HFM Redux, Part Two

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.

Golden Goldman

n+1: Can we talk about the Goldman thing?

HFM: You mean the [SEC] settlement? Sure. Was it fraud? Goldman was not fraud, in my opinion. And I have always talked shit about Goldman. But Goldman, of all the banks, always seemed like they were the most careful about following the letter of the law, especially when they were violating the spirit of the law. And in this situation it’s not clear to me that they had any duty to disclose who the other side of the synthetic CDO was to a buyer of risk.

The idea that it’s now shocking that somebody was short? I mean, that’s the definition of a synthetic CDO—that somebody is short on the other side. In a sense they’re finding somebody who’s going to supply that risk by going short. So I don’t understand what it is they would disclose. It’s inherently the definition of the trade. “Well, Paulson was able to play a role in selecting what was going to go into the portfolio.” OK, the whole idea of the trade is that you need Paulson to sell risk. That’s the whole trade. So of course he’s going to have a hand in selection. It’s like saying you go into the market and buy some stocks at certain prices, and sometimes somebody’s willing to sell at that price and somebody’s not willing to sell at that price. Whether you’re able to buy is partly determined by who’s gonna sell. “Oh this is scandalous! People who were selling had a real hand in what you bought!” It’s the definition of a trade.

There’s maybe some more subtle stuff going on because there’s the actual buyer of risk and then there’s the collateral manager, and if there were some misrepresentations made by the collateral manager about why Paulson is going to be on the other side of this… But the guy at the end of that line, the buyer of that risk, wound up in a complex way being–actually, Goldman itself a little bit–but RBS. And I don’t see that they have any reason to complain. They wanted this risk.

n+1: Why did they want it?

HFM: It was highly rated. It was a high spread relative to the ratings.

n+1:
And of course the rating, if not fraudulent, was . . . off?

HFM: Yeah, the rating was based on a flawed model. But the collateral manager claimed he had expertise. The investors who bought it claimed they were great experts in this aspect of the securities market and had a sophisticated understanding of the market. And you know what? Maybe they did, but it turned out they were wrong. That’s what happens. Sometimes you’re wrong. Paulson was right.

n+1: And this was one of those things that was packaged in a way that [Michael] Lewis describes in his book, right? Where they figure out–

HFM: What was required to get the ratings. Yes. But the collateral manager had the ability to investigate any one of those deals that was going into the synthetic CDO. They could do as much of the deal as they wanted. The guy at the end of the line could say, “I’m not going to trust the collateral manager entirely. I want to understand the underlying fundamentals.” OK, you can go investigate, but they chose not to.

There are different suits to distinguish. The SEC was pursuing an action against Goldman. That’s been settled. Now RBS is suing Goldman.

n+1: Why?

HFM: I think they don’t like losing money. And if there’s a controversy, and Goldman looks bad, and the SEC is going after them, and they settled with the SEC, it would sort of be negligent not to try and get your pound of flesh, too. “Well, Goldman was embarrassed enough that they settled with the SEC. Or they thought there was enough smoke there.” I can’t be like, “Oh, I really think it was my fault, I’m not going to sue them.” That’s not how it works.

Goldman’s decision to settle [with the SEC], I think it’s very strategic. I think they know that they probably observed the letter of the law. Most scrupulously. And they know many of the big banks were involved in this kind of trade. So Goldman is like, “Why am I going to be the guy to go die on the hill to defend everybody else? I’m going to settle, because I can get an OK deal.” It’s probably, you know, “Maybe we would win, and it would cost us a little bit less. But in fact with all the legal fees, if we lose it would be a lot more. We have the best fact pattern of all the big banks, but even so, we could still lose. But if we win, everyone else is probably spared; the SEC would probably be embarrassed and give up. But if we settle, it sort of validates the idea that the SEC should be looking into these. And they’ll go and dig up every other bank, and their fact pattern is going to be worse.” So in a way, if you’re concerned about your relative performance with other banks, why not settle if you can get a good deal and all those other guys go die on the hill?

n+1:
Diabolical.

