Mayfly

And I always used to think that the reason that financial markets’ memory is so short is not because individuals are short-sighted or they easily forget lessons bought at very high cost, but that the average life of an investor is kind of like the life of a mayfly, I mean, they just turn over really fast.

From Diary of a Very Bad Year

Scrooge McDuck. Photo by Ian Munnings. Creative commons license, via Flickr.

n+1: Now that things have improved … now that we’re recollecting in tranquility, what is some stuff that strikes you as scary and crazy from a year ago?

HFM: I think I’ve told you. I don’t think there was anything that I was blocking out at the time. It is funny, though, I’ll tell you this. It’s funny how quickly people forget. One of the things that was very noticeable during the crisis is that banks had been very willing to do derivatives trades with a hedge fund like ourselves with very little margin posted by the hedge fund. So, for example, generally it’s like Goldman and AIG, right? A bank would come to us and say, you know, “Hey, we’re long exposure to Company X. Do you want to get long exposure to Company X, take that exposure from us?” In other words, “Do you want to write credit protection on Company X?” And if we said, “Yeah, sure, we want to do that,” let’s say we’re writing credit protection on Company X for ten years, and it’s a fairly risky company, the bank would take an initial margin from us, so we would have to post some money to ensure that we would make good if the company defaults, and so that if tomorrow we go belly up, the bank would have enough cash so that if they have to go replace that hedge in the market, they would have money to cover their losses.

n+1: Wait, aren’t they trying to trick you? Why would they say, “We bought this thing and maybe you want it”?

HFM: Maybe they originated the loan, and the company needed a three hundred million dollar loan, and they only have the risk tolerance to keep a hundred million themselves. So they need to hedge two hundred million. So they’re going to stay exposed themselves but they need to share the risk around.

In the crisis suddenly it became a salient question, “All these banks, their risk has been reduced by buying credit protection from counterparties like hedge funds or AIG, and they’ve only taken very small amounts of margin, so that if those hedge funds or AIG goes belly-up, these banks, there’s no way they’ll be able to go out and buy protection without losing much more than the margin that they’ve taken from their counterparties, and these banks will wind up sustaining enormous losses.” So the banks just radically changed their policy on how much margin they would take. Deals where if we wrote a million dollars in protection they used to take thirty or forty thousand dollars in margin, they were now asking for two hundred thousand or two hundred and fifty thousand dollars in margin, in other words, 25% of the exposure.

And everybody said at the time, you know, “Gosh, this whole idea of hedging through derivatives, it’s really flawed if account raisers are really only taking a very small margin from each other.” And now we’re only six or seven months from the nadir of the crisis, and we’re working on some trades recently, and we’re like, “What’s the margin on that?” And it was back to twenty or thirty thousand dollars of margin.

And I always used to think that the reason that financial markets’ memory is so short is not because individuals are short-sighted or they easily forget lessons bought at very high cost, but that the average life of an investor is kind of like the life of a mayfly, I mean, they just turn over really fast.

n+1: They die?

HFM: Not their life as a person, their life as a trader. They become a wonderful butterfly and a philanthropist, and then some other caterpillar trader takes their place.

But in this case, it’s not different people, it’s the same people. And honestly for me it’s quite hard to understand how those lessons have been forgotten so quickly. And it makes one wonder whether those people who blame lax practices like posting very low margins on derivatives, those who characterize that as a product of markets and banks being greedy, of guys just wanting to do a loan and lay it off, and they don’t really care that they’re laying it off on a counterparty that won’t ultimately be able to make good, and they don’t care cause they won’t be there, or they’ll get paid a bonus before it happens… I tend to be a little skeptical of that view, but gosh, the fact that people are doing the same thing certainly gives some weight to that view.

n+1: And so do you say, “No, why don’t we give you some more money?”

HFM: [Pause.] No, I wouldn’t volunteer that. But internally we reserve more capital against that position. I don’t want to give money to some bank, because I don’t love the bank’s credit necessarily, right? So why should they be holding onto my money? I feel like, I’m as good a credit as the bank. However, I do believe that the position is riskier than what the margin requirement reflects.

