Knowledge@Wharton Finance and Investment Research Article

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The financial markets are in turmoil. Inflation is picking up. Home prices are falling. More and more companies are laying off workers. Oil prices are sky-high. It's getting harder and harder to borrow money.

It seems like a nest of conspirators is preying on America. Even Washington is reinforcing the impression with talk of sweeping reforms to the system of economic oversight, including proposals to consolidate some regulatory agencies and dramatically expand the authority of the Federal Reserve.It looks like Congress and the White House now realize the regulators were asleep at the wheel.

Indeed, Ben Stein, a well-known economic commentator, has promoted the notion of market manipulation by hedge funds. In a March 23 New York Times column titled, "Making Sense of a Scared New World," he sums it up this way: "In an otherwise inexplicable financial event, the people who profit from it may be understood to have caused it."

Yet there's no indication of sweeping market manipulation, by hedge funds or anyone else, says Wharton finance professor Jeremy J. Siegel, noting that Stein has failed to offer any proof. "He just believes that because one set of securities is under-priced, it's got to be manipulation and it's got to be the hedge funds."

While several Wharton experts say powerful players can briefly dominate slices of the financial market, making prices rise or fall at will, they dismissed the notion of a grand, prolonged market manipulation. Instead, instances of proven market manipulation tend to be very narrow. "Pump and dump" operations, for example, use teams of salespeople to convince naïve investors to buy stocks of companies so small and obscure that just a handful of trades can make prices soar. But these con artists focus on one stock at a time, not the entire market.

Perhaps the biggest known market manipulation of recent years was in the California electricity market in 2000 and 2001. There, companies such as Enron were able to exploit the state's peculiar partial-deregulation rules to sell power at inflated prices. But, again, this was a relatively short-term scheme focused on just one market.

According to Wharton finance professor Richard Marston, there's a difference between deliberate market manipulation and speculation. Speculators often share the same view, driving prices to extremes. "I don't believe that supply and demand calls for $100-a-barrel oil," he says, attributing part of today's high oil price to speculation. But speculators have always been in the markets, he adds. "It's not some kind of conspiracy, where a bunch of hedge funds got together and said, 'Let's drive the price up.'"

Wharton finance professor Marshall E. Blume argues that there was indeed fraud in the mortgage industry. Mortgage brokers conned borrowers into taking on high-risk loans, and appraisers provided inflated home valuations to justify big mortgages, helping to inflate home prices. Also, ratings agencies failed to flag the risks inherent in securities backed by risky mortgages, he says. But while some of the companies and individuals involved in these activities should be prosecuted for fraud, their role does not constitute the kind of extensive market manipulation Stein describes, according to Blume.

Hidden Surprises

Instead, the biggest economic factor today is a return to normal after a period of excess, when the credit markets foolishly ignored risk, says Marston, adding that there is no mystery to this process. "I don't think it was a market failure. There are a lot of new securities that we haven't seen stressed before.... There were hidden surprises in the fixed-income market that people didn't rationally take into account because people didn't understand them.... I don't think the market as a whole is irrational."

Stein, who did not respond to requests for an interview for this article, argues in the Times that the real economy is not in such bad shape. Unemployment, though rising somewhat, is lower than usual in recessions, he says, while corporate profits are "high by historical standards" and agricultural products, mining, refining and most U.S. exports are "startlingly strong."

There is, however, "a serious disconnect when we move over to the world of the financial markets, where chaos reigns," Stein writes, adding that many events simply cannot be explained by fundamental market forces. The "havoc" in the markets for securities based on subprime mortgages far exceeds the actual losses on those loans, he says. The municipal bond market and markets for short-term municipal and corporate "auction" securities are also in havoc, even though there have been no notable defaults.

Losses in various types of securities are nothing new, according to Stein, who points to the tech-stock collapse early in the decade and the junk bond collapse years earlier. "The new part is the hedge funds and the changing of Wall Street from a financing entity to a market manipulation entity," Stein writes, concluding that "...[Hedge funds] have so much money and so much selling power that they can do what capitalists really want and love to do: to make money not by betting on the markets, but by controlling the markets, by putting so much sell side (and occasionally buy side) firepower in play that they know they will move the markets. This takes all the annoying uncertainty out of it.... Once the process starts, it's like shooting fish in a barrel."

According to this view, hedge funds can clean up by betting on falling prices. They can, for example, borrow vast amounts of stock and sell them at current prices, causing an excess supply that drives prices down. Then the funds buy the shares at the lower price to repay their lenders, profiting on the difference between the sales and purchase prices. Similar strategies use stock options and other stock and fixed-income derivatives.

While short sales are a legal and common way to bet on the prospects of falling prices, it is illegal to conduct a "bear raid," where the stock-price manipulation is intentional and often accompanied by the spreading of false rumors.