HFM: Yeah [laughs].


Geographic Lag

n+1:
Can we talk about the situation? What’s going on in the economy?

HFM: I made a lot of inaccurate predictions in the book, which we left in. I guess honesty’s important. But one that was correct, I think, was that I felt like there was this credit heart attack, a real collapse of economic activity, and that after the restoration to normal, of the basic plumbing of credit, you would see a bounce back of activity, you would see an inventory restocking, but you’re still going to hit a wall, because you still have to work off this massive misallocation of resources that happened during the run-up to the crisis. And I think that’s where we are now.

We had the easy gains because the banks have been restored to solvency, the short term credit market’s working, credit-worthy borrowers can borrow. People aren’t worried that their bank account is going to get vaporized tomorrow. There’s been inventory restocking, there’s been an impact from fiscal stimulus, but you still have to work off this tremendous overhang of mal-investment. That is: house owners being over-indebted because they bought things they thought they could afford but they can’t. The household savings rate is going up. Mortgage debts are being paid down. Consumer debts are slowly being paid down. But that means that we have this big infrastructure of retail built for a certain level of spending. People aren’t spending like that because it’s not sustainable. OK, so, these stores need to close, prices in commercial real estate need to fall. We have houses in places that shouldn’t be there, that needs to be worked out. We have whole classes of people who became drywall hangers, working in the construction trade, and the mortgage brokers–that labor needs to somehow be reallocated. We have a geographic mal-distribution of people and resources. Unemployment is 13 percent in Nevada, it’s 4 percent in North Dakota. People are physically in the wrong place, and they’re kind of metaphorically in the wrong place–they’re in the wrong industry, acquired the wrong skills, and that takes time to redistribute. There are actually claims that people have on assets not worth what they were: those claims need to be adjusted. Bankruptcies need to happen, restructuring need to happen, and that’s a very time-consuming and resource-consuming and confidence-jarring process–and that’s what we’re going through.

Unfortunately the government’s policies aren’t addressing those issues–they’re working at a very high level of aggregation. They say, “We really need to stimulate the level of aggregate demand.” I mean that helps cushion the downturn but it doesn’t affect that redistribution, it doesn’t affect the reallocation of resources. And you could say, of the very loose monetary policy:  People interpret that as the Fed trying to prop up asset prices, but then people have in their head, “Well, asset prices are being propped up at artificially high levels,” so they are fearful that there are still price drops to come, which in itself tends to be destructive of confidence. So it seems to me that we’ve reached the limits of macro-focused policy to stimulate growth, and really it’s micro, sort of microstructure that needs to be adjusted.

n+1: What sorts of jobs are there in North Dakota?

HFM:
I don’t know, I don’t live in North Dakota. Another place is Wyoming. There’s natural gas, there’s energy. Soft commodity prices are high, so there’s a lot going on in agriculture. Natural resources, so think of it as the natural resources sector, there’s still some vigor in that sector because there’s still a global demand for that.

n+1: Well if people go up there, it might be 8 percent unemployment . . .

HFM:
And they might have the wrong skills. But if you’re at 4.5 percent unemployment it means that business activity that could happen if there were more labor available isn’t happening. 4.5 percent unemployment means there are jobs, probably, that need to be filled but employers can’t find people to do them, that have the right skills to do them. The head of the Minneapolis Fed gave a speech not long ago where he posited that this is an issue. There are jobs—we just don’t have the right people in the right place to fill them. We have people in jobs that don’t have the skills and are in the wrong place to do them so it may be that if you could find more people to get involved more in agriculture, there would be the demand to employ them. You’re actually constrained by the lack of employees.

n+1: Now, as you know, a lot of people feel this is not just a temporary crisis for the US, it’s part of a long-term crisis for the US. And yet you’re confident.