If I only have to give twenty thousand to the bank for that position, I’m going to keep eighty thousand, or a hundred thousand of liquidity available, because I think the position has risk, it could move that much against me, easily, and I have to have that money available. Now if the bank were more prudent, the bank would want to make sure of that, and the way that it would make sure of that would be to hold onto the money itself. But I’m much happier, I’m much gladder to be able to keep it, to hold onto it myself, rather than give it to a bank that may not be a perfect credit.

n+1: Do you keep it in a bathtub in gold coins?

HFM: I keep that in a gold swimming pool under my house. And I swim in it and cackle and talk like Scrooge McDuck.

n+1: But presumably there are other institutions that are not as prudent as you and that are not doing this, again.

HFM: Yeah, I think there are many institutions that treat the margin requirement that the bank charges as a good indicator as the risk of the position they’re taking on.

n+1: So these guys, when they set a low margin requirement it helps them just put the deal through, and then they get paid.

HFM: Yeah, because even if I believe that I should have a hundred thousand dollars of liquid capital available against a position, I would much rather post none of it to the bank if I can avoid it. So it’s much easier for the bank to get the business done, it’s easier for the trader at the bank, or the salesperson at the bank, to get it done if he can persuade the credit department of the bank to ask for less margin.

And on the other side of it if I’m a hedge fund guy who’s reckless and just trying to make as wild a bet as possible, because my compensation arrangement might encourage that, well then gosh, I would love to post as little margin as possible, so that I can have this big position—the less margin I have to post the bigger the positions I can theoretically run on a given amount of capital, so the universe of willing counterparties for a bank expands the less Draconian its credit policies.

n+1: So you’re saying that these crazy, highly leveraged bank salesmen have emerged from the rubble again to perpetrate their…

HFM: Not at every bank, not at every bank. Some banks have moved much less from their policies in the depth of the crisis than others. But it’s surprising that a number have gone back to policies that look very much like the policies that they had before the crisis.

n+1: Well, shouldn’t we call the police? The regulators? Why aren’t the regulators looking?

HFM: I think the regulators … I don’t know. Maybe they haven’t gotten to these guys yet. Maybe there are bigger problems at these banks that they’re busy controlling. But it’s just surprising to me.

n+1: Me too!

HFM: Hey, look, this is one of the things that convinces me that you can’t have a system that relies on the regulators being incredibly intelligent to control risk. You need blunter instruments.

n+1: In this case that would be …

HFM: In this case maybe it is forcing many of these derivatives to be on exchanges that have very blunt margin policies. Another thing is just making sure that the rules that govern whether a hedge actually reduces a bank’s risk need to reflect the possibility that those hedges may not hold up. It’s too hard for the regulators to look at the minutiae like, “What’s the margin policy for Hedge Fund X?” That’s too fine-grained. So you say, “You know what? We’re just going to assume that there’s some risk inherent in making a loan to Company Y and buying protection on Company Y from a counterparty. That’s not a zero-risk position.”

n+1: Cause otherwise it’s like in Alien, they killed all the aliens …

HFM: You can’t kill all the aliens.

n+1: But there’s this alien out there that’s back to lending!

HFM: It is frustrating. The other source of frustration is, I don’t wish ill on my fellow finance workers in New York, but it is surprising to me that we’re seeing hiring again at some of these banks and not-small compensation packages attached to that hiring. And I’m starting to get calls from headhunters again. It’s kind of surprising. You would think that the banks would be a little bit circumspect about leaping back into some of these businesses. But it’s funny, some of the banks that were unscathed, or less scathed, by the crisis—some of these banks that were less prestigious had a hard time hiring these high-flyers. Now they’re taking advantage of this to bulk up, and to give the same kind of big deals to traders and to investment bankers that their more prestigious cousins were giving before the crisis.

n+1: Amazing.

HFM: And it’s kind of galling. It is a little galling!

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