Anonymous Hedge Fund Manager (III)
september 4, 2008
new york city
n+1: We’re back in your office above midtown. Last time we looked out people were being fired, people were jumping out of windows . . .
HFM: And it’s continued largely in that vein. The credit crisis that was underway is still underway, and the recognition of losses is continuing—but it’s still continuing at a pace that means that the situation is not resolved. We haven’t reached a point where people feel like all the bad news is out of the way. It’s like a rainstorm of shoes: the shoes keep dropping, and there are still clouds in the sky, and there’s still going to be more shoes dropping, and until the footwear stops falling, you know, the crisis will continue.
n+1: You were optimistic that companies were announcing their losses, were dealing with the bad news. Was that not correct?
HFM: No, they are, they are, but people’s estimates of the size of those losses have increased. If you talk about subprime, most of those losses have been recognized. But the losses extend beyond subprime, they extend beyond leveraged loans. So now people are worried about prime mortgages, they’re worried about development loans, mortgages of commercial property, so the losses have not really been recognized, or the loss recognition process there is only just beginning. Then you have the whole issue of Fannie Mae and Freddie Mac: their equity is definitely wiped out, these things are insolvent, the equity has been burned through—you have negative equity. You have to recognize that. If you marked all their assets to market and said, “What are the assets worth?,” you’d find that the assets are worth less than their liabilities, which means that the equity is worth nothing. If that were a regular company—and not a company that plays this really important infrastructural role in the mortgage market—they’d go bankrupt. This company goes bankrupt. The equity should be wiped out and maybe some of the debt should be wiped out, and it needs to be restructured. But instead it’s like the zombies, they’re zombie companies. These companies are very politically powerful and also they’re important, and there’s fear that if they failed or if the equity holders were wiped out, it would lead to a horrible shock in confidence. But in the end, if you have a dead body in the room, and I keep saying, “That person’s not dead, that person’s just resting,” and pretty soon it starts to smell and decompose—there’s only so long we can pretend before the odor becomes overpowering and we have to run from the room.
n+1: And when we talked about whether this was going to spread beyond the credit market—that seems to be happening?
HFM: Well there are two kinds of linkages we can talk about in the ways the rot has spread. One is the financial linkages. So does it spread to other asset classes? And it has—there was a problem in subprime, and then it moved to Alt-A, and now people are worried about prime and commercial mortgages. So there definitely has been a financial spreading. The other linkage you worry about is, “Do the problems in the financial system spread to the real economy?” To a certain extent, obviously, right? The financial system is a way of accounting for what’s going on in the real economy. And so we see foreclosures, and unemployment ticking up and job loss, but I think people have actually been surprised at the extent to which the real economy has been stable in the face of all this. I mean, technically we don’t even have a recession yet! We haven’t had negative GDP growth! And that’s kind of a mystery. People in the financial community have been saying, “Gosh, things are so bad, pretty soon it’s got to spread to the real economy.” At a certain point if that recession never comes, then people will convince themselves that it’s not going to come. But right now, the fact that it hasn’t happened yet has not really changed anybody’s assessment in the financial world that that damage is still coming.
n+1: And is it just that people are still maxing out their credit cards?
HFM: No, but one of the things that has been very beneficial for statistics in the US has been exports. Exports have been a real bright spot because the dollar has been weak and the rest of the world has been strong. The rest of the world is continuing to grow. People have talked about China being a very large source of growth, and some of the countries that have done well with high commodity prices—Brazil, Russia, India. Growth has held up pretty well in these countries, and so that’s been supportive to the real economy in the US. That may be changing—the emerging markets are starting to slow down and running into some more problems. And Europe, too. If you look at what’s happening to the euro versus the dollar, it tells you that people are concerned about growth in Europe.
n+1: The euro is weakening?
