER, CHRISTOPH PAULY, WOLFGANG REUTER, JANKO TIETZ

Translated from the German by Christopher Sultan

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