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.....
Diversification.
Investors can rarely suffer from diversifying among managers.
Want more proof? Here's another word.....
Madoff.
Showing posts with label Michael Lewis. Show all posts
Showing posts with label Michael Lewis. Show all posts
Tuesday, September 27, 2011
Monday, September 19, 2011
Regarding Goldman's Global Alpha Fund
I read the article in Friday's Wall Street Journal concerning the closing of Goldman Sachs' Global Alpha fund with great interest.
Coming as it did on the heels of the UBS so-called rogue trader loss, and this related, recent post, it brought to mind, once more, Michael Lewis' books about publicly-owned investment banks.
The story is rather eye-opening. Begun with Cliff Asness at the helm in 1997, he bolted to form his now-famous AQR hedge fund the next year. No mention of where Global Alpha existed, organizationally, in relation to GSAM, the firm's formal asset management arm. But the Journal piece states that Global Alpha ran $12B in 2007, lost 23% of that "in August 2007 and was down 40% for all of 2007."
According to the Journal article, the fund lost 12% so far this year, and had fallen to just $1B in size. So Goldman has shuttered it.
Global Alpha's last manager, Katinka Domotorffy, is leaving the firm. No doubt with tens of millions of dollars of her own, soon to set up shop managing her own funds and those of a few select friends or colleagues. Perhaps as a consultant, in order to avoid the intrusive new hedge fund rules which have driven Carl Icahn from the business.
I can't help but muse about Goldman's experience with Global Alpha and, perhaps, other funds. I'm sure they charge premium fees. I doubt they allowed much of a hold-back period on incentive fees, or refunded any fees as they closed Global Alpha.
Along with proprietary trading, which former CEO John Whitehead thought a bad idea, so, too, has asset management apparently proven to be an expensive new business- for Goldman's clients.
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.
Today's Journal profiles celebrated fund manager John Paulson in the midst of a tough year. His funds have apparently struggled so far in 2011, posting losses. Paulson's funds are reported to have attracted something like $10B in new money in recent years, which doubled the amount of outside funds under management.
But the article also mentions that, as a result of his very public success betting against mortgage-backed bonds during 2005-08, Paulson personally took home $5B in pre-tax earnings in 2010.
Read that again. $5B last year.
Even if Paulson invested and lost half of that in his own funds, he still kept at least a billion after tax.
How can you reasonably expect him to manage investor funds the same way now as he did before 2005? Sure, he's no doubt competitive and values his reputation. But, like Julian Robertson, who got sloppy with risk management at the end of his Tiger Fund's run, Paulson no longer is staking his ability to make a living on how his funds perform.
At 2 & 20, with even just $20B in outside money, Paulson's complex is earning $400MM in annual fixed fees, regardless of performance. If you allow for extravagant expenses, the group is probably bringing at least $300MM to its compensation pool.
How many businesses do you know of which provide such life-altering compensation in just one or two years, regardless of how customers fare?
I'm not saying it's unfair, or requires regulation. I'm saying investors should beware of jumping into mega-sized, successful hedge funds, expecting a continuation of past performance.
One needn't invest with Bernie Madoff, nor any Ponzie scheme, to experience disappointing results from a hedge fund. Size (of funds) does matter, and investors who ignore that do so at their peril.
Coming as it did on the heels of the UBS so-called rogue trader loss, and this related, recent post, it brought to mind, once more, Michael Lewis' books about publicly-owned investment banks.
The story is rather eye-opening. Begun with Cliff Asness at the helm in 1997, he bolted to form his now-famous AQR hedge fund the next year. No mention of where Global Alpha existed, organizationally, in relation to GSAM, the firm's formal asset management arm. But the Journal piece states that Global Alpha ran $12B in 2007, lost 23% of that "in August 2007 and was down 40% for all of 2007."
According to the Journal article, the fund lost 12% so far this year, and had fallen to just $1B in size. So Goldman has shuttered it.
Global Alpha's last manager, Katinka Domotorffy, is leaving the firm. No doubt with tens of millions of dollars of her own, soon to set up shop managing her own funds and those of a few select friends or colleagues. Perhaps as a consultant, in order to avoid the intrusive new hedge fund rules which have driven Carl Icahn from the business.
I can't help but muse about Goldman's experience with Global Alpha and, perhaps, other funds. I'm sure they charge premium fees. I doubt they allowed much of a hold-back period on incentive fees, or refunded any fees as they closed Global Alpha.
Along with proprietary trading, which former CEO John Whitehead thought a bad idea, so, too, has asset management apparently proven to be an expensive new business- for Goldman's clients.
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.
Today's Journal profiles celebrated fund manager John Paulson in the midst of a tough year. His funds have apparently struggled so far in 2011, posting losses. Paulson's funds are reported to have attracted something like $10B in new money in recent years, which doubled the amount of outside funds under management.
But the article also mentions that, as a result of his very public success betting against mortgage-backed bonds during 2005-08, Paulson personally took home $5B in pre-tax earnings in 2010.
Read that again. $5B last year.
Even if Paulson invested and lost half of that in his own funds, he still kept at least a billion after tax.
How can you reasonably expect him to manage investor funds the same way now as he did before 2005? Sure, he's no doubt competitive and values his reputation. But, like Julian Robertson, who got sloppy with risk management at the end of his Tiger Fund's run, Paulson no longer is staking his ability to make a living on how his funds perform.
At 2 & 20, with even just $20B in outside money, Paulson's complex is earning $400MM in annual fixed fees, regardless of performance. If you allow for extravagant expenses, the group is probably bringing at least $300MM to its compensation pool.
How many businesses do you know of which provide such life-altering compensation in just one or two years, regardless of how customers fare?
I'm not saying it's unfair, or requires regulation. I'm saying investors should beware of jumping into mega-sized, successful hedge funds, expecting a continuation of past performance.
One needn't invest with Bernie Madoff, nor any Ponzie scheme, to experience disappointing results from a hedge fund. Size (of funds) does matter, and investors who ignore that do so at their peril.
Friday, September 16, 2011
Regarding UBS, Their Rogue Trader, John Mack, Morgan Stanley & Howie Hubler
Yesterday's two big financial stories, outside of the continuing soap opera "As The Euro Implodes," were John Mack's retirement from Morgan Stanley and the revelation that UBS rogue trader Kweku Adoboli lost $2B for the bank. Both stories dutifully appeared as prominent pieces in this morning's Wall Street Journal.
