18th
hfm knows
Believe it or not, but one of the better explanations of how we got into this financial mess is contained in two interviews with an anonymous hedge fund manager that appeared over the past year on the website of the pretentious literary magazine n+1.
n+1: When you say the person who knows the mortgage, meaning the person who knows that the person they find on the street…
HFM: May not be a good credit, right? What tends to happen in financial markets, is bad things happen when you really divorce the people who take the risk from the people who understand the risk. What happened is that that distance in the subprime market just increased and increased and increased. I mean, it started out that you had mortgage companies that would keep some of the stuff on their own books. Subprime lenders, it wasn’t a big business, it was a small business, and it was specialty lenders, and they made risky loans, and they would keep a lot of it on their books.
But then these guys were like, “Well, you know, there are hedge fund buyers for pools that we put together,” and then the hedge fund buyers say, “You know what? We need to fund, we need to leverage this, so how can we leverage this? Oh, I have an idea, let’s create a CDO and issue paper against it to fund ourselves,” and then you get buyers of that paper. The buyers of that paper, they’re more ratings-sensitive than fundamentals-sensitive, so they’re quite divorced from the details. Then it got even more extended in the sense that vehicles were set up that had a mandate to kind of robotically buy that paper and fund themselves through issuing paper in the market.
In reality those guys were so far from the true collateral that underlay the paper—they have no idea. It’s like they’re buying CP of a conduit, the conduit’s buying triple-A paper of a CDO, the CDO is set up by a hedge fund that’s bought mortgage pools from a mortgage originator, and the mortgage originator is the one who realizes that they lent half a million dollars on a house in Stockton, California, to… someone who makes 50,000 dollars a year. That’s where the specific knowledge about the risk resides, but the ultimate risk-taker is very very far away from that.
So what happened is this machine—let’s call it, it’s a big machine that wanted to gobble up, you know, rated paper—needed to be fed. So there were people who could make a lot of money feeding the machine, and they were like, you know, “We need to keep originating mortgages, and feeding them to the machine,” and if you have a robot bid, you tend to get a bubble. Someone is hungry for paper, paper will be created.
And that’s almost never a good thing that lending decisions are being driven by the fact that many, many steps down the chain there’s just someone who wants to buy paper.
And:
There were people at the firm, say, at the middle of last year [2006], who were not mortgage experts, who were saying, you know, “I see the run-up in housing prices in some of these geographies, and I just don’t really get it. I go down to Florida and see the forest of cranes, and I just really wonder, who’s going to be in all those apartments? And I hear about all sorts of friends who are getting loans to buy apartments or houses speculatively and who are lying about the fact that it’s not a primary residence, and I see these commercials on TV, you know, about low-doc, no-doc mortgages—and there is no way, there is no way that this is not going to end badly. And I see that these mortgages are being created by this massive demand for CDO paper, by this robotic bid, and this is the perfect example of a bubble—and we should be short, we should be short sub-prime paper.”
n+1: This is what guys do? They travel around Florida, they watch TV?
HFM: Just in your normal life, I mean, like me, I trade a different market, I don’t trade subprime, but, you know, I travel for other reasons, and some of my partners do the same thing. And we all, a number of us thought, “This is just crazy. We should be short. This is a bubble waiting to be popped.” But the person who was the expert [at the fund], the person who ran the sub-prime business, who traded subprime paper and issued the CDOs, he was a true believer in the paradigm: “In 2003, people said that the credit quality of the average subprime mortgage was deteriorating, and now look, those mortgages have performed fine. The subprime market works.”
And, hey, he was the expert—you defer to the expert.
Six months later, just after Bear Stearns collapsed:
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: 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 10 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 2-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 blow-up 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.
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 love HFM.
The full interviews here.
http://www.nplusonemag.com/?q=node/418
http://www.nplusonemag.com/financial-meltdown
We did a final interview with HFM two weeks ago, because we want to put these things in Issue 7 because they’re so funny and so informative—and it’s incredible to see HFM’s mind at work, to me, it’s a wondrous machine—and HFM was pretty gloomy. He felt the losses weren’t being “recognized”—the banks weren’t really owning up to just how much in bad loans they had on their books. So we walk out of his office and a week later Lehman collapses and the market plunges. A market this volatile makes it impossible to be a responsible financial journalist! The Russian market is so distressed they had to close it early, so the Russians—an emotional people—wouldn’t get carried away and like burn their stock exchange down. I asked HFM what he thought now and he said that, well, Lehman falling was more a good sign than a bad sign—a painful but necessary process of loss recognition, but, “If AIG blows up, then you’ll find me in my bunker. Knock three times in quick succession or you’ll get a headfull of shotgun pellets.”
AIG didn’t blow up, so for the moment HFM remains, on his trading floor high up above midtown, sipping a mineral water and pondering the wreckage.
