Anonymous Hedge Fund Manager (II)
march 25, 2008
New York city
n+1: So this is a hedge fund.
HFM: This is a hedge fund. Now you’ve seen what a hedge fund looks like: a lot of flat screens, a lot of people staring intently into them, and not a lot of noise. We’re quite quiet for a hedge fund. We don’t have TVs. That’s probably one of the big differences between this trading floor and a typical trading floor—I got rid of TVs some time ago. I don’t have a TV at home, and I thought it was ironic that I had gone through all this effort to resist having a TV at home and then I would spend all day watching Squawk Box on CNBC, so then we decided, we’ll just get rid of the volume, we’ll kill the volume, but then I spent my whole day inventing dialogue for Maria Bartiromo, and new texts for the—well, there was this foot fungus commercial that would play on CNBC all the time which was really disgusting, and we were coming up with new variations of foot fungus. So we decided finally we really had to get rid of TVs. Other than that it’s pretty standard.
n+1: So how are things going?
HFM: It’s been a really turbulent couple of weeks. Obviously the market has been in some, uh, degree of crisis since the last time we spoke, but what’s new is that it’s really been spreading. I’ve been doing this for over a decade and I’ve seen asset prices generally more distressed than they are today, the equity market has been much more distressed than it is today. The particular market that I trade, I’ve seen prices much more distressed than they are today. But I’ve never seen the financial system as a whole more distressed. Banks, the sense of panic and despair at the major banks, I’ve just never seen it before.
n+1: When we talked a few months ago, you seemed OK with things, you thought everything was going fine, America was going to win this.
HFM: Well, I didn’t want you to start a bank run with your vast readership at n+1. I felt it was my responsibility as a member of the financial community to keep all of literary New York from lining up at the bank or at the ATM the next day.
I still think things will be fine, but I overestimated the degree to which the subprime risk had been off-laid by the banks. I think a lot of it was off-laid—we talked about European buyers and Asian buyers who were the ultimate underwriters of the risk, but as it turns out much more of the risk than I expected was still on the books of the big investment banks. So when you hear about write-downs related to subprime mortgages taking place at Merrill Lynch, Citibank, Bear Stearns, that’s a consequence of their having retained risk related to these assets on their books. We thought it had been sold on to Europeans. And it was: the Germans lost a lot of money, and some of the Chinese banks are announcing earnings in the next weeks and the speculation is that a lot of them will have to announce write-downs related to subprime. But Citibank had a ton of this stuff on their books and had to write down a tremendous amount. Almost all of the major banks have.
At the end of the subprime orgy, it became difficult to place a lot of this debt. So the banks would end up warehousing it. They had a profitable business in purchasing and securitizing these assets, but it was ten minutes to midnight and they didn’t know it. They thought they would be able to place it and securitize it when things calmed down. But it turned out the clock struck midnight and these assets turned into—pumpkins. And they couldn’t move them, and while all these assets were sitting on their books the real estate market started to deteriorate, and the value of these subprime mortgages started to deteriorate with it.
n+1: How long have they known?
HFM: The biggest write-downs mostly were taking place in the fourth quarter of ’07 and they’ve continued. We’ve seen some more for the first quarter of 2008. There may be more to come, but for subprime the write-downs may be close to finished. What people are worried about now and what’s created a lot of tension in the financial markets is that the rot is spreading to other asset classes. So it’s not just subprime mortgages: Now people say, “Gosh, subprime mortgages have performed so poorly that it’s weighing on real estate markets and that means that our Alt-A mortgages will perform poorly, that means people should be worried about prime mortgages, too. People should be worried about companies that are exposed to the consumer who is taking out a subprime mortgage, or companies that relied on spending from consumers that was based on home equity, people withdrawing equity from their homes to buy things.”
When you’re talking about risk management, there’s an assumption that not every asset class will be correlated. So, sure, subprime blows up but the bank’s OK because prime will hold up, or there won’t be a perfect correlation with leveraged loans. But what’s going on is that all these credit products are performing badly at once.
HFM: Because there are some real linkages. If consumer spending has been supported by people extracting equity from their homes, the mortgage market shutting down will hit consumer spending. And that will hurt companies that rely on consumer spending.
