Friday, January 07, 2011

A hedge fund manager's view of financial apocalypse

Diary of a Very Bad Year: Interviews with an Anonymous Hedge Fund Manager by Anonymous Hedge Fund Manager, n+1 [a magazine], and Keith Gessen [novelist and interviewer]

Among the numerous books now available about the great financial implosion of 2007-8 that touched off the current Great Recession (I'm damned if some research board can tell me it's over when almost 10 percent of us aren't working), this one is a curiosity. Gessen found himself an intelligent, articulate specimen of the financial manipulating class who was willing to converse at intervals during the panic. He reproduces the guy's musings and evolution here.

This is not the book from which to start if you haven't already figured out the general contours of the mysterious financial products that traders invented during the financial boom decade and used to line their pockets while fleecing institutions and individuals who trusted them. For that -- explanations of derivatives, CDOs, credit default swaps, SPVs, etc. -- I still recommend one of first books about the collapse, Gillian Tett's Fool's Gold. She may be a little over-kind to her informants at J.P. Morgan, but she explains intricate instruments very lucidly.

The Diary on the other hand provides one man's answer to the vexing question, what did they think they were doing when they turned the financial system away from providing capital to the real economy and into a Winchester mystery house cum casino. (Besides getting personally rich, of course.) The interviewee, referred to here as "HFM", comes across as an honest guy with a ringside seat who apparently largely traded more traditional products and who was suspicious of subprime mortgage finance from early on. As the crisis broke, he was inclined to attribute what happened to the myopia of "experts" in the nether regions of mortgage trading who couldn't see the forest (too much uneconomical building pushed out via phony financing to too many less than creditworthy borrowers) for the trees (charts and graphs used to sell the bad loans.)

...I trade a different market, ... but I travel for other reasons, and some of my partners do the same thing. [And we saw overbuilding in Florida, in California ...] 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, the person who ran the subprime business, who traded subprime paper 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.

It's a tough thing. If you have somebody who's really trained in the mortgage business, he's been in the mortgage business for fifteen years, in equilibrium he'll do a great job. He'll be able to pick, of the mortgage pools out there, which is the good one, which is the bad one. He did a very good job of that, because the ones that he picked were better than the market. But in terms of detecting the paradigm shift, the guy who's just buried in the forest. . . he's not going to see the big picture, he's not going to catch the paradigm shift.

I think there's wisdom in that for people in any field -- sometimes the well-informed outsider can see more accurately than the hyper-experienced, embedded insider.

The interviewer asked this guy what else he might be doing with his acquired wisdom about finance that might satisfy him -- and by implication be more socially useful. That question elicited this:

Being a regulator would be interesting, and it would be useful to have a lot more financial talent at the SEC. The SEC is an organization of lawyers -- they understand the law very well -- but they are at a loss when it comes to understanding actual market behavior. The Madoff thing is a pretty good example. ... what was needed there was not someone who understood the securities laws, it was somebody who really understood how brokerages work, how asset managers work, how the whole fund of fund system works, and would know the right people to talk to, the right questions to ask, and who would really know if there was a fraud going on. Not a technical violation of the laws, but an actual fraud.

...The idea of the Chinese walls that people talk about in broker dealers, in investment banks, is a joke. This is supposed to be the separation between the investment bankers and trading -- in other words, that traders shouldn't be able to take advantage of information that the institution derives from its advisory activities. It's not a Chinese wall, it's a Chinese screen door -- this is obvious. And yet the SEC doesn't seem to be all over that. ...The Madoff thing was incredible. What was incredible was that it was one of these situations where kind of everybody knew except the people who needed to know.

I don't know if he's just peddling 20/20 hindsight there, but the idea that lawyers can get wrapped up in a legal paradigm and fail to see a bigger picture fits with his observation of his own firm's experience with subprime mortgage paper.

As the crisis deepened in the fall of 2008 and showed its scope in 2009, HFM began to lose some of his confidence in the finance world. He says he subjected his co-workers to periodic "fits" in which he would protest

... 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. ...

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 times I've heard that! Yeah, he's proved he's an irrational, crazy risk-taker! ...

By the middle of 2009, he's wondering whether some of the people in his business are simply crooks.

...I always used to think that the reason that financial markets' memory is so short is not because individuals are shortsighted or they·easily forget lessons bought at very high cost, but that the average life of an investor is kind of like the life of a mayfly. I mean, they just turn over really fast. ...

But in this case, it's not different people, it's the same people. And honestly, for me it's quite hard to understand how those lessons have been forgotten so quickly. And it makes one wonder whether those people who blame lax practices like posting very low margins on derivatives, those who characterize that as a product of markets and banks being greedy, of guys just wanting to do a loan and lay it off and they don't really care that they're laying it off on a counterparty that won't ultimately be able to make good, and they don't care 'cause they won't be there or they'll get paid a bonus before it happens . . . I tend to be a little skeptical of that view, but gosh, the fact that people are doing the same thing certainly gives some weight to that view.

By the end of the book, he's ready to, at the least, take a break, move away from New York, see whether he can live without being known as a "hedge fund partner guy."

At a certain point you have to say, "I have enough."

HFM's realization that there is more to life than making money from pushing money around isn't much use to the many victims of financial fraud and folly. But he's an interesting guy. This social disaster was not a product of the weather; it had real people at its center -- via HFM's reflections, we get a little more sense of who they were and their many limitations. Keith Gessen did some fabulous interviewing and editing on this project.

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