HFM:
A lot of it has to do with long-term structural attributes of the US. It feels to me like there is the capacity fiscally to adjust here. In other words, we are talking about maybe changing the retirement age, changing the formula for social security.  We’re talking about perhaps changing the tax system. The electorate seems really focused on the idea that something needs to be done about the runaway fiscal situation. So I have a feeling that that problem will be addressed. I think in other countries it’s a lot harder to address those problems. I think a lot of other countries, if the government said, “Oh yeah, we’re going to give you free healthcare,” people wouldn’t think “OK, can we afford that?” Here, the reaction was, “OK, I understand that healthcare is an issue, and that it would be nice if we had a more sensible system—but wait a minute, we’re reaching the limits of the government’s ability to mobilize resources for all the things we promise.” It’s like, “I don’t want the free cheese. Let’s figure out whether there’s other stuff we need to not be buying in order to afford that.”

n+1: It’s not clear to me that that was the basis of the opposition.

HFM: I think it is. I think the fact that it’s happening at the same time as massive stimulus, people look at the fiscal situation and say, “I’m not sure this is going to work.” So to me, it’s a healthy reaction, that it’s in people’s head that this fiscal sustainability is important. You’re likely to mobilize political support for fiscal adjustment much more than in countries where there’s much greater rigidity, places like France where you say you’re going to move the retirement age from 60 to 62 and the whole place erupts. I also think we have a more flexible economy, so the relocation of people from industry to industry is more likely to happen here—and will happen more smoothly here—than in some other countries.

And we have the gift of time. There’s still a tremendous interest in the rest of the world to build up dollar reserves. That desire to buy dollars buys us time. There’s still a tremendous demand for Treasuries; that buys us time. And in some way the fact that households in the US are kinda risk averse in plowing their money into bond funds, that actually buys some time for the US, where we’re actually able to roll over our debts at very cheap levels. So it gives the country time to adjust. Other countries don’t have that time. Greece, they didn’t have the time. Their spreads, once they’re 900 or over, they need a bailout from the EU. They don’t have a lot of time to deal with this. And time is like space. It’s like space for adjustment. We have that cushion of extra time.

n+1: What about the destruction of our manufacturing base?

HFM:
Well, when you look at our manufacturing base, manufacturing as a percentage of our GDP hasn’t decreased that much over time. Employment in manufacturing as a percentage of all employment changed. That’s just because we’ve become more efficient. Labor has become much more efficient in manufacturing, and low value-added manufacturing has gone offshore. It’s not like we don’t manufacture anymore; we manufacture a lot. One of the sectors that’s been the most vibrant in bouncing back in the recovery is manufacturing.

n+1: Isn’t the argument that the cause of the crisis was search for growth via financialization because manufacturing was no longer a source of growth?

HFM:
I don’t think it was a push factor—that people were being pushed out of manufacturing and into Wall Street. It’s not like guys who are working construction are leaving that and going to work on Wall Street. I do think there’s something to be said for rising inequality in the US being somewhat tied to the crisis because the demand for credit was a way for people who were falling behind to keep up their consumption. And politicians probably friendly to the idea  of credit growth—and politicians were very involved in credit growth, saying, “We need to make more credit easier to get”—as partly a way to cushion the impact of rising inequality by allowing consumption inequality not be as stark as income inequality. Although, we talked about rising inequality in the US, if you look at global inequality, global inequality is shrinking because people in China and Brazil are getting involved.

n+1: Now they’re stealing those—they’re depressing the wages of US employees in manufacturing. Why aren’t they depressing the wages of HFMs?

HFM: We’re already in a globalized market. I competed every day with citizens of every country in the world. A lot of them come here. In a lot of ways it’s a heck of a lot easier for a very talented graduate of IIT in India or of Tsinghua University in China in Physics to get an H1B visa, come here and work for Goldman or work for a hedge fund than someone who operates a drill press. So we HFMs are already in a globalized market for labor.

n+1: Why were those guys coming to New York rather than going to work for a Chinese hedge fund or an Indian investment bank?

HFM: I think there are network effects in finance that don’t necessarily exist as much in manufacturing. This is where other finance people are and you need to have face-to-face interactions—

n+1: A conspiracy.