And then there are the financial linkages—hedge funds blowing up so that they can’t buy leveraged loans anymore, or banks that got hurt in subprime that have to sell down leveraged loans to generate liquidity, and the buyers are gone.
So that’s one financial linkage, but also there’s capital—the banks’ capital base. Every time a bank takes a write-down, that erodes its capital base, and the bigger the base the more risk it can take. There are rules for that—Basel 2 capital adequacy—and if a bank is writing down 10 billion dollars, suddenly the risk-taking capability is reduced. Assume the capital adequacy ratio for all these banks is 10 percent. So if a bank falls 10 billion below its capital adequacy target, that’s 100 billion dollars in risk-taking capacity that disappears.
n+1: And this is regulated by the Fed?
HFM: Yes. The rules can be relaxed—there can be regulatory forbearance—but so far there hasn’t been any and there probably shouldn’t be, because these rules are there for good reason. A good illustration of what can happen is Bear Stearns. Bear is not a commercial bank, it’s an investment bank: it doesn’t have these capital adequacy rules, it’s not regulated by the Fed, and Bear, if your average bank had a capital adequacy rate supporting 10:1 leverage, Bear is more like 30:1. And that is one of the reasons confidence evaporated so quickly: people looked at the balance sheet and realized that if assets have to be written down even a small amount, Bear can be insolvent. And that creates a panic.
In reality I don’t think they had a solvency issue, but when the capital cushion is so small it creates instability.
n+1: So what happened with Bear Stearns? What were the steps?
HFM: Bear was a bank that was very involved in the asset-backed and subprime market. Both as a principal and as an agent.
What happened this summer was funds managed by Bear Stearns—not things on their own books, other people’s funds that they manage—were heavily leveraged and invested in asset-backed securities. Those funds blew up—they went into uncontrolled combustion. They failed very quickly. One day they were there, the next all the assets were marked down, then they were insolvent and folded up. Now that’s not Bear Stearns’s capital, but these were guys sitting in the Bear Stearns office.
n+1: Which is where?
HFM: On, uh, 47th and Madison. Just down the street.
n+1: And they were sitting there; they had a little hedge fund—
HFM: Which means they raised money from outside investors—they get paid based on how the fund does, they get a percentage of the profits. And they traded in subprime assets where the capital was given to them by outside investors.
n+1: These were ten guys?
HFM: I don’t know the size of the team, but they were sitting there, buying asset-backed securities backed by subprime mortgages, they were borrowing a lot of money, they used the capital they had, they borrowed outside money, they bought subprime mortgages. They were highly, highly leveraged. 50:1 leverage.
n+1: Why was Bear Stearns in particular doing this?
HFM: Bear Stearns supposedly had an expertise in subprime and asset-backed securities; it is an expertise of theirs. They’re still alive.
HFM: You know when somebody falls off a motorcycle, and the doctors want to harvest their organs, they’re still alive until they harvest the organs? Right now Bear Stearns, there’s an EKG, it is pinging, they’re technically still alive and JPMorgan is waiting for the healthcare proxy to sign and say they can start harvesting the organs. This is where Bear is right now. They had an expertise.
n+1: So it was 100 billion dollars? How much money?
HFM: I don’t know. It was not huge. One to two billion dollars each. In that range. Which doesn’t make them huge funds. Modest funds.
But from that moment forth, people on the market speculated as to how many similar kinds of assets Bear Stearns must own on its own books. There was a cloud of suspicion over Bear Stearns. As it turns out, I don’t know that they were in that much trouble. They were probably much more careful with their own money than outside money, but once there’s a cloud of suspicion the information asymmetry between people outside the firm who don’t know what’s going on, and people inside the firm, can create a crisis of confidence.
n+1: Can’t the firm say, “Look, we have this, we have that . . .”?
HFM: What are they going to do, show you every instrument they have on their books? People don’t know what these instruments are worth. Like an asset-backed bond—what’s it worth? Nobody knows what it’s worth, there isn’t a market for this anymore. It’s not like there are three bond issues and that’s it—there are thousands, and each one is backed by thousands of mortgages. It just becomes an information-processing problem. You simply can’t prove to me in a reasonable amount of time that everything’s fine.
n+1: They don’t have other instruments besides mortgages?
