Confessions Of A Hedge Fund Manager Redux

n + 1 has a published a sequel to their much-beloved-by-us anonymous interview with a hedge fund manager. In this episode, HFM explains what went wrong with Bear Stearns:

n+1: So can you tell me what happened with Bear Stearns? What were the steps?

HFM: Bear was a bank that was very involved in the asset-backed and sub-prime market. Both as a principal and as an agent.

What happened this summer was funds managed by Bear Stearns–not things on their own books, other people’s funds that they manage, other people’s capital–those funds were heavily leveraged and invested in asset-backed securities. Those funds blew up–they went into uncontrolled combustion. They failed very quickly. One day they were there, the next all the assets were marked down, then they were insolvent and folded up. Now that’s not Bear Stearns’ capital, but there were guys sitting in the Bear Stearns office.

n+1: Which is where?

HFM: On, uh, 47th and Madison. Just down the street.

n+1: And they were sitting there; they had a little hedge fund–

HFM: Which means they raised money form outside investors–they get paid based on how the fund does, they get a percentage of the profits. And they traded in sub-prime assets where the capital was given to them by outside investors.

n+1: These were 10 guys?

HFM: I don’t know the size of the team, but they were sitting there, buying asset-backed securities backed by sub-prime mortgages, they were borrowing a lot of money, they used the capital they had, they borrowed outside money, they bought sub-prime mortgages. They were highly, highly leveraged. 50:1 leverage.

n+1: Why was Bear Stearns in particular doing this?

HFM: Bear Stearns supposedly had an expertise in sub-prime and asset-backed securities; it is an expertise of theirs. They’re still alive.

n+1: Really?

HFM: You know when somebody falls off a motorcycle, and they want to harvest their organs, they’re still alive until they harvest the organs. Right now Bear Stearns, there’s an EKG, it is pinging, they’re technically still alive and JPMorgan is waiting for the healthcare proxy to sign and say they can start harvesting the organs. This is where Bear is right now. They had an expertise.

n+1: So it was 100 billion dollars? How much money?

HFM: I don’t know. It was not huge. 1-2 billion dollars each. In that range. Which doesn’t make them huge funds. Modest funds.

But from that moment forth, people on the market speculated as to how many similar kinds of assets Bear Stearns must own on its own books. There was a cloud of suspicion over Bear Stearns. As it turns out, I don’t know that they were in that much trouble. They were probably much more careful with their own money than outside money, but once there’s a cloud of suspicion the information asymmetry that exists between people outside the firm who don’t know what’s going on, and inside the firm, can create a crisis of confidence.

n+1: Can’t the firm say, “Look, we have this, we have that…”?

HFM: What are they going to do, are they going to show you every instrument they have on their books? People don’t know what these instruments are worth. Like an asset-backed bond–what’s it worth? Nobody knows what’s it worth, there isn’t a market for this anymore. It’s not like there are three bond issues, and that’s it, there are thousands, and each one is backed by thousands of mortgages, it just becomes an information-processing problem. You simply can’t prove to me in a reasonable amount of time that everything’s fine.

n+1: They don’t have other instruments besides mortgages?

HFM: They do, they have their building, that’s one of the things that is probably worth the most. But Bear was involved in a lot of the asset classes that had problems. First it’s sub-prime mortgages, then it’s leveraged loans–they’re exposed to all these things, 30 times levered, so a very small diminution of the value of these assets could mean that their equity is worth nothing. And it’s just going to be impossible for these guys to prove to everyone’s satisfaction in a short period of time with a high degree of precision that their assets are worth what they say they’re worth. There’s been a cloud over Bear Stearns for 8 months and in retrospect people were critical of their management for being insufficiently aggressive in trying to persuade people that everything was fine. They simply asserted that everything was fine.

And the question everyone is wondering:

n+1: Wouldn’t it have been better to let them go bankrupt?

HFM: And let their counterparties face the music? Maybe, but the parlous condition of the financial system as a whole I think persuaded the Fed that this is not the time to experiment and see how interconnected the system has become.