HFM: Well, there’s client-customer relationships. Also in a way the legal infrastructure in the US for starting a hedge fund, and for clients of hedge funds to be able to make sure their money isn’t stolen, is better in the US. It’s harder to start a hedge fund in China, and as for the legal infrastructure for starting a manufacturing concern, the US doesn’t really have an advantage—or has a decreasing advantage over these other countries who’ve reformed their labor markets, who’ve reformed their customs regimes, reformed a lot of the legal and infrastructural issues that in the past have given the US an advantage in those sectors. They lag in the area of finance. (That said, there’s quite a little boom in Brazilian-based hedge funds). Plus, you don’t need a ton of people to work in finance so you can import enough H1B visas to bring in the people that you need—the best people from all over the world. Manufacturing just takes more people. You couldn’t bring half of China to the US. But you need 10 guys to work at a hedge fund. So it’s easier to do that labor arbitrage by bringing the people here.

n+1: The manufacturing wages in China are very low, partly because there are a lot of people, partly because it has an authoritarian government.

HFM: The repression was a factor to a certain degree. For example, the repression of unionization there. Or the fact that the unions were company unions or state unions that were very friendly to the companies. But that’s changing, now you see very strong labor pressures in China. Both at a statistical level – wage increases are very high–and the anecdotal—you see the strikes at Foxconn and the labor actions, the high profile labor actions of China that show up in the press here where the companies have granted very large wage increases. So we see the statistics; we also see the instances of that happening.

n+1:
But those jobs are not going to come back here.

HFM: You do hear of companies that were choosing whether to expand a factory in the US or expand a factory in China saying, “Actually, now in dollar terms wages have come down in the US and have gone up in China and if you factor in the productivity differential and shipping costs, and with the regulatory and legal advantages in the US, we’d actually prefer to invest in the US.”. But you could also see companies looking at Vietnam instead of China, or Indonesia instead of China. So, textbook economics: reality is following the textbook.

n+1: If oil prices spike steeply, or the oceans turn into fire, we could start making stuff again here?

HFM: Yeah, or if Somali pirates make it impossible to ship.

n+1: So you have an optimistic view.

HFM: I don’t want to overdo the pessimism. It’s going to be challenging to work off all the imbalances that were built up during the crisis. We need to make it easier for people to move from the wrong industries to the right industries. In terms of personal mobility maybe you shouldn’t be focused on spending all this money and all these resources and putting all this risk on the page of the FHA [Federal Housing Authority] to “keep people in their homes”–if really what you’re doing is for the benefit of the bank that holds that mortgage, and you’re enslaving someone to their house in a place where there are no jobs. Maybe say, “If you can walk away from that mortgage, and find a job across the country, and your credit scores drop because you default on your mortgage, we’ll still lend you money against your paycheck to fund your ability to move from this part of the country to that part, to make it easy.” Maybe that’s where the focus should be. That’s a great use of credit, to fund mobility so people aren’t stranded where there are no jobs.

And like I said before on the fiscal side, at least a conversation is ongoing about dealing with the long-term fiscal situation. But I tell you, the stimulus is going to expire, there isn’t going to be another TARP, so automatically the fiscal situation will look less heinous one or two years down the road. Hopefully there won’t be another war in the Middle East, and Iraq is winding down, and maybe Afghanistan will be winding down, so that will cost less. So there are a number of tailwinds to fiscal adjustment that will make the situation look less heinous down the road than it does right now.

n+1: But it is hard to find a job.

HFM: Yeah, if you’re in the wrong place and you have the wrong skills it’s hard to find a job.

n+1: How come, if we’re so smart, we don’t make any cell phones?

HFM: We design cell phones.

n+1: We do?

HFM: Well, the iPhone. We don’t manufacture it here,
but there’s a lot of value in that design.

n+1: OK, sure, the iPhone. But Samsung, Nokia, Motorola . . .

HFM: Well, the Koreans are pretty smart too. Some of the software on those phones is designed here.  Motorola is based in Illinois.

n+1: What else?