HFM: They do, they have their building, that’s one of the things that is probably worth the most. But Bear was involved in a lot of the asset classes that had problems. First it’s subprime mortgages, then it’s leveraged loans—they’re exposed to all these things, thirty times levered, so a very small diminution of the value of these assets could mean that their equity is worth nothing. And it’s just going to be impossible for these guys to prove in a short period of time with a high degree of precision that their assets are worth what they say they’re worth. There’s been a cloud over Bear Stearns for eight months, and in retrospect people were critical of their management for being insufficiently aggressive in trying to persuade people that everything was fine. They simply asserted that everything was fine.
n+1: Did they come here, have lunch?
HFM: No, we’re not a big customer, but they did speak to other customers and they did speak in the press, and they came off as—a bit cavalier, I think, and as the credit environment deteriorated the nervousness about them and the rumors about them intensified and it culminated in a process where a lot of customers who had money at Bear Stearns, customers of their prime brokerage business, and regular retail investors, said, “I don’t want my money there. Why not move it to Citi or Goldman to be safe?” And once that process starts, as each account withdraws, it becomes even more enticing for the other guy to withdraw because it looks like things are unwinding. And then institutional counterparties start to refuse to take Bear’s credit . . .
n+1: Are they an investment broker? If you wanted to take your money out you had to call up your buddy?
HFM: Yeah, and the broker could try to persuade you. And look, “I could be wrong about Bear being in trouble and I could lose a little money moving it around and impose upon myself the inconvenience of moving my money—a little money and a little brain damage. But if I’m wrong and leave it, I could lose a lot of money.” That’s the balance of risk.
n+1: It’ll cause you brain damage?
HFM: Yeah, brain damage. Not literal brain damage but, you know, inconvenience—brain damage. So on one hand you’re going to impose an inconvenience on yourself, but on the other—it unwound very quickly. On Thursday they said everything was fine, on Friday they had withdrawals of sufficient magnitude that they had to go to the Fed. They’re not regulated by the Fed, so it’s unusual for the Fed to be lending money to Bear Stearns, but an agreement was put in place to try to provide the liquidity to Bear Stearns, and over the weekend a deal was struck for JPMorgan to help.
n+1: The government struck that deal?
HFM: Well, the government had their role. The difference between what happened and a normal takeover is the Fed, because the Fed is providing JPMorgan some non-recourse financing for Bear Stearns assets. The strange thing about the deal is that Morgan is paying so little for Bear Stearns. Bear Stearns was trading at 170 dollars a share not that long ago, now the deal was two dollars a share. A lot of wealth was wiped out. The question is, why would anyone accept it? Just before you came in today, JPMorgan increased their offer to ten dollars. But a two-dollar share offer, for the most part it’s like, “This is like pennies to me. I’ll say no to this deal and maybe I’ll do better in bankruptcy.” The reason the Fed didn’t want Bear to go through bankruptcy is that there are all kinds of interconnections between Bear and other banks. There’s counterparty risk, it could lead to panic, it could lead to a whole mess in the financial market, so the Fed just wants the problem to go away, the Treasury just wants the problem to go away. But if I am a shareholder it’s not my problem. “Let’s go bankrupt, let’s see, maybe we can do better than two dollars!” So everyone here was puzzled that Bear would agree to that kind of a deal.
Now Bear Stearns is unusual in that a lot of the shares are owned by insiders in the company, and the theory we had at the desk here is that the Treasury Department—not the Fed, the Fed’s not so tough, but the Treasury Department went to the top guys at Bear and said: “Either a deal gets done that saves Bear and calms the financial system by the end of this weekend, or we will find some reason to put you in jail.” And I think one of the things that every officer of a public company is very sensitive to, post-Enron, is jail. There has been a criminalization of failure. And after Sarbanes-Oxley, and in the wake of prosecutions related to business failures, it was like Beria said: You show me the man, I’ll find the crime.