There is, however, a deliciously ironic link between the two tales. For me, it took finishing Michael Lewis' The Big Short to realize the connection. Here's the clue from the Journal piece,
"But in 2007, it hit a rough patch, losing $9 billion on a proprietary mortgage bet that cost the jobs of several of Mr. Mack's lieutenants, including Zoe Cruz, who was widely viewed as a top candidate to succeed Mr. Mack."
Now, it's tempting to think of the Morgan Stanley loss as not caused by a rogue trader. In fact, elsewhere in the Journal article on Mack, it contends,
"He's a battlefield commander who knows how to lead troops......Mr. Mack pushed traders to take more risk and sell more esoteric but profitable mortgage products. Briefly, that move paid off. In 2006, the firm enjoyed record results."
Funny, that's not at all how Michael Lewis described Howie Hubler's calculated $9B loss on mortgage-backed derivatives.
How do you suppose UBS suffered only a $2B loss and blamed it on a rogue trader, whereas John Mack presided over a $9B loss in 2007 and kept his job? In fact, he essentially lost the firm, as it required a federal bailout, plead to convert to a chartered commercial bank, and had to arrange other financing to remain solvent.
Yet Mack kept his job and never called Hubler's loss a rogue trade.
We don't yet know precisely how Adoboli accomplished his allegedly-undetected losing trade(s). One assumes, like Nick Leeson who brought down Barings Bank, he somehow fooled the various electronic systems purporting to monitor positions, desk P&Ls and risk.
But here's how Michael Lewis explains Morgan Stanley's star fixed income trader Howie Hubler's stunning $9B loss. For those wishing to follow along, I'm synopsizing Lewis' Chapter 9 in The Big Short (Norton, 2010), entitled A Death of Interest, pages 200-225. I'm not going to retype the chapter, nor major parts of it, as that would, I think, be a waste of my time, and probably violate Michael Lewis' copyright. Instead, I'm going to abstract the highlights of what went on at John Mack's (and Zoe Cruz's) Morgan Stanley during 2006 & 2007. But I heartily recommend, if you find any of this of interest, that you run over to Amazon and buy a copy (new or, as I prefer, used but 'like new' for only about $6) of Lewis's book.
Howie Hubler was a star trader of mortgage-backed bonds. Sometime in 2004, Hubler begins to realize that a lot of the bonds he's selling, for which Morgan Stanley, like Goldman Sachs, has built its own origination system to capture the entire profit stream, are of highly suspect quality. So he, in conjunction with a colleague, Mike Edman, hatch a proprietary swap which they convince some of their clients to sell to Morgan Stanley. This allows Hubler's desk to own protection, for a small annual fee, on billions of dollars of dodgy subprime-backed mortgage bonds.
Lewis writes,
"It's now April 2006, and the subprime mortgage bond machine is roaring. Howie Hubler is Morgan Stanley's star bond trader, and his group of eight traders is generating, by their estimate, around 20 percent of Morgan Stanley's profits. Their profits have risen from roughly $400 million in 2004 to $700 million in 2005, on their way to $1 billion in 2006. Hubler will be paid $25 million at the end of the year, but he's no longer happy working as an ordinary bond trader......"
Along the lines of my long-expressed belief, Lewis notes that "the best and the brightest Wall Street traders are quitting their big firms to work at hedge funds, where they can make not tens but hundreds of millions."
So Hubler wangles a deal with Morgan Stanley to set up his own proprietary trading group, take his existing desk's swaps positions with him, and get a sweet deal for his group to own a stake in the group, to be subsequently spun out from Morgan Stanley. In short, Hubler extorts Mack and Cruz to give his group a semi-private business and stake in its future value, in return for not bolting from Morgan Stanley.
Here is where the story becomes interesting as it relates to today's WSJ articles about a rogue UBS trader and John Mack being paid homage as a wise senior Wall Street CEO.
Hubler's new group is given a profit bogey of $2B, but is paying about 10% of that, or $200MM, in fees to maintain its swaps, or shorts on bad mortgage bonds. Hubler wants to eliminate this drain, so he sells credit default swaps on a much larger amount of allegedly higher-quality mortgage bonds. About $16B of bonds.
As Lewis puts it,
"In effect, Howie Hubler was betting that some of the triple-B-rated subprime bonds would go bad, but not all of them. He was smart enough to be cynical about his market, but not smart enough to realize how cynical he needed to be."
For some perspective, the original credit default swaps which Hubler and his colleagues sold to their customers only required a 4% default rate among the subprime mortgages backing the bonds, which Lewis writes was expected in good times, to allow the swaps to pay off.
Next, Lewis writes about how Zoe Cruz' risk management people ask for stress tests of Hubler's aggregate positions under scenarios involving a default rate of 10%. A rate Hubler's people, who, remember, are just traders- not PhDs in economics or seasoned mortgage industry researchers (like, for example, Lew Ranieri's original Salomon group contained)- protested would never occur.
I need to make a brief side point here on which I'll elaborate in a subsequent post. Value-at-risk is the main component of most trading desk risk management systems. I've worked on and been around these systems since my days at what is now Accenture consulting back in 1995. One of the problems with VAR systems is that, since they require and assume variance in valuation to impute the capital required for a position, and, thus the losses possible at some probability level, they don't work well with bespoke instruments. Like, say, credit default swaps or so-called 'off the run' fixed income instruments.
Since the entire credit default swap market, as it evolved among AIG, Goldman Sachs, Deutsche Bank, Morgan Stanley, et.al, was a telephone bid/ask market in which valuation was an exercise in judgement, variation in values was meaningless. As my old, sometime-business partner Bob Mankin is fond of saying,
"A model can tell you what something was worth yesterday or may be worth tomorrow. But the only way to know what it's worth today is to sell a piece of it in the market to someone else."
Thus Morgan Stanley's risk group's slow realization that its VAR reports on Hubler's groups risks were also meaningless.
The 10% stress test showed that Hubler's group wasn't short subprime mortgage-backed bonds. It was long, and the 10% default scenario would create a $2.7B loss. Lewis notes that the actual eventual default rate on the bonds on which Hubler sold swaps, i.e., went long, became 40%.