HFM: The euro is weakening. The first time we talked it was interesting because everyone was saying, “The dollar is going to get killed, it’s going to be the end of the dollar.” And I think I said, you know, it’s very hard to project the future of the currency based on its recent past. The currency market tends to be ahead of events; it’s a very forward-looking market. And so, the dollar—in spite of all the prophecies—the dollar’s been on a tear in the last couple of weeks, even the last two or three months. That is because currency traders look at the rest of the world and say, “What the US is going through, the rest of the world is going to start to be affected by that.” So suddenly it’s not so attractive to short the dollar along with everything else.
I think we had this year of people robotically selling dollars and buying every other currency in the world. First out of a sense of optimism about the emerging markets: “There’s so much growth potential there; I want to be exposed to the currency.” Then out of pessimism about the US: “The financial situation in the US is so terrible, the banks are in such rotten shape, I want to be out of dollars.” So there’s been a huge flow out of dollars. The world is, you know, short the dollar. Now suddenly people look at the world and they’re panicked, and they want to reduce risk. They just want to get back to flat, right? “I don’t want to have any positions at all. I’m too scared,” you know, “I just want to curl up into a ball.” And when that happens, if everybody was short dollars, then people have to buy dollars back to flat down, and that’s one of the things that have pushed the dollar stronger.
n+1: And so if these other markets are slowing down, is their slowdown going to slow us down here?
HFM: It will probably have an impact on exports in the US. And this is of course the nightmare scenario, that the whole world slows down simultaneously and you get into a vicious circle.
n+1: And then what?
HFM: And then you have the Great Depression! I don’t think that’s going to happen. But the nightmare scenario is basically that there’s no source of growth anywhere in the world, you have a shrinking of demand, a spreading wave of risk aversion all over the world, and you get into a liquidity trap. That’s still a very extreme scenario.
n+1: When does this begin to feel like less of a cyclical thing, like the weather, and more of a permanent end of the world kind of thing?
HFM: When you see me selling apples out on the street, that’s when you should go stock up on guns and ammunition.
n+1: You make it sound like people just have to come out to the public and say, “We lost all this money.” But the consequences actually would be, ah . . .
HFM: There would be some bankruptcies, yeah, there would be bankruptcies. And shareholders would be wiped out and management teams would be out on their ear. But that probably should happen.
It’s interesting, because how should policy react? And you could break people into two camps. There are people who say, “There needs to be robust government intervention. The government needs to prop up asset prices in order to keep banks solvent. There needs to be a buyer of last resort, and that buyer of last resort is going to be the only player with the balance sheet to do it: it’s going to be the government, it’s going to be the US government, the Treasury.” And then there are people who say, “No. What needs to happen is that we finish this process of loss recognition, the faster the better, so that there’s full transparency as to the true financial condition of banks and companies and everybody, and then prices (financial assets) get marked to levels that reflect their true condition and that don’t have embedded in them this entrenched expectation of continued decline.” There’s some price at which the consumer knows it’s a bargain: everything’s just been marked down.
And which camp you fall into isn’t a matter of ideology; it’s a matter of how bad you think the problem really is. Because, you know, if you had a factory, and you’re like, “The factory is having problems,” one of the ways of recognizing loss is to say to the equity holders, “Sorry, the equity holders’ claim is worth nothing, it really now belongs to the debt holder.” What you’re doing there is shuffling claims—you’re not doing anything to the factory, you’re shuffling claims. And once you’re done shuffling, and everybody knows the financial condition, the factory can continue producing.
What if, though, instead you just go in and you just, like, smash all the equipment in the factory? Then you’ve done real damage, right? The factory doesn’t work anymore.
And when you talk about financial institutions, if you say we can mark everything down to its true condition, you’re saying the markdowns themselves don’t cause damage to the institution. The institution is still there, the bank is still there. There’s still people that show up to work, you haven’t lost all the intellectual capital. These banks continue to exist.
But there’s some people who think the problem is so bad, that if you actually recognize the losses, that it’s akin to smashing the equipment in the factory. Because these institutions can’t exist anymore, right? That for a bank, if you say, “Look, you can’t exist anymore. You’re so deeply insolvent that everybody’s fired and everybody’s got to leave”—at that point, financial intermediation won’t work anymore. It doesn’t matter that you’ve marked everything down to the level that makes sense—you don’t have a financial system anymore. And a lot of people think that’s one of the reasons the Great Depression was so difficult to get out of, was that the financial machinery was smashed. So I think which camp you fall into depends a little on how bad you think the damage is.
n+1: Of all the companies in the world a bank is the least likely to want to go bankrupt.
