Conversations with HFM, December 2008–July 2009

From a continuing series of interviews with a managing partner at a large hedge fund in New York. For the first interviews, see Issue 7.

Default?

n+1: What’s going to happen?

HFM: We’ll probably see more unemployment, we’ll certainly see more bankruptcies. We know damage has been inflicted by the credit heart attack; we know damage has been inflicted by the drop in demand, the drop in commodity prices. You know what it’s like? It’s like somebody drops a depth charge onto a submarine, and you hear a big explosion, but you don’t know what’s happening. Like, a little while later bodies start to bob up? We’re waiting for the bodies to bob up.

In the financial markets, the epicenter of this crisis was financials, banks, hedge funds, and the corporate credit market. I think what you’re going to see is collateral damage in other markets. So you’re starting to see that the commercial real estate market, and commercial real estate–backed loans, are really starting to have some problems. The other thing you’re seeing is the effect on budgets of municipalities and states, some of which were very dependent on profits from the financial industry, some of which were very dependent on profits from economic activity like construction. They’re starting to have problems.

Meanwhile the US government has extended so much aid to various other sectors of the economy, and it’s expected to have to do more, that now people are worried about US credit. To buy credit protection on US government debt now costs you more than to buy credit protection on Campbell’s Soup! But buying credit protection on the US, it’s sort of a mind-bending concept. The US only issues in dollars, it only issues in its own currency. More to the point, from whom are you going to buy protection on the US government’s credit? If the US government defaults, what bank is going to be able to make good on that contract? Who are you going to buy that contract from, the Martians?

Sometimes I think it would be great if this Mars Lander actually discovered life on Mars—we could start trading with them. Somebody finally would be uncorrelated enough, we could buy protection from them on the US government and feel like they could actually pay it back. LGM Capital Management, Little Green Men Capital Management, a perfectly good counterparty.


A Bubble in People

n+1: I want to talk about hedge fund culture a little. You were saying last time that there was a problem with the pay structure.

HFM: Before the labor market changed? Look, bubbles create other bubbles, they’re like derivative bubbles, so to the extent that there was a bubble in credit or a bubble in the mortgage market, that created a bubble for people who could trade those products. There was a misallocation of resources not only into mortgages, let’s say, but also into the trading of mortgages, and it sucked talent into those areas that probably should be deployed other places. And the way talent gets sucked into those places is by a price signal, the compensation going out. So what was happening was that the pay scale for finance was just—incredibly out of whack. You had guys who were literally a couple of years out of college, maybe they’d done a year or two at an investment bank, making several hundred thousand dollars a year doing pretty low-value-added Excel modeling tasks.

n+1: What does that mean?

HFM: They do financial models on Excel.

n+1: I know Excel.

HFM: It was kind of crazy what people were being paid. And for the more senior people, the kind of deals they were getting—because their pay tends to be not just a number range but a percentage of the profits they generate—they were getting very high percentages of the profits, and very high guaranteed income. The decision to pay those kinds of numbers was motivated by the fact that other places were paying those kinds of numbers, and their ability to pay those kinds of numbers was motivated by the fact that there were huge amounts of assets coming into hedge funds, and hedge funds are able to charge a management fee for the assets under management. So if you had tons of assets coming in, you needed people to manage those assets, you had to get quality people, you had a ton of money to spend, and everybody was looking for people who had a resume that singled them out, or that identified them as qualified to work at a hedge fund—there was tremendous competition for those people, and it drove prices to ridiculous levels. It changed people’s attitudes—there was a palpable cockiness that one sensed from employees. And there was a lack of distinction I think between people who were really good, whom you would want in any environment, and people who could just fill a seat because they had a resume that stamped them as minimally qualified.

n+1: And was there a point when you noticed this happening?