Again, to synopsize, by mid-2007, Deutsche Bank, which had bought the swaps Hubler sold to get a $200MM income stream to offset his negative carry on his base position of being long credit default swaps on allegedly-worse subprime mortgage-backed bonds, called Hubler to demand payment on the shifting, now higher value of the swaps Hubler sold. Again, because they aren't exchange-traded or continuously-quoted instruments, their value was the subject of what, in effect, became a verbal pissing contest between Deutsche and Morgan Stanley. By later in 2007, Morgan Stanley had paid Deutsche Bank at least $3.7B, eventually losing the net $9.2B. Hubler had, as Lewis writes,
"...been allowed to resign in October 2007, with many millions of dollars the firm had promised him at the end of 2006. The total losses he left behind him were reported to the Morgan Stanley board as a bit more than $9 billion: the single largest trading loss in the history of Wall Street......Hubler and his traders thought they were smart guys put on earth to exploit the market's stupid inefficiencies. Instead, they simply contributed more inefficiency."
To further add to today's trading loss/John Mack retirement irony, Lewis continued, on page 216,
"The other, bigger, buyer was UBS- which took $2 billion in Howie Hubler's triple-A CDO's, along with a couple of hundred million dollars' worth of his short position in triple-B-rated bonds.....A few months later, seeking to explain to its shareholders the $37.4 billion it had lost in the U.S. subprime markets, UBS would publish a semi-frank report, in which it revealed that a small group of U.S. bond traders employed by UBS had lobbied hard right up until the end for the bank to buy even more of other Wall Street firms' subprime mortgage bonds.....said one UBS bond trader close to the action, "It was a very controversial trade in UBS. It was kept very, very secret.....He further explained that the traders at UBS who executed the trade were motivated mainly by their own models- which, at the moment of their trade, suggested they had turned a profit of $30 million." "
Small world, indeed, eh?
Now with all this information, stop and reflect with me for a moment.
You are John Mack. It is 2006. You meet with your chief risk officer, Zoe Cruz, to ask for a complete examination of Howie Hubler's group's positions, strategies, assumptions, forecasts, etc., because that single eight-person desk is generating, according to Lewis, roughly 20% of Morgan Stanley's profits. You tell Zoe to set aside an entire day- maybe two. You surely want to understand in detail how these eight traders are producing 20% of your firm's profits, and what concomitant risks they are taking to do so.
Or maybe you don't.
The same thing would seem to apply to Zoe Cruz, would it not? Wouldn't she want to protect herself by conducting such a thorough examination of Hubler's group's business, in order to brief Mack prior to presiding over a blow-up of that desk's business?
Evidently not.
Instead, Lewis quotes verbatim from Mack's December 19, 2007 investor phone call. I won't republish the detailed exchanges between Mack and his questioners, including Goldman Sachs analyst William Tanona. Instead, here's what Lewis wrote about Mack's statements,
"The meaningless flow of words might have left the audience with the sense that it was incapable of parsing the deep complexity of Morgan Stanley's bond trading business. What the words actually revealed was that the CEO himself didn't really understand the situation. John Mack was widely regarded among his CEO peers as relatively well informed about his bond firm's trading risks.....Yet not only had he failed to grasp what his traders were up to, back when they were still up to it; he couldn't even fully explain what they had done after they had lost $9 billion."
In a footnote to the verbatim exchange on page 218, Lewis also wrote,
"What John Mack's trying to say, without coming right out and saying that no one else at Morgan Stanley had a clue what risks Howie Hubler was running, is that no one else at Morgan Stanley had a clue what risks Howie Hubler was running- and neither did Howie Hubler."
In an earlier footnote on page 210, Lewis provides a brief discussion of the differing explanations offered by those close to Hubler and Cruz regarding who was ultimately responsible for Hubler's positions' losses- Hubler or Cruz? Lewis sides with those who believe Hubler hoodwinked Cruz into believing the positions' net risks were minimal.
So, what is my point at the end of this very long post involving today's WSJ articles about yesterday's two big breaking stories at UBS and Morgan Stanley, and their mortgage-backed credit default swaps losses four years ago?
It's that, to me, John Mack shouldn't be retiring now as chairman of Morgan Stanley. He should have been fired by his board in 2007 for allowing Hubler and Cruz to lose $9B on one desk. Then Cruz should have been fired, and Hubler, Cruz and Mack all sued by the Morgan Stanley for fraud and breach of fiduciary duty to the firm's shareholders.
That if Howie Hubler was allowed to exit with tens of millions of dollars, and no criminal charges, after putting a $9B hole in Morgan Stanley's 2007 balance sheet, maybe UBS' Adibolo isn't guilty of anything, either.
Maybe both Hubler and Adibolo are rogue traders, or neither one is.
Now, I know that the foregoing story paints Adibolo as a trader trying to hide his known losses, whereas Hubler is portrayed as just too inept to realize what he thought was a net short position in derivatives was actually a net long position.
Personally, I have some trouble really belieiving Hubler was that stupid. Or, if he was, are we actually to believe that people that stupid can make $25MM a year? Plus, Cruz's people did the stress test which alerted them, and Hubler, to just how risky his positions actually were. So, from that point on, it seems unarguable that all concerned at Morgan Stanley could or should have known the truth about Hubler's positions.
But Lewis' book provides details of how Morgan Stanley dithered over exiting the worsening parts of the group's positions. Was that rogue behavior? By Hubler? Cruz?
Something doesn't add up. That's why I don't see a real difference between Adibolo and Hubler. They both were given license to risk their firms' shareholders' capital, and both lost it in positions which should never apparently ever been allowed to exist.
And, yes, Zoe Cruz did lose her job. But not quite the way I suggested above. And neither she, nor Mack, nor, of course, Hubler were sued for violating their fiduciary duty to their firm's shareholders through either gross incompetence, given their compensation and senior positions, or calculated deceit.
I think Lewis' account puts this week's comparatively paltry $2B UBS loss in perspective. And suggests that UBS has an evidently continuing cultural blind spot that makes it vulnerable to rogue trading, however you choose to define the term.
Lewis' book also begs the question, in my view, that Hubler was also a rogue trader. And perhaps Mack was a rogue CEO all the while.
I suspect, if you asked him, that Michael Lewis would say the whole lot- Mack, Cruz, Hubler, Adibolo, UBS's senior management, the boards of Morgan Stanley and UBS- are rogues.
And that anybody who buys shares in those firms, or any of their Wall Street ilk, are foolish and deserve what happens to them. Because for less than twenty bucks, any of those shareholders could buy both of Lewis' appropriately well-regarded books, Liar's Poker and The Big Short, and thus be warned of the risks of owning shares of formerly-private investment banks or brokerage firms.
There is, however, a deliciously ironic link between the two tales. For me, it took finishing Michael Lewis' The Big Short to realize the connection. Here's the clue from the Journal piece,
"But in 2007, it hit a rough patch, losing $9 billion on a proprietary mortgage bet that cost the jobs of several of Mr. Mack's lieutenants, including Zoe Cruz, who was widely viewed as a top candidate to succeed Mr. Mack."
