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Analysis Last Updated: Mar 9th, 2007 - 01:21:20

Japanese interest hike sparks market plunge
By Jerry Mazza
Online Journal Associate Editor

Mar 9, 2007, 01:18

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The market plunge started with the decision of the Japanese central bank to raise interest rates from 0.25 to 0.5 percent. It was supposed to have little or no impact on the �carry trade,� the low-rate for borrowing capital via the yen and investing it in places other than Japan. Yet it turns out there is nothing in the global financial system that is not connected vitally to this yen carry trade.

In fact beyond Japan, there is $500 to $600 billion in investments which came about with the benefits of the cheap yen credits. And if the yen started to rise because of the rise in interest rates, the worldwide ripple effect was much greater than 0.25 percent.

The big winners of the carry trade are big banks and notably hedge funds and equity funds, whose derivatives trading (pieces of debt sold off separately), turn into a floating mountain of debt throughout all segments of the markets. This mountainous bubble of the �carry trade� gets bigger and bigger, in fact, it is driven to keep growing and make profits while it calls for a constant flow of liquidity.

Without liquidity, that is, when the money flow turns down, even due to a bump in low interest and exchange rates, the reaction is chemical: panic, an interwoven series of risks that could break the system apart. Then do we blame it all on the Japanese? Or are there some other merry pranksters at work?

Hedge funds magnify the hike

Behind massive and predatory participation in the �carry trade� we find not only the presence of Wall Street, the signature street of the good old USA, but in an article from the Economist, Britannia Redux: A special report on Britain, the city of London boasts that is has become the most potent financial center in the world. The old lion of the British Empire has resurged to roar in the globalization hunt for prey.

London though is not the capital of your everyday nation, but of a commonwealth that claims no less than the money-magnet Cayman Islands, and corporate havens of Bermuda and the Bahamas. According to the financial authority of the British Colony of the Caymans (CIMA), some 7,481 of the world�s 9,000 hedge funds are registered there. And therein lays the rub.

These offshore accounts are not beholden to any banking oversight or regulation by any central banks or governments. Unfortunately, in 1993, the �Mutual Fund Law� was passed and allowed for a �simplified� registration or establishment of hedge funds in a totally deregulated system. The purpose was that the Cayman Islands (along with the creation of the Eurodollar market), already an intrinsic part of the financial bubble, would become the gold coast of uncontrolled credit, and hand London the scepter of the financial industry.

The Caymans were already one of the original offshore trysting places for corporations and capital. Here they could operate in naked greed, beyond national laws and their regulations. And so they became the locus for the British financial system to grasp the biggest share of hedge funds, increasingly intertwine with them, and now, through their takeover of various corporations, be able to exploit them and suck out the wealth of their native countries.

Yet, as recently as Feb. 22, CBS News reported there are No New Regulations For Hedge Funds. The article noted, �The Bush administration and top financial regulators pledged increased vigilance over hedge funds Thursday but stopped short of proposing any new regulations to control the trillion-dollar industry.� The article also mentioned, �Unlike mutual funds, which generally hold stocks and bonds, hedge funds can invest in anything from commodities to real estate. Some funds even buy whole companies, while others buy and sell stocks like day traders -- but with billions of dollars at stake.�

The International Herald Tribune delivered the same song shortly after, on March 6, sung by Assistant Secretary of the Treasury Anthony Ryan: �Treasury official says hedge fund industry does not need further regulation.� No one wants to touch the tarnished Golden Calf Gambling Casino of hedge fund finance, at least no one with a stake in it.

And the big winner is London, not the US

The financial consulting firm McKinsey and Co. reported that from January of 2007 Wall Street and the US are playing second fiddles to London as the world hub of finance. The sums of investment at stake are huge. For instance, the Bank of International Settlements (BIS) reports there is $370 trillion in outstanding �so-called over the counter� (OTC) derivatives. The largest forms of derivatives are interest rate based, with a whopping $262 trillion, 34 percent of it managed in London and only 24 percent managed in New York and Chicago.

The third largest form of derivatives is the $38 trillion in foreign exchange or currency derivatives managed in London, with only 16 percent handled in New York. These bubbles� assets increased in size and speed in 2006 at about 63 percent in London and a mere 13 percent in the US.

Yet no individual, central bank or government is privy to the real size of the financial activities of the hedge funds, which quietly engulf and devour the innards of valuable industrial firms and any other objects of speculation and profit, leaving the husks behind in ruin. The obvious trouble here is that there is no significant transparency to these funds and their activities to begin with. That would ruin the fun, though it would prevent financial disaster.

Also, the boundless greed of the Caymans� pirates has brought huge losses of public property, driven as well by speculation and unchecked risk-taking. Bottom line, this is one of the greatest threats to the world financial system in a long time. The exponentially growing business of the �carry trade,� in the hands of the hedge funds, could rip apart the system.

The hedge funds thrive on the fact that interest rates do not go up and down with supply and demand but are fixed by central banks. And since Japan went along for years with the squeeze from Washington and London to keep its interest rate hikes minimal, there has been a kind of zero interest rate policy. This allowed speculation to spiral, with the carry trade pumping liquidity into worldwide bubbles, most recently our own housing bubble, now collapsing before our eyes.

Unfortunately, the members of the board of the Japanese central bank showed more concern in stabilizing the yen than in the chain reaction we witnessed when yen interest rate increases were let loose.

As far back as September 1998, as Russia defaulted that August, the LTCM hedge fund, the world�s largest at the time, threatened bankruptcy, which in turn threatened a total breakdown of the world financial system, as noted in the BIS annual report. It took the 16 largest banks in the world to assemble a bailout fund of more than $4 billion for the LTCM hedge fund, to stabilize more than $100 billion in derivatives and avoid a system crash.

Since then, more rather than fewer hedge funds have appeared and more raids have ensued. And so, today the global financial system, backed by drowning-in-debt banks, makes for a world depression waiting to happen. Not a pretty picture, unless you love chaos and a chance for the financial oligarchs to keep their control, and the more humane among us to lose a chance to replace that control with an economics not driven solely by free market greed.

The way out

The way out is to wrest the US government from Cheney and Bush�s financial mishandling, perhaps with Russia, China, even India, and create a new model for financial structure. That would be, as quaint or old-fashioned as it may sound to some, a system more in keeping with the tradition of Roosevelt, with the common good as its keystone, and with the dollar pegged to gold or some other asset.

The hedge funds, equity funds, and their virtual assets would lose their place in a Bretton Woods-like system. More importantly, the latter would be a sounder foundation on which to build a world economy than the pretty little financial bubbles forever blown into the air and now bursting all around us.

Jerry Mazza is a freelance writer living in New York City. Reach him at

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