In the fall of 2007, after two Bear Stearns-owned hedge funds trading in subprime debt suddenly went bankrupt, I sat down with a friend of a friend who worked in finance to see if he could explain it to me. That conversation became the first in a series, which we began publishing at n+1. The conversations continued through the crisis and after, following the trajectory of one financier facing the hardest days he’d yet seen. This week HarperPerennial is publishing Diary of a Very Bad Year, the book that resulted from those conversations. We hope it’s a valuable contribution to the growing literature on the crisis. —KG
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 just 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 just 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, who you would want in any environment, and people who you could just fill a seat with 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 like 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 PhDs and physics PhDs, 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.
n+1: I was reading this book, about Long-Term Capital Management.1
HFM: Ah, I know Long-Term Capital Management. I got many lectures from my boss in the mid-90s about, “Why can’t we be as good as Long-Term Capital Management? We need to be able to generate the same returns Long-Term Capital Management does.” Then they blew up and we stopped hearing about Long-Term Capital Management.
n+1: There wasn’t a lot of skepticism toward them?
HFM: There wasn’t enough, apparently, given how it turned out. But people didn’t have a very long experience with hedge funds, this is before the explosion of hedge funds, and LTCM were very secretive. So all you really saw about these guys was the returns, and who was involved, and the people who were involved all had a really fantastic business and educational pedigree.
n+1: And then it blew up and got bailed out. And after that?
HFM: Those guys all went in different directions. Meriwether [John Meriwether, the founder of LTCM] started a fund called JWM, which did fixed income arbitrage and had a number of very good years, and then in 2008 had a horrible blow-up, again. It’s still around, but it lost a huge amount of money. It never, by the way, grew to nearly the size of Long-Term Capital Management. And let alone the funds that became leaders after Long-Term.
So Meriwether, I’ve never met him, but he was an example that I always cited when I would go and have one of my periodic fits on the desk about how there’s no penalty for failure in the investing world. Which is an exaggeration. There’s not no penalty for failure, but it’s a surprisingly small penalty for failure. When he was at Salomon a guy working under him got Salomon caught up in a scandal relating to manipulation of US Treasury auctions, which nearly blew up Salomon Brothers; then he started Long-Term Capital Management, which blew up; and gets money again at JWM. And JWM blows up! So how many times do you need to blow up before your license to be a hedge fund guy gets pulled? And, maybe that’s picking on Meriwether unfairly. But the amazing thing about that is the incentive structure at a hedge fund is so skewed to the upside that it seems to me like the only way you could restrain hedge fund portfolio managers from taking too much risk is either they have to put a lot of their own capital in the fund or there has to be a really big penalty for spectacular failure–to constrain hedge fund portfolio managers from taking advantage of the trader’s option, the fact that they get a big chunk of the upside but it’s not their money on the downside. The same is true, maybe even more true of proprietary traders at banks. You see people who’ve blown up in spectacular fashion go on to get another high-profile job. And the things you hear are, “I want to hire him; he’s learned a very expensive lesson.” Or, “He’s proved he’s a risk taker.” I can’t tell you how many time I’ve heard that! Yeah, he’s proved he’s an irrational crazy risk-taker!
n+1: We’re talking about guys who are blowing up, guys who seem to have a tendency to blow things up, or to lose a lot of money. Is it because they’re risk-takers? Or is it because they don’t quite know how to make money in any other way?
HFM: There are innumerable ways to blow up. It could be–maybe you could say this about Meriwether–his business was writing fifty-year flood insurance, right? He was putting on arbitrage trades, or trades based on historical relationships between financial instruments, and most of the time, if that relationship widens out, it’ll narrow back in again. But every so often, there’s a huge crisis and those relationships go to unprecedented levels, and by putting on those trades, really what you’re doing is you’re writing insurance on that fifty-year flood. And if that’s your business, then occasionally there will be a fifty-year flood and you’re going to blow up. And maybe, let’s say fifty-year flood is the wrong example—let’s say it’s the two-year flood, right? If that’s the case, maybe there is an excess risk premium over the cycle associated with writing insurance for two-year floods, but the way that your return profile’s going to look, you’re going to make money, make money, make money, and then there’s the flood and then you lose a lot of what you’ve made—but not all. If you’re able to play that game over and over again, that should be good for your investors and good for you. If you sized the trades appropriately so that you survive to write insurance for the next flood, you’re OK.