Now, it's tempting to think of the Morgan Stanley loss as not caused by a rogue trader. In fact, elsewhere in the Journal article on Mack, it contends,
"He's a battlefield commander who knows how to lead troops......Mr. Mack pushed traders to take more risk and sell more esoteric but profitable mortgage products. Briefly, that move paid off. In 2006, the firm enjoyed record results."
Funny, that's not at all how Michael Lewis described Howie Hubler's calculated $9B loss on mortgage-backed derivatives.
How do you suppose UBS suffered only a $2B loss and blamed it on a rogue trader, whereas John Mack presided over a $9B loss in 2007 and kept his job? In fact, he essentially lost the firm, as it required a federal bailout, plead to convert to a chartered commercial bank, and had to arrange other financing to remain solvent.
Yet Mack kept his job and never called Hubler's loss a rogue trade.
We don't yet know precisely how Adoboli accomplished his allegedly-undetected losing trade(s). One assumes, like Nick Leeson who brought down Barings Bank, he somehow fooled the various electronic systems purporting to monitor positions, desk P&Ls and risk.
But here's how Michael Lewis explains Morgan Stanley's star fixed income trader Howie Hubler's stunning $9B loss. For those wishing to follow along, I'm synopsizing Lewis' Chapter 9 in The Big Short (Norton, 2010), entitled A Death of Interest, pages 200-225. I'm not going to retype the chapter, nor major parts of it, as that would, I think, be a waste of my time, and probably violate Michael Lewis' copyright. Instead, I'm going to abstract the highlights of what went on at John Mack's (and Zoe Cruz's) Morgan Stanley during 2006 & 2007. But I heartily recommend, if you find any of this of interest, that you run over to Amazon and buy a copy (new or, as I prefer, used but 'like new' for only about $6) of Lewis's book.
Howie Hubler was a star trader of mortgage-backed bonds. Sometime in 2004, Hubler begins to realize that a lot of the bonds he's selling, for which Morgan Stanley, like Goldman Sachs, has built its own origination system to capture the entire profit stream, are of highly suspect quality. So he, in conjunction with a colleague, Mike Edman, hatch a proprietary swap which they convince some of their clients to sell to Morgan Stanley. This allows Hubler's desk to own protection, for a small annual fee, on billions of dollars of dodgy subprime-backed mortgage bonds.
Lewis writes,
"It's now April 2006, and the subprime mortgage bond machine is roaring. Howie Hubler is Morgan Stanley's star bond trader, and his group of eight traders is generating, by their estimate, around 20 percent of Morgan Stanley's profits. Their profits have risen from roughly $400 million in 2004 to $700 million in 2005, on their way to $1 billion in 2006. Hubler will be paid $25 million at the end of the year, but he's no longer happy working as an ordinary bond trader......"
Along the lines of my long-expressed belief, Lewis notes that "the best and the brightest Wall Street traders are quitting their big firms to work at hedge funds, where they can make not tens but hundreds of millions."
So Hubler wangles a deal with Morgan Stanley to set up his own proprietary trading group, take his existing desk's swaps positions with him, and get a sweet deal for his group to own a stake in the group, to be subsequently spun out from Morgan Stanley. In short, Hubler extorts Mack and Cruz to give his group a semi-private business and stake in its future value, in return for not bolting from Morgan Stanley.
Here is where the story becomes interesting as it relates to today's WSJ articles about a rogue UBS trader and John Mack being paid homage as a wise senior Wall Street CEO.
Hubler's new group is given a profit bogey of $2B, but is paying about 10% of that, or $200MM, in fees to maintain its swaps, or shorts on bad mortgage bonds. Hubler wants to eliminate this drain, so he sells credit default swaps on a much larger amount of allegedly higher-quality mortgage bonds. About $16B of bonds.
As Lewis puts it,
"In effect, Howie Hubler was betting that some of the triple-B-rated subprime bonds would go bad, but not all of them. He was smart enough to be cynical about his market, but not smart enough to realize how cynical he needed to be."
For some perspective, the original credit default swaps which Hubler and his colleagues sold to their customers only required a 4% default rate among the subprime mortgages backing the bonds, which Lewis writes was expected in good times, to allow the swaps to pay off.
Next, Lewis writes about how Zoe Cruz' risk management people ask for stress tests of Hubler's aggregate positions under scenarios involving a default rate of 10%. A rate Hubler's people, who, remember, are just traders- not PhDs in economics or seasoned mortgage industry researchers (like, for example, Lew Ranieri's original Salomon group contained)- protested would never occur.
I need to make a brief side point here on which I'll elaborate in a subsequent post. Value-at-risk is the main component of most trading desk risk management systems. I've worked on and been around these systems since my days at what is now Accenture consulting back in 1995. One of the problems with VAR systems is that, since they require and assume variance in valuation to impute the capital required for a position, and, thus the losses possible at some probability level, they don't work well with bespoke instruments. Like, say, credit default swaps or so-called 'off the run' fixed income instruments.
Since the entire credit default swap market, as it evolved among AIG, Goldman Sachs, Deutsche Bank, Morgan Stanley, et.al, was a telephone bid/ask market in which valuation was an exercise in judgement, variation in values was meaningless. As my old, sometime-business partner Bob Mankin is fond of saying,
"A model can tell you what something was worth yesterday or may be worth tomorrow. But the only way to know what it's worth today is to sell a piece of it in the market to someone else."
Thus Morgan Stanley's risk group's slow realization that its VAR reports on Hubler's groups risks were also meaningless.
The 10% stress test showed that Hubler's group wasn't short subprime mortgage-backed bonds. It was long, and the 10% default scenario would create a $2.7B loss. Lewis notes that the actual eventual default rate on the bonds on which Hubler sold swaps, i.e., went long, became 40%.
Again, to synopsize, by mid-2007, Deutsche Bank, which had bought the swaps Hubler sold to get a $200MM income stream to offset his negative carry on his base position of being long credit default swaps on allegedly-worse subprime mortgage-backed bonds, called Hubler to demand payment on the shifting, now higher value of the swaps Hubler sold. Again, because they aren't exchange-traded or continuously-quoted instruments, their value was the subject of what, in effect, became a verbal pissing contest between Deutsche and Morgan Stanley. By later in 2007, Morgan Stanley had paid Deutsche Bank at least $3.7B, eventually losing the net $9.2B. Hubler had, as Lewis writes,
"...been allowed to resign in October 2007, with many millions of dollars the firm had promised him at the end of 2006. The total losses he left behind him were reported to the Morgan Stanley board as a bit more than $9 billion: the single largest trading loss in the history of Wall Street......Hubler and his traders thought they were smart guys put on earth to exploit the market's stupid inefficiencies. Instead, they simply contributed more inefficiency."