If we were in a calm economic environment and Bear, for non-systematic reasons, failed–say they put all their money into cheesesandwich.com or something, and they failed for that reason, then it might be appropriate to let them go bankrupt because the rest of the financial system would be stable. Even if it inflicts losses on the rest of the financial system and causes a lot of brain damage for me, it won’t be a risk to the system as a whole.

But every bank out there to some degree or another is suffering the same problems that led to the cloud of suspicion over Bear. So this is not a great time to test a proposition that the financial system can cope with disorderly unwinding of all these contracts.

Lots more good stuff over there.

Financial Meltdown [n+ 1]
(Photo:Getty)

Comments

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  1. DevPts says:

    The fix, then, is to eliminate the fractional reserve funding policies and revoke the charter of the Federal Reserve. Put the power to coin moneys and to set the value thereof back into the hands of the people as intended in the Constitution.

    Anyone ever truly wonder why such a thing as a ‘run on the bank’ could ever actually cause a bank to collapse? Simple. They do not keep enough assets to actually back their securities. They are allowed to loan out, at interest, many times the book value of the fiscal assets.

  2. KCJMAC says:

    Note to self: start selling shares of cheesesandwich.com before word gets out…

  3. Trai_Dep says:

    I wish the followup questions could have been, “Considering that large swaths of reasonable people thought this was unsustainable, why didn’t either BS or other entities pull out, require lower leverage amounts, etc., to mitigate the inevitable explosion? What measures would prevent these vastly overpaid Kool-aid sippers from destroying the next sector of the global economy?”

    Just so I could hear the guy chuckle, roast another baby to perfection, rend its flesh and devour it, washing it down with a $4,000 bottle of claret.

  4. Trai_Dep says:

    @DevPts: That’s silly talk. Take a basic Economics class at your local college and get back to us?

  5. laserjobs says:

    BINGO!!!

    Term of the Year: Counterparty Risk

  6. B says:

    @DevPts: Ron Paul, is that you?

  7. Just hen I think I’ve got a grip on economics, I read stuff like this and I’ve got 8 tabs on my browser running cross references to dissect all this…I need a new hobby

  8. dammit….when*

  9. AtomikB says:

    @Trai_Dep: Silly talk? Can you put a little more effort into your ad-hominem rebuttal?

    Fractional reserve banking is a wonderful tool for banks who want to increase their profits (i.e., all banks, obviously). The more capital you control, the more you have to gain by weaker reserve requirements. The inverse is also true, which is why the less wealthy among us have failed to benefit from the progressively looser reserve restrictions over the past 100 years. Low reserve requirements are what allow the kind of leveraging that contributed to this economic crisis, the dot com bust, the S&L crisis of the 80’s… Shall I go on? Any community college economics course will be using a textbook from the 90’s, which is nothing but a 1000-page tribute to the modern banking system. So yes, fractional reserve banking is the status quo… And no, our current system isn’t necessarily the best or only option if our goal is a stable, transparent economy.

  10. B says:

    @AtomikB: Fractional reserve banking has allowed people to purchase homes, cars, educations. Things they couldn’t afford without the ability to borrow money.

  11. Wormfather says:

    @DevPts: While aggree with the second part of your comment, giving the power to make money back to the people means giving it back to the legislature. I for one am completly opposed to that. Now on the other hand the Fed needs to be reigned in a bit. They created all this mess when they lowered interest rates like crazy after the .com bubble they set an ugly precident. Now it’s killing us because the Euro is a formidable opponent and while the banks are surviving the rate of inflation is going through the roof.

    I havnt lost my job buy my paycheck is comming up shorter and shorter. You can blame the oil companies for the skyrocketing oil/gas prices but the real culprit is the Fed. Oil/Gas is closly related to the dollar, if the value of the dollar goes down, the price of oil/gas/petrolium is going to go up.

    Let the market work out its own problems. It is not in the best interest of the American people for these large firms to keep a nice share price when compared to the average american’s inability to make ends meet due to the cost of imported goods. Hell previously, when the dollar was weak, investers from abroad swooped in for a bargin, but outside a few select people/companies, no one wants to touch our economy right now.

