n+1: We need to remind people what it was like during the scary months, because, okay, you told me a story about your colleague that you ran into who was withdrawing. . .
HFM: Who was withdrawing the money from Citi, yeah.
n+1: And you told me that the scariest moment was when, when they delayed, when they voted down the TARP the first time.
n+1: But, you know, what else was scary at the time?
HFM: Well, coming in every day, hearing about another fund that was blowing up, or another rumor about a bank blowing up, many of which turned out to be false, but you think about, “What’s my exposure to that bank? Oh my gosh, if that happens I’m going to lose this amount of money. And if I lose that amount of money in normal times that wouldn’t be lethal, but then maybe the banks, the other banks that I’m relying on for financing will pull my lines, and. . .” I definitely had many sleepless nights which turned out to be pointless worrying, but you can envision these very extreme scenarios, where yesterday I was sitting at a very conservatively run, stable fund, and tomorrow, because of panic, we’re out of business. You’d have to imagine a concatenation of very extreme events for that to happen, but you were seeing some of the first links in that concatenation happening each day, and rumors about the next links possibly happening, and you go from something where it’s a 1 percent chance of this, of Link 1 happening, and a 1 percent chance if Link 1 happens that Link 2 happens, and all the way down the chain, so that the probability of a catastrophic result is infinitesimal. Suddenly, you see Link 1 go. You’re like, “Holy cow. Six months ago I thought that was a 1 percent probability, but now it’s just happened, well, maybe the next link isn’t a 1 percent probability, it’s a much higher probability, and now if I multiply all these probabilities together, there’s like a meaningful probability that we could get blown up!”
So that was pretty scary.
n+1: So you would get in in the morning at, what time?
HFM: I get in, you know, five-thirty, five forty-five.
n+1: Whoa. And there were already people in?
HFM: There weren’t necessarily people here. But I would talk to London, and the people in London say, “Oh, did you hear a rumor this bank is in trouble? Or this fund, they’re being liquidated, their prime brokers are liquidating them.” I mean every day there would be some crazy rumor like that, sometimes they’d be true, mostly they’d be false.
And then you’d get calls. Like, say, one thing that’s scary is, what would happen to our financing? Like every hedge fund, we are reliant on financing from banks; we’re leveraged. Our leverage is very low, relative to other hedge funds. So we’re probably about the most safely positioned hedge fund you can imagine. It’s meant that our returns have sometimes been lower than our competitors’, but we feel like we’ve minimized the risk of a catastrophic blow-up to about the lowest level you can have for a hedge fund. But even so, we do rely on financing, on banks for financing. And we had to come up with all sorts of contractual arrangements, back in the calm times, to make it impossible for that financing to disappear overnight. And that had required a lot of work on our part, and it had a cost, but we felt it was worth it, to be prepared for potentially bad times.
But sometimes during the crisis we saw banks trying to back away from or even renege on those deals. The fact that they had committed to locking up that financing for a certain amount of time—they didn’t care! It was interesting, we had an arrangement that related to a very narrow asset class that I trade, I don’t want to get into too much detail, and the amount of financing that was being provided was actually very small, it was on the order of tens of millions of dollars. And it was an arrangement where the terms of that financing couldn’t be changed except with six months notice, and they just called up one day and said, “We’re changing our requirements, we’re changing our margin requirements, we’re multiplying them by three or four.”
And, it was funny, we had so much extra liquidity, because we were managed very prudently, that we could just meet that. But this was a commitment that they’d made, a contractual commitment.
“You’ve made this contractual commitment.”
“Well, we don’t care, we’re changing the rules.”