To further add to today's trading loss/John Mack retirement irony, Lewis continued, on page 216,
"The other, bigger, buyer was UBS- which took $2 billion in Howie Hubler's triple-A CDO's, along with a couple of hundred million dollars' worth of his short position in triple-B-rated bonds.....A few months later, seeking to explain to its shareholders the $37.4 billion it had lost in the U.S. subprime markets, UBS would publish a semi-frank report, in which it revealed that a small group of U.S. bond traders employed by UBS had lobbied hard right up until the end for the bank to buy even more of other Wall Street firms' subprime mortgage bonds.....said one UBS bond trader close to the action, "It was a very controversial trade in UBS. It was kept very, very secret.....He further explained that the traders at UBS who executed the trade were motivated mainly by their own models- which, at the moment of their trade, suggested they had turned a profit of $30 million." "
Small world, indeed, eh?
Now with all this information, stop and reflect with me for a moment.
You are John Mack. It is 2006. You meet with your chief risk officer, Zoe Cruz, to ask for a complete examination of Howie Hubler's group's positions, strategies, assumptions, forecasts, etc., because that single eight-person desk is generating, according to Lewis, roughly 20% of Morgan Stanley's profits. You tell Zoe to set aside an entire day- maybe two. You surely want to understand in detail how these eight traders are producing 20% of your firm's profits, and what concomitant risks they are taking to do so.
Or maybe you don't.
The same thing would seem to apply to Zoe Cruz, would it not? Wouldn't she want to protect herself by conducting such a thorough examination of Hubler's group's business, in order to brief Mack prior to presiding over a blow-up of that desk's business?
Evidently not.
Instead, Lewis quotes verbatim from Mack's December 19, 2007 investor phone call. I won't republish the detailed exchanges between Mack and his questioners, including Goldman Sachs analyst William Tanona. Instead, here's what Lewis wrote about Mack's statements,
"The meaningless flow of words might have left the audience with the sense that it was incapable of parsing the deep complexity of Morgan Stanley's bond trading business. What the words actually revealed was that the CEO himself didn't really understand the situation. John Mack was widely regarded among his CEO peers as relatively well informed about his bond firm's trading risks.....Yet not only had he failed to grasp what his traders were up to, back when they were still up to it; he couldn't even fully explain what they had done after they had lost $9 billion."
In a footnote to the verbatim exchange on page 218, Lewis also wrote,
"What John Mack's trying to say, without coming right out and saying that no one else at Morgan Stanley had a clue what risks Howie Hubler was running, is that no one else at Morgan Stanley had a clue what risks Howie Hubler was running- and neither did Howie Hubler."
In an earlier footnote on page 210, Lewis provides a brief discussion of the differing explanations offered by those close to Hubler and Cruz regarding who was ultimately responsible for Hubler's positions' losses- Hubler or Cruz? Lewis sides with those who believe Hubler hoodwinked Cruz into believing the positions' net risks were minimal.
So, what is my point at the end of this very long post involving today's WSJ articles about yesterday's two big breaking stories at UBS and Morgan Stanley, and their mortgage-backed credit default swaps losses four years ago?
It's that, to me, John Mack shouldn't be retiring now as chairman of Morgan Stanley. He should have been fired by his board in 2007 for allowing Hubler and Cruz to lose $9B on one desk. Then Cruz should have been fired, and Hubler, Cruz and Mack all sued by the Morgan Stanley for fraud and breach of fiduciary duty to the firm's shareholders.
That if Howie Hubler was allowed to exit with tens of millions of dollars, and no criminal charges, after putting a $9B hole in Morgan Stanley's 2007 balance sheet, maybe UBS' Adibolo isn't guilty of anything, either.
Maybe both Hubler and Adibolo are rogue traders, or neither one is.
Now, I know that the foregoing story paints Adibolo as a trader trying to hide his known losses, whereas Hubler is portrayed as just too inept to realize what he thought was a net short position in derivatives was actually a net long position.
Personally, I have some trouble really belieiving Hubler was that stupid. Or, if he was, are we actually to believe that people that stupid can make $25MM a year? Plus, Cruz's people did the stress test which alerted them, and Hubler, to just how risky his positions actually were. So, from that point on, it seems unarguable that all concerned at Morgan Stanley could or should have known the truth about Hubler's positions.
But Lewis' book provides details of how Morgan Stanley dithered over exiting the worsening parts of the group's positions. Was that rogue behavior? By Hubler? Cruz?
Something doesn't add up. That's why I don't see a real difference between Adibolo and Hubler. They both were given license to risk their firms' shareholders' capital, and both lost it in positions which should never apparently ever been allowed to exist.
And, yes, Zoe Cruz did lose her job. But not quite the way I suggested above. And neither she, nor Mack, nor, of course, Hubler were sued for violating their fiduciary duty to their firm's shareholders through either gross incompetence, given their compensation and senior positions, or calculated deceit.
I think Lewis' account puts this week's comparatively paltry $2B UBS loss in perspective. And suggests that UBS has an evidently continuing cultural blind spot that makes it vulnerable to rogue trading, however you choose to define the term.
Lewis' book also begs the question, in my view, that Hubler was also a rogue trader. And perhaps Mack was a rogue CEO all the while.
I suspect, if you asked him, that Michael Lewis would say the whole lot- Mack, Cruz, Hubler, Adibolo, UBS's senior management, the boards of Morgan Stanley and UBS- are rogues.
And that anybody who buys shares in those firms, or any of their Wall Street ilk, are foolish and deserve what happens to them. Because for less than twenty bucks, any of those shareholders could buy both of Lewis' appropriately well-regarded books, Liar's Poker and The Big Short, and thus be warned of the risks of owning shares of formerly-private investment banks or brokerage firms.
Wednesday, September 14, 2011
More On Michael Lewis' The Big Short
Last month I published this post based on a partial reading of Michael Lewis' 2010 book involving the recent financial crisis, The Big Short.
While away in New Hampshire late last month and early this month, I finished the book and have since been reflecting on it. I'll be publishing several posts in the near future on various aspects of Lewis' book.