HFM: I mean, it’s been building over the years. It probably became craziest post-2005, and continued in 2006, and then started to ebb in 2007 because we did start running into problems in 2007, and 2008 turned it around 180 degrees. Look, as a boss it was kind of a good thing. You can distinguish between good performers and poor performers a lot more sharply when the price to get somebody to show up is some ridiculous amount of money. And it’s society-wide—I mean, it’s funny, I worked in finance through the internet boom, right? And the internet boom, it was the same thing, it was a price signal pulling people into a sector, because it was evident to people how much money you could make if you created cheesesandwich.com and sold it for a couple of million. It was an exodus from finance—I can’t tell you how many times I would call up to do a trade and someone would say, “Oh, yeah, this trader, he quit, he’s going to join a friend at an internet startup.” And then the internet bubble popped and all those people filtered back into finance.

Then finance started sucking people from all over. You’d walk around our trading floor and there were guys who were math Ph.D.s and physics Ph.D.s, and chemists, and lawyers, and doctors—there were doctors on our trading floor, who trade, you know, the health care sector. The bubble in financial assets had a derivative bubble in people. Some of these physicists should be doing physics; some of these computer scientists should be doing computer science. Doctors should be curing people! It’s not a bad thing.

n+1: If someone had had a heart attack on the trading floor, you could have—

HFM: You know, they really don’t like it when you ask them to diagnose you. If you’re like, “You know, I have a stomachache, and uh—” They don’t like that.

Madoff

n+1: So the Madoff thing—what was interesting about that?

HFM: The Madoff thing was incredible. It was one of these situations where everybody knew except the people who needed to know. When the news came across the tape here, the trading day was over, and there weren’t that many people in the office. It said: “Bernie Madoff arrested.” I had never heard of Bernie Madoff, OK? But one of the guys here who is very active in the options world, which is what Bernie Madoff was allegedly trading, as soon as the headline came across—it didn’t say what he was arrested for—he said two things. He said, “I knew it, I knew that guy was a fraud.” And the second thing he said was, “This is going to be huge. This is going to be the biggest thing ever.” So here is a guy who happens to trade options in our office—just seeing the words “Bernie Madoff arrested,” he knew exactly what had happened.

So I immediately went to the guy in our office who does the black-box trading. Because what Bernie Madoff did, it sounded to me a little bit like black-box trading, and I said to him, “Gosh, Bernie Madoff was arrested, if it turns out that his book needs to be unwound tomorrow, is this going to cause big disruptions in our market, should we just turn off our machine?” And that guy, he had also heard of Bernie Madoff, and he said, “No, no, of course not.” I’m like, “Why?” He’s like, “He doesn’t have any book. It was all a Ponzi scheme, I’m sure of it.” So these people had known forever, it was something that people in that world knew—they heard about his returns, and they said, “There’s just no way that anybody has returns that stable.” Doing the strategy that he alleges he was doing, which was what he calls split-strike conversion—which is basically buying stock, and selling calls, and buying puts, so it’s sort of like you’re buying stock and your downside is limited by options and your upside is limited by options. It’s quite easy to simulate it, and you can tell that there’s no way that if you just did that mechanically, you could generate the returns that he generated. Of course, to be fair to the people who fell for it, he didn’t say he was doing this all the time. He said, “Sometimes I’m in the market, sometimes I’m out of the market,” his market timing could be the source of the returns, but everybody who’s a professional investor knows there’s no way that somebody would have over that period of time such good market timing ability that he could generate the stability of returns that he did.

