HFM Redux, Part One

Entrance to Latvijas Banka (Latvian Bank), February 2009. Image from riga.in.

Anonymous Hedge Fund Manager is a recently retired financial wizard and co-author with n+1 of Diary of a Very Bad Year: Confessions of an Anonymous Hedge Fund Manager. We caught up with him recently on a visit to New York.

A New Life

n+1:  You’re back in New York.

HFM: I’m back in New York, thankfully only briefly.

n+1:  How are things in your new life?

HFM: My new life is substantially more relaxing than my old life. I moved to Austin. I am enjoying a life of leisure down there. It’s amazing how little I miss New York. I thought I would miss it more than I do. Maybe it’s just that I’m more adaptable than I think. But Austin’s a great town. It’s very laid back. People are very friendly. It’s quiet. Coming back here, the noise is driving me bonkers. I wonder how much of what I thought was finance driving me crazy was really New York.

n+1: What do you do all day?

HFM: I get up a lot later than I used to. I’m doing a lot of reading. I have, for the first time in a long time, a TV with a DVD player. There’s a video store that’s like the stereotypical hipster behind the counter at the video store, pontificating about film. So I’m completing my film education.

n+1: Seen any good movies?

HFM:
I’ve seen a lot of good movies!

n+1: Want to share any with our readers?

HFM: Masaki Kobayashi, The Human Condition. If you have 11 hours to spare, worth seeing.


Publishing

n+1: We put out a book.

HFM: We did.

n+1: How did you feel about that?

HFM: I was glad the reviewers didn’t savage us. I’m grateful for that. I was a little surprised, given the mood about finance and financiers.

n+1: Businessweek savaged it.

HFM: They did, that’s true, because I didn’t want to pay New York State and City taxes. I’d like to point out, if I have the opportunity–I don’t want to be one of those whiny guys who writes a letter saying “You misinterpreted my book!”–but I did pay a lot of taxes in New York when I made the money. Now that I’m retiring and not making as much money, I’d like to pay less. I didn’t consume very much in New York, no kids in schools, my house didn’t burn down, I didn’t call the police very often. But I paid a lot.

n+1: Still.

HFM: No, it was fair, it was fair. I agreed to be here.

n+1: How did you feel about the business model of publishing?

HFM: It’s better to be a hedge fund manager.

It’s tough, right? Intellectual property has been devalued. The winner-take-all society is something that’s operative in the world of intellectual property, too. You have J. K. Rowling selling hundreds of millions of books. But when you figure on a small audience it’s probably quite difficult to make a living.

n+1: Is it more operative in the world of publishing than in other businesses?

HFM: Yes. If you actually spent full time on finance–if you got somebody to give you a job full time in finance–there’s no way you’re going to be in the red. But you could work very hard at writing, I think, and end up making no money. Did we negotiate a bad deal?

n+1: No, we had a good agent. We did what we could.

HFM: I think we did, but that’s just the nature of the beast. I think it’s true of any business: The worse the business, the better. Whereas if you are doing something that people like to do, that they get some positive value out of doing–for example, expressing yourself is very gratifying, having shared ideas with others is very gratifying–that often makes it a worse business because it’s something people feel in some sense called to do—it’s a vocation in the true sense—and it’s not about economic incentives. It’s like the music business, all these rock stars. “Isn’t it terrible how iTunes and peer-to-peer destroyed the model for popular music?” But it’s not like people are not forming bands anymore, or they’re not making music, just because the business model is compromised.

n+1: If you were the owner of the New York Times, what would you do?

HFM: First, I’d shoot myself in the head. But then, I think you’d have to test the proposition that what you provide does not have easily available substitutes. And the way you test that proposition is you make people pay. If the audience goes down, you have to reevaluate whether what you provide is truly as valuable as you think it is. If you give it away for free, only an idiot would go and buy a paper copy. To me, a paper copy is worth less. I have to carry around this annoying piece of paper and get schmutz on my hands.

In a sense, there were two things they were selling. They were selling eyeballs that were coming to the Times because it was providing something unique. But also they were selling eyeballs because they had a distribution channel to get eyeballs: delivering pieces of paper to your house. For which there is now an obvious substitute, which is to go on the internet and see whatever you want. And so that part of the business model is destroyed.

