Tuesday, September 27, 2011

Moral Bankruptcy Among Hedge Fund Managers

This topic was one I listed in my post discussing my reaction to Michael Lewis' recent book on the recent mortgage-backed bond-led financial crisis, The Big Short.

Almost two weeks ago, I wrote this post discussing the recent UBS so-called rogue trader, and how it compared or contrasted with the story in Lewis' book concerning Morgan Stanley bond trader Howie Hubler.

For what it's worth, yesterday's Wall Street Journal reported that UBS' CEO resigned over the comparatively small $2.3B trading scandal. Comparatively small in relation to Hubler's 2007 $9B loss. As I noted in the second linked post, John Mack didn't resign over that much larger loss. But you can read my thoughts on the matter in the post.

Regarding today's topic, I touched on it in this post a few days later, concerning Goldman's closing of its Global Alpha fund, writing, in part,

"Even at just an average size of $5B, Global Alpha was probably earning at least $100MM annually in management fees, and who knows how much more by executing the fund's trades on Goldman's own desks? Then there are the incentive fees in the good years, which for the year in which it earned 30+%, translates into another 6% of assets, or $300MM in additional revenues. The fund doesn't take a share of losses, so this asymmetric payoff, along with redemption lockups, can quickly result in sizable income for Goldman.

Add in the fund manager's probable large cuts for not leaving to join folks like Asness in the true private hedge fund business, and you have Global Alpha becoming a gigantic funnel for client assets being transferred to Goldman fund managers, bit by bit.

Heads, both parties win, tails, the client loses and, eventually, departs.

From Goldman's perspective, it's even richer than brokerage or proprietary trading, because there's a nice fixed fee, regardless of the client's losses. Yes, over time the fund can tank, as Global Alpha eventually did. But the problem is firewalled to just that fund.

If Goldman was able to manage an average of $5B for almost 15 years in Global Alpha, I'm sure it was a very lucrative venture for the firm and the fund's managers, regardless of how much the fund's investors ultimately lost before redeeming.

This is a theme on which Michael Lewis touched in The Big Short. Something most people can't quite comprehend.

When fund assets reach such large sizes that fixed fees alone provide adequate revenues, in a very few years, the firm and the fund's managers can become sufficiently wealthy from their cuts that they simply don't have to care so much as they may have initially what happens to their investors' money."

Perhaps the best example of this is Lewis' telling of the story of Wing Chau. Mr. Chau had been,

 "making $140,000 a year managing a portfolio for the New York Life Insurance Company. In one year as a CDO manager, he'd taken home $26 million, the haul from half a dozen lifetimes of working at New York Life.

Now, almost giddily, Chau explained to Esiman that he simply passed all the risk that the underlying home loans would default on to the big investors who had hired him to vet the bonds. His job was to be the CDO "expert," but he actually didn't spend a lot of time worrying about what was in the CDOs. His goal, he explained, was to maximize the dollars in his care."

Chau managed, or should I write mismanaged, CDOs for an outfit named Harding Advisory. Harding, Lewis writes,

"would be the world's biggest subprime CDO manager.....had established itself as the go-to buyer for Merrill Lynch's awesome CDO machine, notorious not only for its rate of production but also for its industrial waste (its CDOs were later proven to be easily the worst.)"

The details of what Wing Chau was supposed to do are fairly arcane, and can be found on page 141 of Lewis' book. Suffice to say, it was intended to safeguard investors' interests by continually staying abreast of the value and condition of defaults within various mortgage-backed bonds.

I can't find a reference by Lewis to just how many billions of dollars Chau had under his care, but if he was earning even as much at 5% to take home $26MM, then the figure would be in the $4-6B range. It was probably much larger.

Lewis is careful not to quote Chau but, rather, pretty clearly report his remarks about how much he earned, and his goal of simply maximizing dollars under management, as hearsay through Eisman.