So it was quite obvious to professionals that this guy was a fraud. But the source of the fraud, there was some disagreement. Some people said, “Oh it’s just a Ponzi scheme.” Other people said, “No it’s not a Ponzi scheme. Bernie Madoff also runs a market-making operation.” Which means, if you or I put an order at Fidelity to buy stock, Fidelity routes that order to a market maker. Bernie Madoff was one of those market makers; he paid for order flows, so he saw people’s order flows. One thing you worry about, with a market maker, is that the market marker will use the information about customer order flow to trade in front of the customers. So for example if I say, “I’d like to buy 100 shares of IBM at 100,” and the market maker gets that order, he knows I’m not going to withdraw that order, I’m just leaving that order out there all day, he effectively has an option to sell IBM at 100. Because he can just fill my order. So what he does—illegally—is he goes out there and he buys IBM at, you know, 100 spot 01, and he just waits and hopes that it goes up. If it goes up to 103, he sells it, and then he tells me, “Sorry, your order didn’t get filled.” If, in fact, something bad happens, and IBM trades down to 98, he just fills my order at 100. So he has no downside.

That’s illegal, that’s known as front-running. So some people thought that that’s what Bernie Madoff was really doing. And that’s sort of plausible, that you could make the kinds of returns that he made, if you committed that particular illegal act. But not on 50 billion dollars of capital! You could make those kinds of returns on some small amount of money, or some amount of money that’s roughly equivalent to the order flow you’re seeing, but he wasn’t seeing tons and tons of order flow.

So it was like an open secret, and yet he was still able to raise all this money and evade the scrutiny of the regulators. It was pretty amazing.


New New Deal

n+1: What do you think of the new New Deal, and what are you worried about?

HFM: Well, look, first of all I wasn’t an Obama supporter, but I’ve been very impressed with the appointments that he’s made, I have to give him credit, he’s recruited a very solid economic team, and that’s reassuring.

What do I fear? The stimulus package scares me a little bit. Not because I think the stimulus is a bad idea—I think the stimulus is a good idea, but I fear it will be executed in a way that will be ineffective as stimulus, but create a lot of problems down the road. Ultimately what you’re looking for in a stimulus, is you’re saying, “There’s a shortfall of demand right now, there’s a shortfall of aggregate demand relative to aggregate supply. So we need to stimulate demand.” What you want to do is find things that the government can spend on today that will soak up some of that excess aggregate supply, and that will either yield returns to help pay back the debt that’s being taken on or will obviate spending down the road. So an example would be, “Let’s take all the bridge maintenance that needs to be done in the next five years, and let’s just do it all in the next two years.” Right? “By the time that’s done, hopefully the economy will be growing again, and then we don’t have to spend the money that we would have had to spend then.” Or if schools are overcrowded, “Let’s give aid to municipalities that need to build more schools—they’re going to have to do it at some point, let’s just do it now, all of the construction workers who aren’t working on housing, they can go work on building schools, and, you know, in a year or two when the economy’s recovering, all the school building that we need to do in the next few years is done, and, you know, they can go back to building housing.” I think that’s ideally what you want to do with stimulus.

What I fear is that stimulus is just going to mean spending. It’s going to mean creating programs that create permanent spending requirements, and that’s going to be a real problem, because the amount of stimulus that’s being proposed, it’s so much money. We can’t spend at that level permanently. We’re borrowing, and ultimately spending will probably have to be lower than it would have otherwise been, in order to pay back that borrowing. Or you’re going to wind up with serious damage to the credit-worthiness of the US.

We’ve had the government intervene in a lot of unusual ways, or a lot of unwanted ways, to try to solve the crisis. And ultimately many of those ways are about the government assuming risk onto itself to relieve the private sector of risk. The government can say, “You know what, we’re going to guarantee bank deposits,” and people are calm because they view the government as a good credit in a way that they didn’t view banks as a good credit. But there’s a point at which the government takes on so much risk that its credibility is eroded. We’ve seen that in some other countries—actually what’s happening in Ireland is a good example of that, Ireland basically guaranteed all bank liabilities, and suddenly Irish sovereign credit is very damaged, and credit protection on Ireland, which was once considered one of the best credits in the EU, now costs about 2.5 percent a year to guarantee against default. We don’t want to get to that point in the US.

n+1: But weren’t you saying that that is specifically something that can’t happen to the US?

