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Why the "Smart" Money is Stupid

They Bought Greece... Again

Written by Briton Ryle
Posted July 1, 2015

U.S. stocks got pounded on Monday as the last hopes for more bailout money for Greece faded. The S&P 500 was down 2.1%, or around 45 points. The Dow was down 350 points.

To put those declines in perspective, Bloomberg tells us the 400 richest people lost $70 billion during Monday's rout. Yeah, boohoo...

I'm not shedding any tears for the billionaires, and I'm sure you aren't either.

But you may be wondering why. Why do asset prices get creamed over the Greek debt situation? What does the price of olive oil have to do with the price of Bakken Shale oil?

After all, Greece's GDP was just $242 billion in 2013. That's about $10 billion less than the GDP of Connecticut. Greece's entire annual output is about that of Chicago's: $563 billion. And Greece doesn't even compare to the GDP of New York City, which is around $1.4 trillion.

Even if Greece went completely out of business and that $242 billion was simply subtracted from the world's total GDP, would we really miss it? With apologies to the Greek people, their $242 billion is a drop in the bucket. Why, then, should the U.S. stock market lose around $1 trillion in value?

The answer: because the so-called "smart money" often does really stupid things. 

The Smart Money Ain't Always So Smart

The term "smart money" is supposed to refer to the insiders, hedge fund managers, and institutional traders who have resources that individual investors like you and I don't have. They've got the high-priced research, CEOs and congressman on speed dial, and tens of billions of dollars that they use to push prices in the direction they want. 

But all those advantages don't make them smart. Wealthy? Usually. Ambitious? Yes. Greedy? Definitely. But smart? Not necessarily...

The thing is, the smart money believes its press. They hear they are the smart money enough times, and they have the bank account for proof, so they become absolutely convinced that yes, without a doubt, they ARE the smart money.

Problem is, the single-biggest reason people do stupid things is because they are absolutely convinced they are smart enough to pull it off. That's called hubris, and it never ends well. 

So when Greek bank stocks get cheap, and when Greek bonds are yielding +20%, these smart-money hedge fund guys start licking their chops. They see the potential to make some quick money once Greece gets its bailout money, and they completely ignore the risks.

You could certainly say this is the effect of the bailout mentality many investors have. If things get really bad for a company or an industry or the economy in general, investors are now very comfortable with the notion that the Fed or the government will bail them out. And so risk isn't really risk at all.

We've seen it with companies like insurance giant AIG (NYSE: AIG). AIG had written a couple hundred billion in insurance policies for mortgage-backed securities in 2005 and 2006 because mortgage default rates had been steady for 50 years.

But when default rates skyrocketed in 2007 and 2008, AIG was suddenly on the hook for a ridiculous amount of money. Of course, that was the "buy" signal, because the Fed and the U.S. government swooped in and bailed out AIG to the tune of some $80 billion.

The smart money made out like bandits that time. But it doesn't always go so well.

Legg Mason's Bill Miller was one of the best-performing mutual fund managers of the 1990s and 2000s. He tried to make the same bailout bet on the government-sponsored entities (GSE) Fannie Mae and Freddie Mac.

I vividly remember when he doubled down on these investments. He was already down something like 70% when he confidently stated he was doubling his investment because the government was going to bail them out and he'd make a ton of money and look like a genius.

Wrong.

The government did eventually bail out Fannie Mae and Freddie Mac, but it was too late for Miller. His $16 billion fund had fallen in value to around $4 billion. 

The Bailout Mentality

The smart money tends to think it knows what's going to happen, thinks it can actually see the future, and then bets the farm on it...

We've even seen it with Greece before. Remember Jon Corzine, former CEO of Goldman Sachs to New Jersey governor and back to CEO? As CEO of struggling trading firm MF Global, he though he could cash in big buying the bonds of debt-ridden European countries like Greece and Spain in 2011.

He "invested" $6.3 billion of MF Global's cash on the assumption that the European Union would bail these countries out. Once again, the EU did throw out tens of billions in bailout money, but they took a long time doing it — too long for Corzine and MF Global. 

Corzine had leveraged all his bets, and when prices went lower, he had to make margin calls. He used the only cash he had: client funds. Corzine basically stole $1.4 billion in client funds to pay the margin calls, effectively driving MF Global into bankruptcy. 

It's scary how much the government and the Fed's financial crisis bailouts have changed the perception of risk in America. The smart money doesn't see risk anymore. They are completely convinced they can buy the riskiest bonds and stocks because there will be a bailout if things get really bad. 

But the really tragic part of it is that we — the individual investors — pay the price when the "smart money" inevitably screws up. 

The so-called smart money likes to use leverage when they invest. Leverage is like margin — where the investor uses an asset he or she has bought as collateral to borrow more money to invest. It works great when prices are going up. You're making money on money that's not even yours. 

The problem starts when prices go down. If the value of an asset you've used as collateral for a loan falls, you have to make up the difference between the new lower value of your collateral and the amount of the loan you received.

And you have to make it up in cash. That almost always means a leveraged investor has to start selling assets. When you start selling, asset prices fall, which means your collateral value falls, which means more selling...

It becomes a very vicious cycle. You could absolutely say the financial crisis was a long series of margin calls fueled by bailout cash from the Fed and the government. And the longer the government and Fed kept paying the margin calls in bailout money, the longer zombie banks and companies could have assets that were doing nothing but falling in value. 

The Fed and government made sure no one (except for Lehman Brothers) had to take their medicine, and that's why we are where we are today...

Today's Margin Calls 

So it shouldn't come as a surprise that, once again, the "smart money" loaded up on Greek banks and Greek bonds yielding 20%. That's the bailout game plan.

John Paulson is one big hedge fund name that's bought into Greece. As of the last time he had to report his holdings, he had something like $737 million invested in a couple Greek banks. That stake would be worth around $200 million today. 

I don't know to what degree Paulson was leveraged on this "investment." But I wouldn't be at all surprised to learn he had to sell off some assets and meet a $100 million margin call. I also wouldn't be at all surprised to learn that Paulson wasn't the only "smart" investor who made this really stupid investment in a Greek bailout. 

Once you get a few "smart" investors being forced to sell a few $100 million in stock, you'll get some pretty big sell-offs like we had on Monday. It happens every time.

Thanks a lot, "smart" money!

Until next time,

Until next time,

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Briton Ryle

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A 21-year veteran of the newsletter business, Briton Ryle is the editor of The Wealth Advisory income stock newsletter, with a focus on top-quality dividend growth stocks and REITs. Briton also manages the Real Income Trader advisory service, where his readers take regular cash payouts using a low-risk covered call option strategy. He is also the managing editor of the Wealth Daily e-letter. To learn more about Briton, click here.

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