HFM: We build weapons. We have excellent aviation, aircraft . . . we have a tremendous automotive manufacturing base here. A lot of it is owned by foreign companies but the manufacturing base is here. A lot of automotive design studios are here, actually. And we still have Microsoft, Google, Facebook. We’re destroying other countries’ productivity by exporting things like Facebook. It’s like Tetris: Tetris was the great Russian weapon against the US. The greatest minds were playing Tetris all day long.

So we’re great at a lot of things. Our financial sector made a lot of errors, but still we’re very dominant in asset management. Some of our biggest global banks these days are doing OK. So the fact that finance hit the rocks doesn’t mean that there’s no value in the financial expertise that the US has. The banks and asset managers and insurance companies–there’s real value there.


A New HFM?

n+1: So, are you going to go back in?

HFM: No plans at the moment. I’m happy being an uncle.

I do feel a little bit chagrined about one thing. I did emerging markets for so long, and when you’re doing emerging markets you have to become an expert in fiscal affairs, right? Whereas until recently traders in the US Treasury market or the European bond market knew nothing about fiscal policy–they thought very little about it, because credit risk just wasn’t an issue. If you’re trading treasuries you don’t think about US default risk, you don’t think about UK, or German, or even Greek risk for that matter. Now everybody’s talking about fiscal sustainability, every research report you read is about figuring out how to model the fiscal path. I spent years mastering that, and it was the minor leagues. It’s like, if you use a certain pitch, the knuckle ball, that people only use in the minor leagues, and then you’re like, “Forget it, I’m done with knuckle ball, I’m retired from baseball,” and then suddenly knuckle balls are all the rage in the major leagues. You do sort of kick yourself a little bit–you’re like, “Gosh, I built this expertise, and now this is the number 1 issue in financial markets and I’m not in the markets.” That’s a little annoying.

n+1: You mean sovereign debt . . .

HFM: There’s a lot more risky sovereign debt to trade. Medium-sized countries, nobody really cares about trading their debt. But now there are these huge bond markets where credit risk is a big issue and the spreads are fluctuating all the time.

n+1: There is a guy as we speak who’s poring over these lists of spreads and saying, “That one’s wrong!”

HFM: Poring over the finances, trying to figure out which one is in better shape, which one is in worse shape, what are the levers that are going to determine whether that country can recover. People are really spending time on that, and they didn’t before.

n+1: And if you have a group of these guys, the group leader says, “You guys go and look at these lists and tell me if you see anything.” But it’s not like each of them comes up with ideas, right?

HFM: Different firms are organized differently, but usually you have a portfolio manager who’s making the actual investment calls, and you have analysts. The manager has an idea, the analysts drill down and research.

n+1: Well we should stop wasting our time and go study some lists.

HFM:
There’s probably a huge number of Bloombergs sitting in Uncle HFM’s messaging system.

n+1: That’s what you call it, “Bloombergs”?

HFM: Bloomberg messages, yeah. I’ll show you, I have it on my Blackberry–see, these are Bloomberg messages. This is actually kind of messy because it’s on a Blackberry.

n+1:
“Chile.”

HFM: Chile is at 5 percent—

n+1:
“Costar,” what’s that?

HFM:
Costa Rica, 9 percent . . . that’s a coupon on the bottom. The spread is really low. Under 200 basis points for Costa Rica.

n+1: [intrigued] A little low?

HFM: Costa Rica is a great investment right now, don’t mess with Costa Rica. Dom-Rep, Jamaican Republic . . . 290, 250, 330 . . .

n+1:
[probing] 250, that’s a little high…

HFM: Yeah but, DomRep’s a little sketchy.

n+1: You look at these and they mean something to you?

HFM: Yeah, you learn to parse this stuff. See, here are the Argentine bonds. That’s an Arg Bonar. Bonar’s just the name of one of their types bond–endless fodder for puns. The Bonar is going up. Bonar’s firm today. I’ve got a long Bonar position. Somebody’s out there whacking the Bonar! The Bonar X, this is the 2017, used to be rich, now it’s cheap.

n+1:
“Unable to keep up USG rates. Bonds are better off throughout the day. Liquid, December 24th.” So this is all sovereign.