HFM: Well, no, if the government is feckless enough it could happen. Maybe it would be reflected not in credit spreads, but in expectations of inflation. The US would inflate rather than default, but those are both bad outcomes. There’s this professor at Princeton named Edward Tenner, he writes a lot about safety technology, and he says that a lot of safety technology doesn’t actually make things safer, it’s about trading off catastrophic risks against chronic risks. He uses the example of ski bindings. Before you had auto-release ski bindings, if you had a problem, the problem was rare, but you broke your leg catastrophically. With auto-release ski bindings, people very rarely break their legs anymore, but they more frequently wind up with a knee sprain, so it’s a chronic problem. I think when you’re talking about government intervention, it’s kind of in the other direction: it’s more broadly about trading off rare and catastrophic risks against chronic risks. So, if higher-than-usual unemployment and a slow economy is something like a chronic risk, the government can deal with that by borrowing and spending on stimulus. If the government takes all this risk onto itself, it may attenuate those chronic risks, but you might get to the point where something goes wrong in the US and then the government’s credit-worthiness is in jeopardy and you have a huge mess. It’s like building flood-walls on a river: you could have a little bit of flood every year, you build flood walls so you don’t, but every fifty years you have a flood that’s bigger than the flood wall, the flood wall collapses, and it’s just catastrophic. You have the same issue with the government.

I’m sure Obama and his team understand that, but he’s not the only guy in the room—there’s Congress, and Congress has different priorities, and may wish to spend on things that don’t really make a lot of sense.

n+1: When you’re talking about this catastrophic scenario, what would that actually look like?

HFM: It could be a credit-worthiness issue—one of the ratings agencies could downgrade the US from its triple-A rating.

n+1: And then what happens?

HFM: Think about what happened in Octo­ber 2008, but with no party that’s credit-worthy enough to be able to step in and soothe people’s fears. It would be like October times ten. Bank runs, and the government unable to issue a guarantee that would be convincing to people. Or it could be that people fear inflation and the fear of inflation creates inflationary momentum, and you have a real inflation problem at the same time as the economy is doing poorly. Or it could lead to a dollar crash. Foreigners could think, “Gosh, there’s no more perfect credit in the US anymore, I don’t want dollars. I want to get out of dollars.”

n+1: What happens if the dollar crashes?

HFM: Our standard of living goes down because we can afford less imported goods, and we have inflation while the economy is contracting or doing poorly, which is not a pleasant thing. It would have big distributional consequences—generally inflation hits the poor harder because they have fewer ways to hedge against it, to cope with it, and it could really stress our political system.

n+1: So a pair of sneakers costs 500 dollars?

HFM:I don’t think we’d have hyperinflation. You know, think about the late ’70s, that kind of inflation, and that kind of economic outlook. It would lead to a longer recession, in the long term a lower standard of living.

n+1: Wait, wait, aren’t we already in a worse situation than the late ’70s?

HFM: We don’t have an inflation problem like the late ’70s. We don’t have unemployment yet like the late ’70s. So we’re not there yet. We might get there. It might look like an emerging markets crisis. What the US has always had—it’s not just the lender of last resort, it’s the borrower of last resort. The sovereign credit of the US has always been unquestioned. And that’s a really powerful tool—if you lose that tool, you lose a lot of policy options. And that means that whatever challenges we have to face are going to be really amplified.


China

n+1: You were in China. Did you sense that there was anger at the US?

HFM: I’m dealing mainly with business people who probably aren’t going to harangue me. But it was funny. I did sense a strain of maybe . . . “triumphalism” is the wrong word, but maybe a little amusement at the US’s predicament. And so definitely at some of the meetings I had—more than one—there were some comments about how, you know, it was now China that was going to be helping the US by continuing to lend to it. And the power relations had reversed. There was a little, a sort of . . . call it a gentle raillery.

n+1: Hasn’t that been the . . . I was under the impression that the Chinese have been lending to us for a long time?