So I think for these guys it wasn’t just, “I’m risking two dollars if I say no,” it was, “I’m risking two dollars plus anal rape in jail.”
n+1: I don’t think they put them in that kind of jail.
HFM: OK, then tennis. “I’m risking exposing the weaknesses of my tennis game.” So anyway that was the reason that deal was struck.
n+1: And the Treasury, those guys are tough?
HFM: Well Hank Paulson is tough, yeah.
It was very strange because the Fed providing liquidity to Bear Stearns is kind of unprecedented. It’s not regulated by the Fed and if it turns out that the Fed finds that an institution like Bear Stearns is so integral to the smooth functioning of the financial system that it needs to bail it out, it makes you wonder whether the regulatory regime needs to be pretty radically overhauled.
n+1: And the Fed has more money than anyone?
HFM: The Fed can print money. They can create money. They can’t create value but they can create money. To the extent that there are dollar claims that people have on banks, and the banks can’t satisfy those claims—the banks can take assets they have to the Fed and borrow dollars against those assets.
n+1: The Fed can print money over the weekend.
HFM: No, it’s not quantitative easing, but in this case they lent treasuries—assets that people will treat just like money—against risky assets that Bear had on its books. That’s why they’re the lender of last resort, because they have as many dollars as they need to lend. In this case they used Treasury bonds from their portfolio. But if they go and print money promiscuously the dollar won’t be worth very much.
n+1 [glumly]: It’s already not.
HFM: And one of the reasons the dollar is doing so poorly is that there are worries about our financial system and people anticipate that the Fed will have to run an easier monetary policy in order to deal with it.
n+1: What’s going to happen to the guys who worked at Bear Stearns?
HFM: Some of them will wind up working for Morgan and a lot will be laid off, and people talk about it as a bailout but I don’t think it’s a bailout of Bear’s management or shareholders. The shareholders get maybe ten dollars a share, but they used to trade at 170 per share, so they’re pretty much wiped out. The senior management is all gone. And some people say a quarter, some people say half will be laid off.
If you really look at what the Treasury and/or the Fed was doing, they know that they have to protect the financial system from grinding to a halt, but they don’t want to create a moral hazard as a result of people thinking they’re going to get bailed out no matter what. So yes, there was a bailout of the counterparties, but they needed to take Bear out and shoot it in front of everybody. So they took it out, at a two-dollar offer, all the senior management is gone, and that’s the financial equivalent of taking the shareholders out and shooting them.
From time to time you have to kill a management team to encourage the others. So now Citibank and Merrill Lynch realize that it’s unlikely they’ll be allowed to default. But at the same time the people who are actually taking risk, the senior managers at Merrill Lynch, know that if a blowup happens, the institutions may be saved, but their shareholdings will be worth zero, and their job tenure will be—done.
n+1: Wouldn’t it have been better to let them go bankrupt?
HFM: And let their counterparties face the music? Maybe, but the parlous condition of the financial system as a whole I think persuaded the Fed that this is not the time to experiment and see how interconnected the system has become.
If we were in a calm economic environment and Bear, for nonsystematic reasons, failed—say they put all their money into cheesesandwich.com or something, and they failed for that reason, then it might be appropriate to let them go bankrupt because the rest of the financial system would be stable. Even if it inflicts losses on the rest of the financial system and causes a lot of brain damage for me, it won’t be a risk to the system as a whole.
But every bank out there to some degree or another is suffering the same problems that led to the cloud of suspicion over Bear. So this is not a great time to test a proposition that the financial system can cope with disorderly unwinding of all these contracts.
n+1: Why is it that after eight months of suspicion this happened in 48 hours?
HFM: That’s one of the crazy things about bank runs—it’s not clear what triggers them. I was actually in Argentina the day of the bank run in 2000, and I couldn’t tell you why it happened that day. It was beautiful weather, and I was having meetings in the office building of a bank called Banco General de Negocios. And everything was great and then when I came down the elevator at the end of the day, late afternoon, there was a line of people out the door of the bank. I can’t tell you why it was that day. Argentina had been in economic difficulty for the prior year but that day the bank run started. And then they had to impose basically a deposit freeze.
n+1: Were people mad?