So you make people pay for content. Do you really provide unique content? Well, charge. See what happens. And they tried that a little with Times Select, but that’s not a corner solution. They tried to optimize. Often that’s the wrong approach.

n+1: What kind of solution?

HFM: The corner solution. In exchange rates we talk about the corner solution: is it a fully fixed exchange rate or a fully floating exchange rate? Compromises–target zones or bands or crawling ped models–tend to fail. Sometimes in life you have to go for those corner solutions. For the Times, it’s like, “You have to pay. Period.” I pay for the Wall Street Journal online. It’s not my company paying anymore, it’s me. I pay because there is no good substitute for that.

n+1: In book publishing the problem’s a little different.

HFM: Too many books being published? I’m afraid we didn’t do anything to help that.


Shorting Latvia

n+1: When you have a trade idea, where that does that come from?

HFM: Sometimes I’m just reading the newspaper or reading research that gets sent to me and something strikes me as wrong or off. I say, “Let me look at the actual financial instruments involved,” and I see that there’s an opportunity.

n+1: Can you give me an example?

HFM: I don’t want to give away trade ideas.

n+1: You could give away old trade ideas.

HFM: Nothing comes to mind that’s not alive, that’s not in some sense a live situation.

n+1: How about the thing you mentioned . . . Latvian currency, Latvian bonds.

HFM: Oh yeah, when Latvia was trading at 9 basis points. That’s years and years ago.

n+1: How did you find out about that?

HFM: Different banks quote markets in credit default swaps on sovereigns and they send what we call runs, a list of prices. And I watch this and I see, “9 basis points? That’s low for anything.” And Latvia! It’s very small, it’s very exposed to the Russian economy, and the Russian economy’s volatile. It’s small enough that a meteor could hit it and that would be the end of Latvia. So 9 basis points–it just seems too low. I said: “Why is that?” And it turns out there’s a quirk in the way capital requirement works for European banks, so that it’s actually very profitable for an individual trader at certain European banks to write protection on Latvia. And that’s what caused the price to move to such an irrational level. So you say, “OK, this price isn’t where it should be; I understand why it is where it is; and I understand it probably won’t persist forever.”

n+1: You saw it was low. How did you find out why?

HFM: You call banks that make markets in this and you say, “What kind of accounts are writing protection on Latvia?” And they say, “Oh, it’s a lot of German landesbanks, policy banks.” Those tend to be motivated by strange regulatory incentives, so then you do research on it. What is the capital weighting required for exposure to Latvia sovereign credit? And you find actually you don’t need to reserve capital for a trade, you can have an infinite return on a capital trade. So I understand why an individual trader might be doing that.

n+1: When you make that sort of call, do you give yourself away?

HFM: Yeah, I might be giving up the game. But the thing is the banks that make up these markets, there’s a limitation on how much of a position they can take themselves. Or maybe the trader, all he does is manage flow but he doesn’t really take positions. That’s why we love the Volker Rule. Getting rid of prop trading, walling off prop trading so the banks that make markets can’t really take a position. It makes things a lot clearer.

And I still get Bloomberg and the runs and I still read research, because it’s just something that I’ve discovered is really interesting to me. Obviously it’s very different when you’re not accountable. It’s kind of like–I don’t have any kids, right?–but I kind of imagine it’s very much the difference between being a dad and an uncle. It’s fun to be an uncle but when the kid shits himself you hand him off to Dad. And that’s the way it is, I can suggest these ideas and think about what would be a good trade, but if the thing went totally haywire it’s not my problem anymore.

n+1: So you’re basically looking through the reports for anomalies–which are created usually for some sort of political reason?

HFM: Maybe it’s for political reasons, something about the structure of regulation. Sometimes it’s basically that the world is laboring under a misapprehension about some fundamental factor. Let’s take European sovereigns. Italy recently was trading very wide to Spain. Actually in the short term, for a variety of reasons, the Italian sovereign is probably safer than Spain’s. But people look at static debt-to-GDP ratios, and Italy’s worse than Spain, so they get on the wrong side of it. The market is laboring under a misapprehension.

n+1: In the case of the Latvians, there was a political reason for the Europeans to want to lend to them?