But what if you have a lot of guys who are doing that trade, effectively writing two-year or writing fifty-year or whatever flood insurance, and they don’t understand that that’s what they’re doing? You have these blow-ups over and over because they don’t really understand the business they’re in.
The other way you blow up is you have people who start in a business that they’re good at, and with success they grow and they get into other areas that they’re not so good at, and that’s a way to blow up. It could be that you have guys who are in businesses and they don’t get into other businesses so much as their business grows and they have to add more and more people but they’re not good managers, and then you have an operational issue that blows you up. That’s a way to blow up.
And then you have guys, you have what you alluded to before, guys who are just truly coin-flippers. They persuade somebody they have the secret to flipping a coin. And you know what? Occasionally heads comes up three times in a row, they make a bunch of money for their investors, they take a percentage for themselves, and eventually tails comes up and that’s the end of the road. That’s the most infuriating one. There are guys who you know are like that, and they’re able to pull this coin-flipping grift more than once. You would think after the first time people would realize that’s what’s going on.
n+1: And, one of the things we’re seeing now is all these banks that are blowing up or shutting down, they’re getting taken over, they’re getting nationalized, people getting fired… the top management has to go. What happens to those people?
HFM: They golf.
HFM: It depends. Many of them wind up, you know, on the beach, but it depends how high up they are. I don’t think Chuck Prince has ended up anywhere. The guy who was the head of Citi before Vikram Pandit. If you’re high enough profile, any other job would be a big step down for you and maybe you’re just old and you retire. But some of these guys wind up at private equity firms where their name can still open a lot of doors, so they’re not really investing, but a private equity firm can use their contacts for fund-raising or for finding deals. Some of them go more to boutique advisory firms, same thing. Usually their name, they still have relationships, they have a Rolodex they can monetize. You don’t see too many of these very senior guys at banks go and start a hedge fund, but you do see many guys a few layers down at a senior risk-taking capacity at a bank, if the bank blows up, or even their division blows up, they go out and try to raise money for a new fund of their own.
n+1: I guess, you know, they make it sound so horrible that these guys got fired, but they’re making…
HFM: Which, gimme an example…
n+1: You know… who was running Bear?
HFM: Yeah, his bank I mean completely blew up. Jimmy Cayne.
n+1: Uh huh.
HFM: I don’t think he’s doing anything. He’s playing bridge.
n+1: But this guy was making, how much money was he making every year?
HFM: But it was mostly in Bear stock. Those guys were true believers. Say what you will about them, they ate their own cooking. They owned a lot of Bear stock. Of all the investment banks, that company had the highest insider ownership. So, many of these guys, it’s funny. People look at some quoted number for their compensation, and it’s some large number, but it wasn’t like it was delivered in suitcases of cash, right? It was stock options that are valued at a certain price. It’s stock and cash, and they use some of the cash to buy stock. And a lot of them held that stock. Now Citi stock’s at $3, Bear was taken out at $10. These guys lost. Their options wound up being worthless, the shares, a lot of them, ended up being a fraction of what they were worth. They walked away with plenty, don’t get me wrong, but it’s not the same as if you added up all the quoted numbers you ever saw in the Wall Street Journal. They usually walked away with a good deal less than that.
n+1: Okay, but still…
HFM: I don’t think anybody’s crying for Jimmy Cayne. Or for John Thain at Merrill… I don’t think anybody’s crying for him.
Roger Lowenstein’s When Genius Failed: The Rise and Fall of Long-Term Capital Management (2000). Describes the trajectory in the early 1990s of a very high-powered and arrogant hedge fund made up of refugees from Salomon Brothers which used mathematical models to make several billion dollars playing the bond market. In 1998 they lost it all when market volatitility in the wake of the Russian meltdown, and the surprising correlation of diverse market factors, went beyond what their models had predicted. The fund, which included two Nobel Prize winners in economics, had to be bailed out by a group of private banks cobbled together by the New York Fed. ↩