At present, I think the topics will include:
-S&P's inept ratings analyses
-Regulatory failures
-Goldman Sachs' typically rapacious behavior
-Moral bakruptcy among fund managers
-The largely-unpublicized nature of structured instrument valuation and/or non-exchange-traded invesetments
And probably a few more as they occur to me.
While away in New Hampshire late last month and early this month, I finished the book and have since been reflecting on it. I'll be publishing several posts in the near future on various aspects of Lewis' book.
At present, I think the topics will include:
-S&P's inept ratings analyses
-Regulatory failures
-Goldman Sachs' typically rapacious behavior
-Moral bakruptcy among fund managers
-The largely-unpublicized nature of structured instrument valuation and/or non-exchange-traded invesetments
And probably a few more as they occur to me.
Monday, August 22, 2011
Michael Lewis' The Big Short- Initial Observations
After writing this post earlier this month about Michael Lewis' 20+ year old book Liar's Poker and exchanging comments with a reader presenting himself as a young prospective investment banker, I went ahead and bought two of his subsequent books, Moneyball and The Big Short. Incidentally, in keeping with the times, I ordered both as nearly-virgin, used copies from Amazon resellers for no more than $10 each, including shipping. The latter arrived looking every bit like a brand new, unopened book.
Despite my intentions to save The Big Short, published last year, to read in a classic summer situation of electronic unconnectedness, I have read roughly one-fifth of it already. Being the second of Lewis' financial books that I've read, and having reread Liar's Poker, his first, in the past few weeks, I have a few observations to offer on The Big Short.
The first is simply how Lewis focuses on people with amazingly good luck. In Liar's Poker, he made the point of how few people were granted the exalted status he enjoyed by being hired by then-dominant Salomon Brothers.
In The Big Short, he initially profiles a one-eyed doctor-turned-equity portfolio manager, Mike Burry. Burry first attracts attention from Joel Greenblatt and his colleagues, New York-based hedge fund managers, rather unbelievably from their following his selections as posted on stock trading message boards of the time, and his own nascent AOL 'blog.' Later, Lewis confirms that Burry was the only person Greenblatt's firm ever subsequently approached with an offer to buy part of his firm. 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.
It's likely that Burry's being a subjective stock picker had a lot to do with his intellectual property not simply being stolen. I have friends who unwisely approached GE Capital years ago with a financial concept. The management at GE officially rejected the concept, but only months later were seen having appropriated the idea and implemented it at the unit, at scale. Suffice to say, my friends were out millions due to unrealistic expectations of GE Capital's operating procedures.
Similarly, when, a few years ago, an intermediary offered to introduce a then-business partner and me to Goldman Sachs, in order to obtain investment funds, we declined. We realized we weren't going to be, for example, in a private meeting with the firm's CEO or any other single senior officer. Instead, the intermediary was probably going to have us presenting our IP to, and answering the questions of, a dozen or more smart, hungry Goldman junior staffers all eager to climb over each other- and us- to make their fortune.
One of my business partner's colleagues in private equity later confirmed that it was imperative we never let a large investment bank or fund manager, like Goldman, have any whiff of the details of our approach, lest they move heaven and earth to obtain information on our trades and mimic them for free. And that we were correct to avoid providing any details of my equity portfolio management approach to anyone at Goldman.
More often than not, an existing financial firm will take what they can, rather than formally approach someone with a new, profitable concept and offer value for it.
Thus, it's very difficult to adequately explain, or overstate, just how wildly improbably Burry's good fortune was. First, to be a subjective equity analyst-cum-investor who actually beat the S&P500 is pretty rare. To have divulged his selections online and then have a hedge fund find, track and ultimately buy a piece of his operation is even rarer. And to survive essentially completely changing the nature of his fund without giving investors a chance to redeem.
Think rare as in the exceedingly long odds of any one low-income, uneducated minority youth devoting all his time to playing basketball, and eventually making it through a college basketball program to be selected by an NBA team and actually playing for at least a few seasons, thus scoring the sports equivalent of a lottery win.
Lewis writes engaging, interesting and true stories. He has a wry manner of educated the novice in the arcane ways of finance, while exposing fraud, luck, and many other aspects of the human condition.
The way in which Lewis has, so far as I have read at this point, composed The Big Short gives the appearance of a few honest, initially-naive souls at Oppenheimer and elsewhere standing up to widespread housing finance fraud, fighting the good fight and, I'm assuming, ultimately triumphing through immense financial gains.
As I read Chapter Two, In The Land of the Blind, about Burry, I couldn't help but think about the legions of other analysts and investors who could and probably did have other equally-profitable approaches, but, at some stage of their efforts, failed to receive the luck which found Burry.
In short, I think Lewis' tales of finance give the illusion of skill trumping fraud and greed, when, more accurately, it's luck and some skill accidentally getting a lightning strike amidst greed, fraud and herd investing mentality in the fund management, trading and investment banking businesses.
Despite my intentions to save The Big Short, published last year, to read in a classic summer situation of electronic unconnectedness, I have read roughly one-fifth of it already. Being the second of Lewis' financial books that I've read, and having reread Liar's Poker, his first, in the past few weeks, I have a few observations to offer on The Big Short.
The first is simply how Lewis focuses on people with amazingly good luck. In Liar's Poker, he made the point of how few people were granted the exalted status he enjoyed by being hired by then-dominant Salomon Brothers.
In The Big Short, he initially profiles a one-eyed doctor-turned-equity portfolio manager, Mike Burry. Burry first attracts attention from Joel Greenblatt and his colleagues, New York-based hedge fund managers, rather unbelievably from their following his selections as posted on stock trading message boards of the time, and his own nascent AOL 'blog.' Later, Lewis confirms that Burry was the only person Greenblatt's firm ever subsequently approached with an offer to buy part of his firm. 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.
It's likely that Burry's being a subjective stock picker had a lot to do with his intellectual property not simply being stolen. I have friends who unwisely approached GE Capital years ago with a financial concept. The management at GE officially rejected the concept, but only months later were seen having appropriated the idea and implemented it at the unit, at scale. Suffice to say, my friends were out millions due to unrealistic expectations of GE Capital's operating procedures.
Similarly, when, a few years ago, an intermediary offered to introduce a then-business partner and me to Goldman Sachs, in order to obtain investment funds, we declined. We realized we weren't going to be, for example, in a private meeting with the firm's CEO or any other single senior officer. Instead, the intermediary was probably going to have us presenting our IP to, and answering the questions of, a dozen or more smart, hungry Goldman junior staffers all eager to climb over each other- and us- to make their fortune.