HFM: The idea was if you’re in the EU, an EU sovereign is considered an effectively riskless trade. Which is a stupid idea! Why the rules were made that way, I don’t know. Perhaps the EU never thought it was going to be a problem. Maybe they overlooked it. Maybe it was a political issue, that within the EU it’s hard to make distinctions, like, “Oh, well, we’re all in the EU but Greece is actually a risky sovereign.”

n+1: When you made that trade, the Germans lost money, and you earned money, is that correct?

HFM: The German banks, yeah. In reality in the end went we found out that Depfa Bank, the biggest offender, they actually wound up being a hybrid, German-Irish. Anyway, it was a certain group of banks that lost money when we made money.

n+1: In a certain way this was a wealth transfer from Europe to the US.

HFM: Woohoo!

n+1: Is it correct to say that part of what we call “financialization” is a lot of very smart people in the US, such as yourself, sitting around looking for these anomalies in the rest of the world and attacking them?

HFM: There are a lot of people doing this, yes. I think you could say though that it’s not merely a transfer of wealth if, by buying risk on Latvia, pushing up that spread, I deterred other capital from flowing into Latvia. In other words: the price sends a signal about the riskiness of Latvia. I was saying, “Well, look, the market’s out of whack. I’m pushing it the other way.” Maybe that will stop a foreign bank from doing mortgages in Latvia and pumping up the Latvian economy, which is what had happened. The accumulation of private debt in Latvia was ridiculous, it created an enormous bubble that eventually popped. It inflicted a lot of losses all over the place, on anybody who went into Latvia, and it inflicted a ton of losses in Latvia itself because their economy got completely distorted. They wound up having enormous output loss, enormous job loss, a lot of misery. People like me saying, “This price is wrong. We’re going to move it the other way and hopefully make money because it will move the other way”–maybe we accelerated the move the other way and stopped that bubble from getting worse.

People talk about the Paulson mortgage trades. But if there had been more people like Paulson shorting the mortgages, that might have pushed the spreads wider and raised an alarm bell.

n+1: You should have gone short, too.

HFM: Don’t remind me. Everybody kept asking me, “Have you read that book, The Big Short?” And I’d say, “No, its just too painful.”

And then I read it. It’s a great book.

n+1: But actually what you’re describing with Latvia is: there’s stupid money flowing in from Europe, and then there was smart money, your money, flowing in on the other side.

HFM: I wish there’d been more of us and less of that money finding a way to flow into Latvia and pumping up an irrational bubble in Latvia. As it was we had to stay in that trade a long time. We probably did that trade in 2005 and only made money in 2008.

n+1: It turns out neither of those things was good for Latvia.

HFM: No, I wouldn’t say that. What we did was not bad for Latvia. We played it very small; we should have done more, we should been on the trade bigger. We restrained the bubble. We didn’t do anything to precipitate that bubble popping, which is evidenced by that I had to sit on that damn trade from 2005 to 2008. If we had precipitated a readjustment of prices and a reevaluation of riskiness in Latvia in 2006, Latvia would be much better off. There would have been many fewer imprudent mortgages, much less credit card debt taken out in Latvia, much less inflation of a property bubble in Latvia.

n+1: So what you’re describing, the low credit spreads, it’s low interest rates.

HFM: Low interest rates and a low perception of risk in Latvia

n+1: And then what happened?

HFM: They got caught in the crisis just like here. Households were massively over-indebted. The property sector was hypertrophied, European banks that had been lending in Latvia stopped and the merry-go-round stopped. Property values fell, unemployment is 20 percent, the GDP shrunk by high teens. It’s a place that is really suffering quite a bit.

n+1: It’s like the US of Europe.

HFM: It’s worse—in a sense they have taken the hit, unlike us, up front. Prices have adjusted down very fast. They’ve cut government spending a ton. They didn’t have the ability to do quantitative easing because they have a fixed currency. They took their loss upfront and things have kind of stabilized there but there’s been huge welfare loss. It’s not fun to be alive there.

n+1: And it’s the fault of the Germans.

HFM: Well, the Latvians borrowed. It’s their fault too. It’s much like here. It’s like dancing or consensual sex. It takes two people.

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