HFM: Definitely. Definitely. But the sense now is that they’re lending to us out of a policy decision in order to prevent the US from having serious problems. I don’t think that’s a fair picture . . . but it’s new.

n+1: But we’ve been feeling that way for a while.

HFM: That they’ve been bailing us out? No, that was based on their policy priority to try to stimulate their own economy through exports and keep their currency undervalued, and that required them to lend to us—to get us to buy from them they had to lend to us. But now they sort of feel like it’s not something they’re doing for purely selfish reasons, now it’s China’s responsibility as an important economic power in the world to keep lending to the US so the US doesn’t have problems.

n+1: And, ah, this is, they find this . . . ?

HFM: They think it’s funny.


Populist Rage

n+1: You know, people are mad. Even I’m mad. Because when you talk about misallocation of resources—what you’re really talking about is that somebody was given money to do something that didn’t need to be done, right?

HFM: Exactly. Some very smart, intelligent people, very intelligent physicists spent their time creating mortgage-backed securities to fool S&P into giving them a rating that they shouldn’t have given them. That’s one example. Another example is a Mexican, a rural Mexican, swam across the Rio Grande to hammer together houses in the exurbs of Arizona that no one is ever going to occupy.

n+1: But somebody . . . money changed hands. And the people who got that money—the misallocatees, say—well, they get to keep it.

HFM: Ah, yes, but here’s the question. Who paid that Mexican guy to hammer together those houses? Well, the developer—where did the developer get the money from? The developer got the money from a bank. Where did the bank get the money from? The bank got the money from a depositor. The depositor doesn’t think he spent the money. The depositor still thinks he has a claim on the money, right? The problem is that what underlies that claim is an empty, uninhabited, uninhabitable house in Arizona. That’s what I mean by allocating the losses, right? There’s a loss there the depositor doesn’t know that he’s lost yet.

n+1: But he lost that money to someone. What I’m saying is, somebody has that money.

HFM: Yeah, the Mexican guy who hammered the house; he sent it back to his family in Mexico.

n+1: You’re saying the Mexican guy has the money? Surely the developer has some of the money?

HFM: No! The developer spent it all developing these houses! The developer’s bust too.

n+1: You’re saying the Mexican guy spent all the money? That doesn’t make sense.

HFM: He spent it on himself, or he sent it to his family, and his family bought stuff they wouldn’t have been able to afford otherwise.

n+1: Billions of dollars? You’re saying that the Mexican guy took billions of dollars?

HFM: Well a billion Mexicans . . . not one Mexican guy! How about all the mortgage brokers who were brokering these mortgages that didn’t make any sense? They all got paid, right?

n+1: Right, those guys! So it’s not just . . .

HFM: No! Anybody who worked in sectors where there was a tremendous amount of activity where there shouldn’t have been. So we’re talking about housing: It means the Mexican guy who hammered together the house. It means the logger who cut down the wood that was used in the structural lumber. The guy who worked at the saw mill. It means the steel company that created the steel for the nails. It means the mortgage broker who sold the mortgage. It means the physicists who decided instead of doing physics they should work on Wall Street to create the asset-backed security that helped to fund the mortgages that the mortgage broker was originating. All of these people were doing things that turned out not to be productive. The loser was whoever turned out to be the investor at the end of the chain. So there’s a loss that needs to be allocated. That’s backward-looking. On a forward-looking basis, now we all know there shouldn’t be 50 zillion mortgage brokers, right? There shouldn’t be 50 zillion people working on this stuff. What do you do with those people now? They need to find, we need to, the economy needs to find another use for them; and via that process, we will find a new equilibrium, right? These pay scales will shift, and those people will be moved to their highest and best use, right? But the dynamics are very tricky because, you know, these are quantities in a—ultimately people are not quantities in an equation—but it’s difficult for that mortgage broker to find the right job for himself. Maybe he needs to move across the country? All of that is a slow process. And a costly process. And a difficult and disruptive process.

n+1: Well, but and also I mean there might not be jobs for those people.