HFM: This is Mexican local debt. Peso debt. One-year rates, 2, 4, 5, 7, 10, 20 year. This is how much they change, this is the spread over US Treasuries.

n+1: How would you go about . . . ?

HFM:
That’s the secret sauce. I can’t tell you that.

n+1:
Like, you would know something about Mexico that somebody doesn’t know.

HFM:
I know what’s going on in Mexico and have an opinion about what’s going on in Mexico and, you know, have insight into how that translates into where prices should be. It’s lots of fun when you’re not accountable.

n+1:
They should have like a fake, they should have just a fantasy football type league . . .

HFM: People do that, they call that paper trading. When you’re testing a strategy you’ll paper trade it.

n+1:
That must be very frustrating, actually.

HFM:
If it works out, it’s frustrating, but then you’re like, “Oh, this strategy will work.” So now I have confidence it will work, and I’ll go trade it. And if it doesn’t work, you’ll go, “Wow, I’m glad I didn’t trade it.”

n+1: You know, I read that Mallaby book [More Money Than God] . It goes through a lot of strategies, and some of that stuff, especially during the dot-com, it’s just like . . .

HFM: We talked about coin flippers. There are a lot of guys who are effectively coin-flippers.

n+1: And you’re saying we can’t beat those guys?

HFM: You should be able to beat those guys. The thing is, this is the problem with the compensation systems for hedge funds. If you have investors that are willing to pay 2 and 20 based on annual performance, I’m not going to be able to recruit talent if I say, “No, I think you’re foolish, pay me 2 and 20 based on ten-year performance.” I won’t have the revenues to offer competitive deals to porftolio managers. So in the end, I have to be responsive to my clients.

But it’s foolish to pay 20 on an annual basis for strategies that are very volatile, so effectively you’re flipping a coin. It’s worse than that, it’s like you’re rolling a die. It’s a strategy that makes money at every roll except if a 1 comes up. So you’re going to pay that guy after every roll. You’re like, “Ooh, you rolled a 5, that was a great investment, here’s some money.” OK, roll again. “Ooh, you got a 4,” here’s some money. And each roll is a year. Then you roll the 1. The fund loses all the money saved from the prior rolls, right? His investors lost all their money. But the fund got paid for all those years before.

And that’s an error in judgment of people who invest in funds. They look at a strategy and its returns and don’t consider what is the distribution of returns for somebody pursuing this strategy with no skill whatsoever. If the no-skill pursuit of the strategy would give positive returns four years out of five, you shouldn’t be paying the manager for annual returns.

n+1: You know what else occurred to me reading these books–just in the way that there’s a lot of people with skewed incentives w
ithin a particular regulatory system, because they’re getting a percentage of some kind of issuance, in the same way that German landesbank had skewed incentives, couldn’t you also target traders, people who are in the market with wrong incentives–I mean wouldn’t you want to look for a place–

HFM: That has a lot of idiots? Yes, you want to be in an inefficient market, with “noise-traders”–people who believe that they have some skill but they really don’t. A great time for stat-arb was during the inflation of the internet bubble, because so many people, so many average retail investors decided “I’m a stock market genius!” They were just crazy, they were just noise-traders that were creating a lot of distortion. They were sloppy in the way that they traded, and they were also doing things that were just foolish and that created a lot of anomalies that stat-arb guys were able to exploit. After the internet bubble collapsed, that next year was a much tougher year for stat-arb because those noise-traders were gone. It’s sort of effectively functioning like the house in the casino, the gamblers are all like that, when there’s more of them you do well.

n+1:
It’s just I read all these books. And I thought–

HFM: It could be you?

n+1: Yes! I haven’t actually moved on this, but I feel good about it.

HFM:
The important thing is the belief and the confidence.

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