But it's totally believable. Elsewhere in that chapter, Spider Man at The Venetian, referring to an industry conference at which the conversation took place, Lewis paints a larger picture of an industry with many small players purporting to do what Mr. Chau did. Much like the unexamined CDO insurance, in the form of derivatives, which AIG sold to fund managers like Mike Burry, mentioned in this earlier post, this cottage industry of middlemen ostensibly monitoring institutional investors' CDOs seems to have been largely unregulated.

So the first point of this post is to reinforce what I noted in the earlier piece on Global Alpha. Investors need to consider what the income dynamics are for their money managers when investing with funds other than plain vanilla actively-managed mutual funds.

It apparently escapes the notice of many investors that for sufficiently large funds, earning just one or two years' of 2% management fees from a just a few years of operation can make a very few people rather wealthy. If they actually had a good performance in the early years, and the fund grew by attracting new money, without corresponding growth in the analytic, investment and trading functions, then those lucky fund owners and employees could very well enjoy a windfall which would satisfy the average working person without ever actually having another good performance year. The numbers I used in the Global Alpha post for both that fund, and John Paulson's fund, make the point fairly clearly.

Most people just can't conceive what the 2 & 20 hedge fund formula can earn for a fund when the 2% is levied on billions of dollars of client assets. One billion dollars yields $20MM. If a fund owner takes home just 10% of that, how many years must he do so before his personal wealth function's minimum threshold is satisfied? Not too many.

The other point of this post has to do with what Lewis wrote about hedge fund manager Mike Burry, a subject of my first Lewis post, linked above. It partially involves two topics that I want to address from Lewis' book- fund manager behavior and the nature of bespoke instruments like the credit swaps Burry bought.

"Then Burry, seeking to profit from the troubles of companies involved in sub-prime finance, shifts from equities to debt, buying derivatives on CDOs which he is certain will lose the bulk of their value due to underlying defaults. His investors, learning of this, want to, but can't redeem their funds because of Burry's lock-up rules.

Then Burry manages to coax, badger and persuade several banks to sell him the derivatives he wants on selected mortgage-backed CDOs. Eventually, the banks catch on and begin doing the same, all the while Burry and the traders at these banks lie to each other about exactly what they are doing.

What's ironic is that Lewis paints Burry as the most honest of hedge fund managers, eschewing a fixed management fee. But he doesn't adequately, in my opinion, explain the very serious fraud Burry committed when he informed his investors and backers that he'd completely changed the investments in his portfolio. That Burry survived this is even more immense luck."

Now that I've read the rest of the book, I know that Burry fought with his investors throughout 2007. Because of his no-fee management philosophy, he had to fire the bulk of his staff as his fund faced redemptions while the instruments he had bought for the portfolio, credit swaps, failed to rise in value, being non-exchange traded assets which were only quoted by a few brokers and market participants. Since most of Wall Street chose to ignore the gathering storm of collapsing mortgage, and mortgage-backed bond values, they also chose to undervalue derivatives which bet on such a collapse.

Thus, Burry fumed that his investors weren't patient enough, although the instruments which Burry chose to buy were, in fact, not salable at values which were implied by market conditions. Here's a passage on page 223 describing this phenomenon,

"Twenty-two days later, on August 31, 2007, Michael Burry lifted the side pocket and began to unload his own credit default swaps in earnest. His investors could have their money back. There was now more than twice as much of it as they had given him. Just a few months earlier, Burry was being offered 200 basis points- or 2 percent of the principal- for his credit default swaps, which peaked at $1.9 billion. Now he was being offered 75, 80, and 85 points by Wall Street firms desperate to cushion their fall. At the end of the quarter, he'd report that the fund was up by more than 100 percent. By the end of the year, in a portfolio of less than $550 million, he would have realized profits of more than $720 million. Still he heard not a peep from his investors."

Eventually, Burry and Greenblatt' Gotham Capital, his original investor and backer, turned on each other. Burry "kicked them out" of his fund, sarcastically replying to Greenblatt's inquiry regarding the value of his stake that he keep the "tens of millions of dollars" Gotham had tried to keep Burry from earning, and "call it even?"