Because hedge funds are secretive and report results only voluntarily, it is hard to know just what all of them are doing. Surveys conducted by Chicago-based Hedge Fund Research show the average hedge fund returned nearly 10% in 2007, compared to 5.5% for the Standard & Poor's 500 index of big U.S. stocks. This year, the hedge funds lost about 0.5% through the end of February, while stocks were down just over 9%.

HFR's Short Bias Index, which tracks hedge funds using short selling and similar strategies that profit when prices fall, returned about 4.7% in 2007, trailing the S&P 500. But it was up more than 6% this year through February, beating the stock index by 15 percentage points.

However, funds that specialize in short sales make up only a tiny slice of the hedge fund market, holding about $5.4 billion in assets at the end of 2007, compared to $1.87 trillion in assets for all hedge funds. Mutual funds, which are not allowed to engage in short sales, have about $11.7 trillion in assets. "It is possible for hedge funds with their large amount of money to temporarily disrupt the market," says Blume. "However, it is unlikely that hedge funds have sufficient funds to cause the major disruptions we're having in the housing market."

That disruption, which was the trigger for much of the trouble that followed in other credit markets and the broad economy, is caused by fairly obvious factors rather than hidden forces, he says. Eager home buyers with access to low-interest loans that required little or no down payment bid up housing prices in the middle years of the decade. As interest rates subsequently rose to normal levels, many buyers couldn't afford the higher payments on their adjustable-rate loans, and more and more of them started falling behind in payments. Investors who bought securities based on those loans worried they would not get the payments they had been promised, so those securities lost value. "We're unwinding an excessive investment in housing," Blume notes.

Lenders were also throwing cheap money at other borrowers, such as corporations, with loose requirements for collateral or other repayment guarantees, he adds. "We actually had an excessive amount of credit across all segments of the markets." Now there is simply a corresponding pullback, typical after any period of overdoing it.

Avoiding the Poisoned Jug

Although Stein is correct that there have not been large numbers of defaults among bonds and other credit-related securities, investors don't know where defaults might strike, Marston says. That has made them leery of all credit securities, causing demand -- and therefore prices -- to fall. He cited one observer who correctly likened this to a situation in which one of 100 gallon jugs of drinking water is thought to be poisoned. No one wants any of those jugs.

The situation was aggravated, according to Blume, by the market's hunger for high-quality debt. Some institutional investors are permitted to invest only in debt securities with top ratings. To produce more of those, the firms that create securities took bundles of lower-quality debt, such as subprime mortgages, and sliced them into segments of varying qualities.

The top-rated slices had first rights to homeowners' monthly payments, making them relatively safe. But these were matched by other slices that would be the first to suffer if homeowners fell behind, making these securities very risky. As defaults rose, these riskier slices plummeted in value, and nervous investors then began to shun the safer slices as well, worried that they, too, might be riskier than was first thought.

The swings in investor sentiment can be tracked by comparing interest rates of risky high-yield corporate bonds and safe U.S. Treasury bonds, Marston says. Last summer, yields on high-yield, or "junk" bonds were only about 2.4 percentage points higher than those of comparable Treasuries, an unusually low spread that means investors did not consider junk bonds terribly risky. "Smart people in the market were assessing credit risk as being very small."

This sanguine attitude has changed -- the spread is currently more than eight percentage points, which is more typical. Part of the reason is that junk bonds are now considered riskier, but a "flight to safety" has also driven Treasury yields down, Marston notes. All of this is a normal and understandable reaction as investors learn they have underestimated risks, he says, dismissing the market-manipulation theory. "I bristle at the idea."

No one knows exactly how hedge funds may be influencing the market, since they are very secretive about their holdings and investment strategies. But Blume suggests it is unlikely that hedge funds would act in unison for a long period. "There might be certain volatility caused by people following similar investment strategies, but it will wash out in the fairly short term."

One reason is that short sellers aren't simply dumping securities into a hole. For every short seller unloading securities that he expects to fall in price, there must be a buyer who's betting the price will rise. If everyone becomes pessimistic, short sellers will find no buyers, and they will lose any ability they had to manipulate prices by dumping securities.

Ultimately, adds Siegel, the short sellers must themselves become buyers because they don't make money until they purchase shares to replace the ones they borrowed and sold. At some point, he says, short sellers "covering" their bets with purchases will restore demand -- and shore up prices.

The recent turmoil in the financial markets is scary because it was triggered by something new and poorly understood -- the collapse of subprime mortgages. But it's not surprising for moods to turn sour when the good times end, Siegel notes. A few years ago, the trigger was the collapse of the tech-stock boom. This time, it's the end of the easy-money era and housing bubble. "Swings of sentiment," Siegel adds, "have happened forever."

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