One of my business partner's colleagues in private equity later confirmed that it was imperative we never let a large investment bank or fund manager, like Goldman, have any whiff of the details of our approach, lest they move heaven and earth to obtain information on our trades and mimic them for free. And that we were correct to avoid providing any details of my equity portfolio management approach to anyone at Goldman.
More often than not, an existing financial firm will take what they can, rather than formally approach someone with a new, profitable concept and offer value for it.
Thus, it's very difficult to adequately explain, or overstate, just how wildly improbably Burry's good fortune was. First, to be a subjective equity analyst-cum-investor who actually beat the S&P500 is pretty rare. To have divulged his selections online and then have a hedge fund find, track and ultimately buy a piece of his operation is even rarer. And to survive essentially completely changing the nature of his fund without giving investors a chance to redeem.
Think rare as in the exceedingly long odds of any one low-income, uneducated minority youth devoting all his time to playing basketball, and eventually making it through a college basketball program to be selected by an NBA team and actually playing for at least a few seasons, thus scoring the sports equivalent of a lottery win.
Lewis writes engaging, interesting and true stories. He has a wry manner of educated the novice in the arcane ways of finance, while exposing fraud, luck, and many other aspects of the human condition.
The way in which Lewis has, so far as I have read at this point, composed The Big Short gives the appearance of a few honest, initially-naive souls at Oppenheimer and elsewhere standing up to widespread housing finance fraud, fighting the good fight and, I'm assuming, ultimately triumphing through immense financial gains.
As I read Chapter Two, In The Land of the Blind, about Burry, I couldn't help but think about the legions of other analysts and investors who could and probably did have other equally-profitable approaches, but, at some stage of their efforts, failed to receive the luck which found Burry.
In short, I think Lewis' tales of finance give the illusion of skill trumping fraud and greed, when, more accurately, it's luck and some skill accidentally getting a lightning strike amidst greed, fraud and herd investing mentality in the fund management, trading and investment banking businesses.
Tuesday, August 09, 2011
When Salomon Brothers Was King
I had the occasion to reread Michael Lewis' 1989 classic book about investment banking and the first mortgage crisis, Liar's Poker.
A good friend had recently finished Lewis' Moneyball, the book he wrote about baseball team managements' use of key statistics to select and pay players. Somehow we got onto the subject of his first book, and I lent him my copy.
Upon his returning it to me last Thursday, I began to selectively reread it. Not being the sort of book that I reread often, I hadn't actually opened it, to my knowledge, in 22 years. Thus, many of the passages were quite surprising.
To give some perspective regarding some of what I recalled, thanks to the aid of Lewis' book, let me recount a story from my business youth. Back when I was in Corporate Planning at Chase Manhattan Bank, troubleshooting businesses as one of a few elite internal consultants working for Gerry Weiss, I would often be immersed in a project for months. After its completion, I'd tackle the mountain of BusinessWeeks, Fortunes and Forbes magazines which were routed through the group. What I found typical at that time was that headline issues and stories, read several months later, invariably had developed almost completely opposite of the then-breaking stories. Headlines, read 3-4 months later, often seemed ridiculous.
And so it is with the recent mortgage-originated financial debacle, thanks to Lewis' book.
First, it surprised me to relearn that Lew Ranieri's mortgage research department at Salomon was novel at the time. And that, given the prepayment option embedded in every mortgage, they had been shunned by investment banks for their unreliable duration characteristic.
Second, there had been just one CMO originated and sold before the guy who actually authored the mortgage-backed origination and trading business, Bob Dall, got the green light from Gutfreund & Co. to open for business.
Third, Salomon spent large sums on lobbyists to get Congress to enact federal legislation, overriding state laws, making it legal to issue bonds collateralized by mortgages. Further, Salomon persuaded Congress to allow government-backed mortgages to be so used. This was supremely important, because with FNMA insurance, buyers were assured that defaulted mortgages would be made good by the federal government.
Reading the evolution of the mortgage-backed business, the first time, through Lewis' telling, it's stunning to recall that from 1981-86, now approaching 30 years ago, the first mortgage boom was largely missed by First Boston (where current BlackRock CEO and founder Larry Fink was merely the head of its mortgage-backed business), Morgan Stanley, Kidder Peabody, Goldman Sachs, et. al. Most of the investment banks which did play a role poached Salomon traders in the latter years of the boom.
Fourth, the sums of money then paid to rising mortgage-backed trading superstars seems laughable now. None of the original trading wunderkinds broke $1MM in compensation for their first few years.
But perhaps the most amazing piece of history is to read Lewis' description of Salomon at its peak. With (don't laugh) a huge equity base of $3B, Salomon was unrivaled among investment banks for its scale, profits and influence. In one of the latter years of its mortgage trading dominance, Salomon's mortgage business had profits which were roughly equal to the rest of Wall Street's investment banks in total!
Here's the funniest part. I mentioned that to a friend on Friday, asking him to guess how much that profit was? He guessed, of course, in the tens of billions. In fact, at the time, around 1985-86, it was about $750-800M.
Since Lewis' book is really about himself, and not just the Salomon mortgage-backed business, it relates much of the story historically. By the time Lewis arrived as a trainee, Ranieri's operation had reached its obese, swaggering, arrogant apogee.
It took Lewis' recounting of the affair to remember how Warren Buffett became involved with Salomon, and the almost perfect parallel with his rescue of Goldman Sachs just a few years ago.
Ronald Perelman, with the backing of Drexel Burnham's Michael Milken, put Salomon into play in September, 1987. Lewis provides an extensive discussion of how Milken's junk bond empire would soon eclipse Salomon's focus on mere mortgage-backed bonds. How Salomon's corporate infighting and inept senior management allowed it to completely miss the junk bond market development until it was too late.
Also woven through the tale is Lewis' explanation of why Bill Simon was passed over for CEO of Salomon when the last family member, Billy Salomon, retired, in favor of Gutfreund, because Gutfreund sided with Billy on never taking the private partnership public. Then Gutfreund sold the firm to Phillips Brothers, a commodity giant, within just a few years. Bill Simon went on to found the LBO movement with a little deal involving Gibson Greeting Cards.
However, back to Buffett. Buffett lent Salmon a large sum to buy out most of the share that Perelman sought from then-holder Minorco, along the same lines as his recent Goldman Sachs loan- a high coupon rate and convertibility to equity at a rather attractive strike price.
That's how Buffett ended up temporarily running Salomon after the Treasury bid-rigging scandal a few years later.