Then Burry shut his fund.

Let me reiterate that I like Michael Lewis' writing. He makes otherwise obscure financial issues clear to laymen while, for people like me, with industry experience, he provides behind the scenes information concerning major events and news stories.

But Lewis was a Salomon bond salesman, not a portfolio manager. Nor a salesman for a portfolio management firm. So I think he misses a very important aspect of Burry's story. One which, frankly, puts me on the side of Burry's angry investors.

As I noted in my earlier post about this point, Burry deliberately went out of his chosen area of expertise when he took an equity portfolio into the uncharted territory of custom-crafted credit swaps. Those were derivatives with no continuous, large and deeply-liquid pool of buyers and sellers which provided an accurate, moving price reflecting their real value at any moment the markets were open.

His investors felt justifiably upset for two reasons. The first is that he didn't stick to what he did which originally motivated them to trust him with their money. The second is that, if these investors wanted to invest in mortgage-backed bond credit default swaps, maybe they'd have searched for other managers who did that, and not chosen Burry.

[Additional note: In the original posting of this piece, I neglected to mention cost of carry. For investors used to equity portfolios with occasional hedging using options, Burry's use of swaps, which, like all insurance, require the ongoing payment of premiums, must have come as a shock. I believe premiums were something like 2% of face value. With options, there is a one-time premium, but they expire. For swaps, to remain in force, the carry must be paid. This was another reason Burry evidently angered his investors, but chose to ignore the consequences of his unilateral move into fixed income derivatives.]

Burry clearly ignored this possibility. Unfortunately, I think Michael Lewis did, as well. Perhaps he develops bonds with the subjects of his personal interest storylines. Those anecdotal plot lines which so nicely color and personalize his book. But it seems to me that Lewis lost his objectivity in Burry's case.

By late 2007, when Burry and his investors and backers were in full tilt at each other, the swaps were sold for what Lewis explains was a huge profit. In retrospect, the investors and backers look like ungrateful, nasty, childish recipients of Burry's largess.

But that's in hindsight. For over two years, from May, 2005 until August, 2007, Burry's investors were strapped into their seats for a ride with no clear destination. Burry invoked side pocket and redemption clauses to keep his investors from withdrawing their money.

Let me tell you, from experience working with hedge funds, investors do not like uncertainty or risk. It's not correct to say, or believe, that, in the end, having made unbelievable profits, all will be forgiven. It won't be.

For every Mike Burry, investors can think of a LTCM or Nick Leeson at now-defunct Barings Bank. Impassioned portfolio managers don't see things objectively. I was once told by the head of research at Bernstein that I needn't worry about anyone with an existing equity strategy stealing mine. He told me, to paraphrase,

'Another equity strategist/manager will stick with his own approach, even as it keeps losing money, rather than steal yours, if it's making money. He'll swear that his method has just hit a temporary bad patch, or that he will fix it, and he doesn't need your strategy.'

Amazingly, he was right. And it's that attitude which must have worried- frightened- Burry's investors and backers.

Moreover, once Burry had this conflict with his investors, due to his deliberate departure from subjectively selecting equities, it is very likely that he would have had little luck attracting new investors. After explaining what he'd done, how brilliant he'd been to completely leave his typical area of expertise and subject his investors to years of profitless risk in arcane, seldom-traded swaps, not many other investors would probably have signed up for a ride on Burry's roller coaster fund management ride.

The first point of this post- to beware of huge hedge funds and their underlying profit motive- is one about which investors can do something. They can ask about fund sizes and fees, expenses, and figure out whether actually making money for clients is crucial to the fund's own internal profit objectives.

The second point- getting trapped in a fund which switches what it holds- is harder to guard against. That is, unless a manager openly tells you he's done that before, or wouldn't hesitate to do it, you won't know until it's too late.

In either case, though, the solution is the same, and it's an old one. In a word.....


Investors can rarely suffer from diversifying among managers.

Want more proof? Here's another word.....


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