HFM: In the end, we paid them the money. In fairly short order we found another bank, actually more than one bank, that was willing to give us a better deal, that looked more like the original deal that we had with the first bank, and we moved the positions over to that bank, and terminated the arrangement with the first bank. But, if that happens once, it’s something that you consider pretty unimaginable, because it was a contract. And then you say, “Well gosh, let me think of all the other financing arrangements that we’ve done, where we think we’ve protected ourselves by, you know, getting guaranteed terms for that financing, so that it can’t be canceled on short notice… if this one can be canceled, what if these ten others are canceled, what do we do then?” Our whole liquidity planning was predicated on the idea that these banks will actually honor their contracts.
n+1: You were continuing to receive financing from them, is that right?
HFM: Yeah, yeah. But let’s say, you know, for a hundred million dollars of positions in this asset class, we had in the past had to post, you know, five million dollars. And maybe internally we had reserved five million more, because we thought that five was too low. Suddenly they’re saying, you need to post thirty million dollars. And we had plenty of cash, it was fine, we could do that, it wasn’t going to sink us, but if every single financing arrangement we had did that, then we would be in a very distressed position.
n+1: Is that legal? Can they do that?
HFM: They couldn’t, but it’s like, what are you going to do?
n+1: Can’t you sue them?
HFM: They’re going to close you out, at some horrible level, they say, “You didn’t post the margin, we’re going to close you out,” and then what do you do? You’re going to sue them? By the time this thing wends its way through the courts, you’re out of business. And if you’re being foreclosed on by a bank, and you’re in litigation, that massively increases the probability that other banks will do the same thing to you, because they’ll be worried, and you’re caught in this vicious circle. Yeah, so, theoretically, in calm times you would look to the courts for vindication, but in difficult times the damage that’s done may be irreversible before you can get any kind of remedy.
There was an interesting case back in 1998, some similar kinds of things happened. I recall that there was a hedge fund called III High Risk Opportunity fund, that had bought local ruble-denominated bonds in Russia, they were called GKOs. And they had hedged the currency risk with a French bank. And they were earning as spread between the rate on the treasury bills and the rate they were paying to hedge against ruble devaluation. So when the ruble did devalue, the French bank said, “Well, you know, there is a term
in your hedge that says that if there is a convertibility event, in other words the imposition of capital controls, then we don’t need to pay you.” And that was just complete bollocks, as far as I can tell. The documentation–it’s funny, this bank tried to get us to do hedge business with them back then, so I think I got to see similar documentation, and we passed because the documentation was a little bit non-standard–called for final settlement to be delayed until a convertibility event was resolved, but not for payment to be eliminated tout court. But in the meantime, this fund, it had leveraged the position, it had bought those treasury bills and borrowed money to pay for them—maybe it had put up 10 percent—and it had entered the hedge. And the idea is that if the ruble devalues, then the hedge counterparty has to pay the fund, and then that money would be used to pay their financing counterparties on the treasury bills to make up for the fact that the value of the treasury bills is dropping. But the French bank said, “No, we’re not going to pay you.” So they couldn’t meet their margin calls on the treasury bills. They got blown out of those positions at these horrible levels, and the fund was basically out of business. And they sued, but it took years to go though the courts, and by then the fund was out of business.
n+1: Did they win the lawsuit?
HFM: In the end, you know, I’m not even sure. Because it took years, it was like Jarndyce vs. Jarndyce.
n+1: What would happen if they won? I mean, you win that lawsuit and you get your fund back?
HFM: No, your fund is done, right? Maybe then they have to pay out on the contracts. But by that time the losses that you’ve incurred are much worse than just the fact that you weren’t paid, the money you were owed on the contracts, it’s like you don’t have a business anymore, right? You just lost, you just got blown out the other side, and your ability to recover from that is limited, you just don’t have a business anymore. Your reputation is damaged. And maybe, let’s say that fund, let’s say that situation by itself hadn’t been enough to ruin the fund completely, if the fund’s other counterparties see this is going on, they’re saying, “Oh my gosh, this fund is in real trouble, I’m going to do whatever I need to do to withdraw my financing from that fund, because I don’t want to suffer losses.” So it would be enough to, to, you know, lead to the fund’s failure.
n+1: So you would come in very early. Why would it be guys in London who had information?