HFM: That’s what started the unraveling of the Argentine government; people were standing outside banks banging on pots and pans.
n+1: Did you run from the run?
HFM: There was a big line and I went to the airport.
n+1: And you were here the Thursday that the Bear Stearns run happened.
HFM: We were just sitting here watching. It was amazing how the stock just dove. It had been trading poorly for months but it lost 60 percent of its value in a couple of hours. We were mesmerized just watching on our Reuters screens. And everyone in the market was doing the same thing, the phone stopped ringing, I stopped getting Bloomberg messages, everyone was just watching: “It can’t be! What’s going on! Stuff doesn’t lose that much value on no news in a couple of hours.”
And really what was going on was that there was a run on against Bear and people were getting wind of it.
n+1: Can you talk about what the hedge fund might have done to make money?
HFM: We could have been trading the debt of Bear Stearns, which gyrated wildly. Credit default swaps, for instance, are an instrument that lets you trade the credit risk of a borrower. One-year credit default swaps on Bear Stearns at their height were trading at 2,000 basis points, or 20 percent—you would have to pay 20 percent a year to ensure yourselves against the default of Bear Stearns. Today it’s about 200. They went from 200 to 2,000 to 200 in the space of a week or so. We could have traded that but we were staring in awe instead of making money! We didn’t lose any money, either, so I guess we got some entertainment out of it, which has some value. Now, we could have made money to buy entertainment; instead we just watched screens and got entertainment directly and that’s not taxed.
n+1: So there’s a financial meltdown. Are you worried?
HFM: Worried about what? Specifically? I am always worried. I’m not worried about a catastrophic unwind at this point. Our fund is extremely conservative, we have a ton of liquidity and we’ve always run our business to be robust to financial crises. We’re not directional and we’re not highly leveraged. The downside is that in good times we’ve generated solid returns but we’re never, you know, up 80 or 100 percent. It’s a low-risk fund by design.
n+1: What about when you lost 150 million dollars in subprime?
HFM: We’re not going to talk about that. But that is about as much money as we’re ever going to lose. We had planned that that was the amount of risk we would take to that asset class and our worst possible outcome for that asset class happened. I don’t want to get into too much detail, but we weren’t in the situation where our lenders were pulling lines to us or we couldn’t cope with investor withdrawals. We were at a low degree of leverage, so I’m not worried about that.
I do worry about the hedge fund business—I think that it may wind up being a much more difficult business going forward for various reasons. You’ve had a number of blowups of high-profile funds in the past couple of months. I think that damages the credibility of the asset class. People who invest in hedge funds have thought of it as an asset class that would be robust in any environment, that you’re getting the best investment talent, and you’re least likely to have these kinds of disasters. But the outcomes of some of these funds give the lie to that belief. So what may happen is that even if you outperform all the other hedge funds—if everyone else is down 10 percent and you’re up 1 percent—the structural damage to the asset class is so large that it doesn’t matter that you outperformed, money is going to be pulled out of hedge funds.
n+1: A hedge fund is an asset class?
HFM: I think we can talk about alternative investments—hedge funds and private equity—as an asset class.
n+1: Are hedge funds considered more aggressive?
HFM: The reason it’s called a hedge fund is that originally the investment would be hedged to broad market factors. Now it’s a very plastic definition—just a leveraged investment vehicle—but I think people like to think they’re getting the best investment talent, the best risk management, because they’re paying a lot more than they would pay for a mutual fund. And if hedge funds have a high probability of spectacular blowup, that makes it a less attractive asset class.
Problem number two is that people invest in fund-of-funds—that is, vehicles that farm out money to several hedge funds on the theory that hedge funds are very uncorrelated with each other, each one has its own investment strategy and their returns won’t be correlated—but what we’re seeing this year is a high degree of correlation of hedge fund assets. So if I was thinking I’d benefit my diversification by investing in hedge funds but I’m not, if in fact there’s a hedge fund factor that underlies the performance of all these funds—then money might leave the asset class and this hurts everybody.
n+1: What about the whole thing?