HFM: Yeah, because the whole business model is based on trust, it’s based on the appearance of solvency. The structural damage you can do to a bank, through bankruptcy, is much larger than the damage you can do to a factory through bankruptcy. So there are reasons that have to do with the fundamentals of business, not just the interests of management. Banks are going to struggle much harder to avoid admitting that they’re bust, and that’s why the regulators have to step in and say, “You’re bust.” Which has happened for IndyMac Bank and a couple of other community banks—FDIC has been taking them over, so you are starting to get that process of recognition. But we’re not at the end of it.
One way that people try to get a handle on how big the losses could be is to look at the profits to the financial industry in the US relative to GDP over a long historical period. And you see that as a percentage of GDP it has tended to be pretty stable over time, but in the last five years it became a much larger proportion of GDP. So you can say, “Well look, if the true profits really should have been at the historical trend, how much excess profit was made which was really phony-baloney and probably needs to be reversed, you know, CDOs, subprime, this kind of stuff?” If you do that analysis, you get to a number between 1.25 trillion and 1.5 trillion dollars. The write-downs so far are on the order of 500 billion, OK? Risk capital has been raised, there’s been something like 350 to 400 billion dollars raised; so new equity has been raised to cover those losses. But I think people do that analysis and say, “There must be more, there must be more to go.”
n+1: You’re feeling pretty low?
HFM: I’m feeling pretty low, yeah. “Low” is probably the wrong word. I’m feeling pretty nervous and I’m feeling a certain degree of frustration that this situation is stretching on as long as it has, because the losses, the true losses, were inflicted a long time ago, when people built houses they shouldn’t have built or built the park buildings they shouldn’t have built or bought cars they couldn’t afford or whatever. Those losses were created a long time ago.
n+1: When you’re talking about recognizing these losses, how much of that is connected to the real economy and people actually losing their houses?
HFM: Some of these houses aren’t even occupied. It’s about misallocation of resources, right? I mean, yeah, some of that was people being put in houses they couldn’t afford. Now what is that house worth? It was sold to some poor schlub for 400 thousand dollars because he was able to get a 400-thousand-dollar mortgage. His ability to get the mortgage is what created the price. In reality, this guy can afford to carry a mortgage on a 150-thousand-dollar house, and there’s nobody else to buy this house, based on where it’s sited and what its features are. And yet if you had to write down the mortgage, you’d have to sell the house to someone else who can afford that 150 thousand dollars, or you’d need to come to an agreement with that guy and say, “Look, your payments are now commensurate with a 150-thousand-dollar mortgage.” The loss needs to be recognized. The house shouldn’t have been built. Now that it’s built, what’s the maximum value you can get out of it? That’s what it’s worth.
n+1: But, you know, some of this is gonna mean . . .
HFM: That people are kicked out of their homes? Some of it will. But to the extent that there’s nobody else to occupy those houses, then the process involves turning those people back into renters or writing down their mortgage, giving them a forgiveness on that. It doesn’t help anybody—let me put it this way—it doesn’t help get a better recovery on the value of those assets, like those houses, to keep them empty. So somebody is going to maximize the value of that house, somebody is going to occupy it. Maybe it’s the same family who lives there now, maybe it’s a different family, but it’s certainly not going to be anybody who buys the house for 400 thousand dollars. It’s going to be somebody who pays a lot less for that house.
n+1: OK, a last question, a more general question. You know, you have a beautiful mind. I listen to you talk, and then I read over the transcript, and I’m just amazed at the way your mind works. And now we’re living through a crisis in capitalism, possibly a historically bad crisis. And do you feel, you know, do you feel that your mind is being used right now in history in the best way it possibly could?
HFM: Well, where do you think it would be used better? I mean, I think if there’s a problem here, this is the place—this is where the problem is.