HFM: Just because of the time zones. I get in before most people in New York, and London is already actively trading, and as soon as people congregate, wherever it is, that’s when the rumors start. They probably got the rumor from Asia, and it was passed on to London, passed on to New York.
n+1: So what do you do? How do you deal with that?
HFM: You wind up becoming a vector of the rumors, because you call up other places and say, “Hey, did you hear this rumor that X, Y, and Z, and what color do you have on that?” You’re trying to gather as much pub as you can, but in reality it was a waste of time, because if a place is in crisis they’re going to try to keep it under wraps, and it’s not like calling around, scouring your social network or your business network for gossip is going to give you an accurate picture of what’s going on.
But you have to feel that you’re doing something.
n+1: But some of these places, they were going under, right?
HFM: Yeah, a few of them were. But there were many more false positives than false negatives. I mean, Lehman’s collapse had definitely been announced a dozen times before it happened, and Bear’s probably two dozen times, and, you know, Goldman Sachs probably half a dozen times. Very few names were completely unsullied by these rumors.
n+1: Was it just these enormous places?
HFM: No, hedge funds. Hedge funds, too.
n+1: So these banks that tried to pull financing. Are you no longer friends with them?
HFM: With that part of the bank, sure, we won’t do business with them. But there are other parts of the bank that we do business with, there’s a certain amount of autonomy between business units.
n+1: And are you mad at those particular guys who went and did that… or are there not sort of people involved in this?
HFM: They were people, and now they’re wearing cement boots at the bottom of the East River.
n+1: I mean, when something like that happens …
HFM: Yeah, there’s a lot of yelling and screaming. There are even swear words used.
n+1: Uh huh. And you’re mad at those particular guys, as opposed to the institution so much, or–?
HFM: I’m mad at both. You’re facing one or two people, right, and it’s hard to know whether they’re acting on their own initiative, or whether they’re being forced to do this by people above them, so it’s hard to know exactly who to blame. My rule of thumb is I just yell at everybody.
n+1: But have you had situations where somebody behaved in that way and then, you know, a couple years later they resurfaced at some other bank, and they called you and said, “Hey, I’m sorry about that a few years ago, that was. . .”
HFM: That would be so much more upstanding than the way people actually behave. They call you up and they . . . you know what it’s like? Were you picked on as a kid ever, like in elementary school?
HFM: You weren’t? Well I was, and it’s like I go back to the town I grew up in, you know, and I run into somebody, my main interaction with this guy is that he would pick me up and throw me into the garbage can in the girls’ bathroom, okay?
n+1: [Laughing. . .]
HFM: For instance. And this was years ago, and now maybe he’s pumping gas and I’m the hedge fund guy, right? And so you’d think he’d imagine I had some resentment or something, but, you know, he comes up and says, “Hey, it’s great to see you!” You know, “We had such good times in school, didn’t we? We should hang out sometime!”
It’s much like that, it’s like they can’t live with themselves if they confront the fact that they’ve behaved atrociously, and victimized people because it was convenient for them, and so they just create this alternate reality in their heads.
And so I have to say, “Are you kidding me? You tried to put me out of business three years ago! I would never deal with you!”
n+1: Does that happen often?
HFM: No, this tends to happen in difficult times, and there certainly have been a number of cases where somebody who has treated me in a way that I’ve found to be really unfair resurfaces somewhere else and tries to behave as though it never happened. And if you call them on it, they go, “You know, it was my boss or my credit department or whatever.” But this isn’t a court, you’re not innocent until proven guilty.
n+1: This person in your hometown, did they know that you’ve gone on to great success, or did they just happen to see you and they’re like, “Oh, hey … you.”
HFM: No, he just happened to see me. I don’t know if he had any idea what’s become of me, and I didn’t drive up in a Ferrari wearing an Armani suit or anything.
I was just grateful he didn’t throw me into the garbage can, honestly.