HFM: The financial system as a whole will be all right—the Fed and the Treasury drew a line at Bear Stearns and the line held. We haven’t seen any evidence of the average Joe going to a bank and pulling money out of his checking account. Terrible scenario number one, where the average person loses confidence and the banking system goes bankrupt like in Argentina—the probability of that in the US is close to zero.
n+1: Doesn’t everyone also owe credit card debt? They would show up at their bank and ask for their money, and the bank would say, we want our money!
HFM: I think people may owe their money to bank x and deposit it in bank y, so it’s not actually something they can set off against you. I think another bad path is the Japan scenario—where losses don’t get recognized and all these banks are in worse shape than they let on, they don’t take risks because they don’t really have the capital, but they can’t raise capital because they don’t recognize the losses, so no one is going to invest in the bank if it hasn’t given a true picture of its balance sheet. Then you have zombie banks like in Japan, and that retards recovery, and you have an economy that can never build momentum to grow again.
n+1: They have zombie banks?
HFM: People talk about the banks in Japan post the crash of the early ’90s as zombie companies and zombie banks—the bank has a loan to a company that is clearly insolvent, the bank should be doing a restructuring, but the bank doesn’t want to admit the company is insolvent so it doesn’t restructure the loan to the company, it’s in limbo—they’re like, undead.
In the situation we have today, where people have made bad investment decisions, where people built houses they never should have built, there’s a misallocation of resources. The loss has already happened. The loss isn’t what happens on a balance sheet: the loss is what happened when someone cut down a tree, made cement, built a 6,000-square-foot house in a place it should never have been built. So the loss has already happened. The question is: How do you allocate that loss? And if you don’t allocate the loss, if you pretend it isn’t there, then this has really baleful consequences for the economy. So now we’re going through this process of loss allocation. It can be done swiftly, fairly, and intelligently, or it can be done slowly, messily, and inefficiently, or it can not be done at all. The best is to deal with it swiftly and fairly. And when the shareholders get hurt really badly and the banks have to recapitalize at punitive levels, or get taken over at two dollars a share, I think it’s fair—the banks made bad decisions, the equity holders are the prime beneficiaries of the activities the bank is undertaking. When things go poorly they should be the primary bearers of the loss, I think that’s good.
n+1: They’re not going to want to do that.
HFM: They’re being forced to do that. The regulations are forcing them to do that and it’s happening. I mean, Citigroup, Merrill Lynch raised capital, they did it at prices that I don’t think they’re happy about.
n+1: Their share prices went down.
HFM: They went down and they raised capital at that lower price. I think it’s fair that those guys should bear the loss. Now who else can take loss? Foolish borrowers—they lose their homes or wind up having to sell assets to pay back their debts. Or taxpayers can take the loss, through paying for some kind of bailout or through inflation, which isn’t fair, but which is likely to happen to a certain degree. What’s important is that this is done quickly and that when it’s done there’s certainty that loss has been recognized and that losses have been distributed, and then we can start moving again.
n+1: Otherwise we have zombies?
HFM: Otherwise we have these zombie banks that can’t lend, zombie companies that shouldn’t exist, and resources that should be released aren’t being released. When Russia defaulted on its ruble debt in ’98, we knew of a Japanese company that had bought a lot of it. And we noticed that they never publicly disclosed the loss. Not just us, other people knew, too. And somebody asked the management, Didn’t you own hundreds of millions of dollars of GKO? “Yes.” So aren’t you going to take a loss? “No . . . we plan on holding the debt to maturity.” It was defaulted! That’s failure to confront the problem. So we’re going through this loss recognition and liquidation—it’s a painful process and you want to do it in a way that doesn’t inflict further damage but you also do have to do it.
I was just in Florida and it was amazing to see all the new housing that’s just empty. I was visiting relatives in a relatively upscale property development in south Florida that is 2,500 homes. The initial phase sold out quickly, and many people who lived there decided to invest in the last phase of development and buy some units in order to resell them—and it’s like it’s a movie set or something. It’s like a neutron bomb went off, there’s no one there.
n+1: Could we squat in them with our magazine?
HFM: I wouldn’t encourage you to break the law but I do think that squatters in the East Village or wherever, we should tell them they’re better off there—they don’t need to live in a building with no power or water and rats and garbage. You can live in a nice building with a pool and sunshine.