There are many fascinating parallels from investment banking in the early 1980s with the runup to the financial crisis of 2007-08. But there are some important differences, too. Specifically, back in its day, Salomon managed to tower over its less-capable competitors for years as it dominated the first incarnation of the mortgage-banking market. Some twenty-five or so years later, the other investment banks had learned a thing or two, and were much quicker to jump on a developing bandwagon. As were commercial banks.
Thus the wholesale economic disaster that arrived when the federal government, led by Fannie Mae and Freddie Mac, whose involvement in mortgage-backed bonds had been engineered by Lew Ranieri back in the early 1980s, insured the bulk of mortgages, with ever-declining quality standards, which backed bonds sold to investors around the globe.
And, finally, one recalls, after (re)reading Lewis' book, that Goldman Sachs isn't the first and only investment (now commercial) bank which people love to hate. First, there was Salomon. And at the time, nobody could envision Salomon not dominating global investment banking for decades.
It's an instructive and fun reread, or, if you're too young to know of the book, first time read.
Heck, it's only August 9th. Still time to quickly step through Liar's Poker on the beach before Labor Day arrives.
A good friend had recently finished Lewis' Moneyball, the book he wrote about baseball team managements' use of key statistics to select and pay players. Somehow we got onto the subject of his first book, and I lent him my copy.
Upon his returning it to me last Thursday, I began to selectively reread it. Not being the sort of book that I reread often, I hadn't actually opened it, to my knowledge, in 22 years. Thus, many of the passages were quite surprising.
To give some perspective regarding some of what I recalled, thanks to the aid of Lewis' book, let me recount a story from my business youth. Back when I was in Corporate Planning at Chase Manhattan Bank, troubleshooting businesses as one of a few elite internal consultants working for Gerry Weiss, I would often be immersed in a project for months. After its completion, I'd tackle the mountain of BusinessWeeks, Fortunes and Forbes magazines which were routed through the group. What I found typical at that time was that headline issues and stories, read several months later, invariably had developed almost completely opposite of the then-breaking stories. Headlines, read 3-4 months later, often seemed ridiculous.
And so it is with the recent mortgage-originated financial debacle, thanks to Lewis' book.
First, it surprised me to relearn that Lew Ranieri's mortgage research department at Salomon was novel at the time. And that, given the prepayment option embedded in every mortgage, they had been shunned by investment banks for their unreliable duration characteristic.
Second, there had been just one CMO originated and sold before the guy who actually authored the mortgage-backed origination and trading business, Bob Dall, got the green light from Gutfreund & Co. to open for business.
Third, Salomon spent large sums on lobbyists to get Congress to enact federal legislation, overriding state laws, making it legal to issue bonds collateralized by mortgages. Further, Salomon persuaded Congress to allow government-backed mortgages to be so used. This was supremely important, because with FNMA insurance, buyers were assured that defaulted mortgages would be made good by the federal government.
Reading the evolution of the mortgage-backed business, the first time, through Lewis' telling, it's stunning to recall that from 1981-86, now approaching 30 years ago, the first mortgage boom was largely missed by First Boston (where current BlackRock CEO and founder Larry Fink was merely the head of its mortgage-backed business), Morgan Stanley, Kidder Peabody, Goldman Sachs, et. al. Most of the investment banks which did play a role poached Salomon traders in the latter years of the boom.
Fourth, the sums of money then paid to rising mortgage-backed trading superstars seems laughable now. None of the original trading wunderkinds broke $1MM in compensation for their first few years.
But perhaps the most amazing piece of history is to read Lewis' description of Salomon at its peak. With (don't laugh) a huge equity base of $3B, Salomon was unrivaled among investment banks for its scale, profits and influence. In one of the latter years of its mortgage trading dominance, Salomon's mortgage business had profits which were roughly equal to the rest of Wall Street's investment banks in total!
Here's the funniest part. I mentioned that to a friend on Friday, asking him to guess how much that profit was? He guessed, of course, in the tens of billions. In fact, at the time, around 1985-86, it was about $750-800M.
Since Lewis' book is really about himself, and not just the Salomon mortgage-backed business, it relates much of the story historically. By the time Lewis arrived as a trainee, Ranieri's operation had reached its obese, swaggering, arrogant apogee.
It took Lewis' recounting of the affair to remember how Warren Buffett became involved with Salomon, and the almost perfect parallel with his rescue of Goldman Sachs just a few years ago.
Ronald Perelman, with the backing of Drexel Burnham's Michael Milken, put Salomon into play in September, 1987. Lewis provides an extensive discussion of how Milken's junk bond empire would soon eclipse Salomon's focus on mere mortgage-backed bonds. How Salomon's corporate infighting and inept senior management allowed it to completely miss the junk bond market development until it was too late.
Also woven through the tale is Lewis' explanation of why Bill Simon was passed over for CEO of Salomon when the last family member, Billy Salomon, retired, in favor of Gutfreund, because Gutfreund sided with Billy on never taking the private partnership public. Then Gutfreund sold the firm to Phillips Brothers, a commodity giant, within just a few years. Bill Simon went on to found the LBO movement with a little deal involving Gibson Greeting Cards.
However, back to Buffett. Buffett lent Salmon a large sum to buy out most of the share that Perelman sought from then-holder Minorco, along the same lines as his recent Goldman Sachs loan- a high coupon rate and convertibility to equity at a rather attractive strike price.
That's how Buffett ended up temporarily running Salomon after the Treasury bid-rigging scandal a few years later.
There are many fascinating parallels from investment banking in the early 1980s with the runup to the financial crisis of 2007-08. But there are some important differences, too. Specifically, back in its day, Salomon managed to tower over its less-capable competitors for years as it dominated the first incarnation of the mortgage-banking market. Some twenty-five or so years later, the other investment banks had learned a thing or two, and were much quicker to jump on a developing bandwagon. As were commercial banks.
Thus the wholesale economic disaster that arrived when the federal government, led by Fannie Mae and Freddie Mac, whose involvement in mortgage-backed bonds had been engineered by Lew Ranieri back in the early 1980s, insured the bulk of mortgages, with ever-declining quality standards, which backed bonds sold to investors around the globe.
And, finally, one recalls, after (re)reading Lewis' book, that Goldman Sachs isn't the first and only investment (now commercial) bank which people love to hate. First, there was Salomon. And at the time, nobody could envision Salomon not dominating global investment banking for decades.
It's an instructive and fun reread, or, if you're too young to know of the book, first time read.
Heck, it's only August 9th. Still time to quickly step through Liar's Poker on the beach before Labor Day arrives.
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