HFM: At some price there’ll be jobs for those people. If you have perfectly flexible prices, there will be a clearing price for the labor of people with various skill sets. But yes, they overinvested in skills that maybe aren’t worth that much. So if you really know a lot about mortgage brokering, that may be worth nothing. Maybe the only thing you have to offer is the strength of your back when you’re moving boxes, right? And that means that it’s a very painful adjustment for somebody to make. I mean let’s say that we have a class of people who are very highly paid to be witch doctors, and then tomorrow Western medicine comes to the economy, and everybody realizes that witch doctors . . . it’s much better to take pills than go to the witch doctors. These witch doctors had some very specific knowledge that was worth a lot but now is worth nothing. But there’s some use for them, right? They can become manual laborers. But that’s a very difficult transition. They’re not just going to accept that right off the bat, that witch doctor skills are worthless and the price of their labor has gone from very high to practically nothing.

n+1: And this goes to a bigger problem. We also talked about these bubbles, right? That they happen and happen, like a wave—it goes from one sector to another sector to a third sector. And then we’ve had this long bubble in the financial sector—isn’t it possible simply that there was no other place to make money, no other place for growth? That people have all the stuff that they need?

HFM: Well, look, this is one of the axioms of economics, that people have unlimited wants and limited resources. Personally, I feel like I have enough stuff—it’s painful for me when I get a gift. The idea that I have to put it somewhere is painful for me. But then if you look at a broad swath of the population of the US and then if you think about poorer countries and people, there’s much more that they want. People will always find new things to want.

n+1: But you don’t think this is a real, systemic problem we’ve run into, finally?

HFM: Is it new? Here’s what I believe. I believe when you’re looking at economies, because I do emerging economies, this is a pretty important part of emerging economies. You have to be epistemologically modest. People say—let me give you a sort of analogy—when emerging markets were doing well, say in 2005 to 2006, people were saying: “Emerging economies, they’ve emerged. They’ve figured out the institutions that are required for sustainable growth.”

But Latin America, practically from the time Europeans came to the Western hemisphere—or very shortly thereafter—North America actually diverged from Latin America. There wasn’t convergence, there was continued divergence. What are the odds that it just so happens that the day I show up, that the few-year period that I’ve shown up in the financial markets, that this multi-hundred-year process has suddenly and sustainably reversed? I mean, you have to be incredibly epistemologically immodest to think that. By the same token, we have, you know, ten thousand years of human history where people are always wanting more, making more, and getting more. What’s the probability that it just so happens that you and I have been born into the generation where we finally run out of wants? I just think it’s impossible. Maybe we’re that special—I dream of being special in some way, but I think I’m just another human involved in a very long chain that stretches far back into the past and will stretch far forward into the future, of human beings that have the same intellectual equipment and tend to behave in similar ways.

n+1: You know, we haven’t had capitalism for ten thousand years.

HFM: But we’ve had property for ten thousand years. We’ve had monetary exchange for ten thousand years. We haven’t had advanced capitalism, but people have always striven to get more and in general the trend has been for a higher level of consumption. There’ve been periods of setback, but the long trend is very clear. I think it’s very unlikely that we’ve suddenly hit our limit, that we can’t come up with more needs, and therefore we’re at crisis because we can’t grow anymore. Ultimately the moment when we might be heading into a change that is challenging to our economies is if, in the advanced economies, we see the end of population growth. And we are seeing some countries where there has been a very important pivot, countries going into long and sustained population shrinkage for reasons not related to war, reasons related to reproductive choices. And it’s not clear whether, I take your point that it’s not clear whether our brand of capitalism, call it our political economy, capitalism plus the welfare state, can be easily sustained in this era of shrinking population. But that’s a much bigger question, and I think it’s different from the one you asked.

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