    Sorry for droning on.

  12. stinkydonkey says:

    I know I’d invest in cheesesandwich.com, those things are totally delish…

  13. Wormfather says:

    Oh and before anyone says anything, Ayn Rand would be flipping out today if she could see how the government manipulates the market.

    Companies that make inferior products should suffer and or fade away. Bear Sterns made bad choices, they cant cover the call, they should be bankrupt.

    I mean fuck, these rate cuts arnt even making they’re way to the subprime borrowers (dont get me wrong, I feel no sypmathy, but if I’m going to have to pay for rate cuts via inflation then at least get it to the people who need them most). The banks are using the cheap money to bolster their bank sheets which is NOT going to fix the problem as a whole, when 3 houses on a block of 10 forclose then everyone on the block suffers. What’s happening here is the banks are building capital for they’re next big mistake.

    THE OIL BUBBLE!

  14. savvy9999 says:

    @Wormfather: Before anyone says anything, I would be flipping out if I saw Ayn Rand today.

    I’d kick her in the nuts for even dreaming up objectivism, to which (via loving addict Al Greenspan) we largely owe this crappy mess we’re in.

    Take the money and run is a fine way to manage the economics of the USA.

  15. bohemian says:

    I like the idea I heard a couple of places last week. The fed needs to have better accountability on anyone who comes asking to borrow from the fed in the first place. It was something to do with requiring banks and other financial entities to show their books in detail before the fed would float them money.
    Supposedly this would help prevent more money getting sucked into really bad ideas like these sub prime packages of loans being resold as investments.

    I think I have finally hit max density in dealing with the farked up economy and the war on a daily basis. I listened to part of the congressional testimony yesterday and just had to turn it off when the ambassador for reconstruction couldn’t give anyone a straight answer. I’m getting tired of all of this and I just want if fixed like yesterday.

  16. landsnark says:

    “So this is not a great time to test a proposition that the financial system can cope with disorderly unwinding of all these contracts.”

    Hedge fund managers will never think it is a “great time” to face the obvious, predictable consequences of their actions. They will always have an excuse about why the Fed or someone needs to bail out their latest screw-up, and the worse they screw up, the more compelling their argument will be.

    I just love how these same hedge fund managers who pray at the altar of the free market immediately change their tune and demand a gov’t bailout when they screw up.

    God, these guys piss me off.

  17. jeff303 says:

    @Wormfather: Thank you for the Rand observation – very accurate and appropriate. Also some people argue that a good “intermediate” step to getting rid of the Fed is to leave the prime rate to the market. They can still issue and repurchase bonds to influence liquidity but they cannot simply set the rate.

  18. jeff303 says:

    @savvy9999: You might want to do a bit of research before spouting off about the relationship between Greenspan and Rand. It’s not what you think. [www.aynrand.org]

  19. guymandude says:

    @AtomikB: This is Keynsian rubbish. Perhaps then you’ll be kind enough to explain what “margin call” means? Let me help you out. For the sake of computational simplicity let’s assume the reserve requirement (RR) is 10%. You come into my bank. I’m a member bank so my reserve requirement is 10%. You deposit 1000$. That means I stash 100$ in the vault and loan out 900$. Cletus takes that 900$ and deposits it in his bank. It too is a member bank with a 10% RR. That bank takes 90$ and puts it in the vault and loans out the other 810$. Can you see that @ the end of the day that initial 1000$ deposit represents over 20,000$ on the books of various member banks. So when the margin call comes (as it did) where does all the money to pay back those loans come from Mr. Smart guy? Also fiat currency is back by *CREDIT*. That means the Fed has debased our money simply by printing more of it. Commodity currency can’t be debased because you can’t just print it up. Maybe you should take your own advice and actually read up on the history of economics instead of stupidly thinking a community college text book could capture the essence of this problem. If that were so we’d all be billionaire brokers.

  20. sleze69 says:

    @savvy9999: I would kick Ayn Rand in the nuts too. Not because I disagree with Atlas Shrugged’s message…but because it’s about 500 pages too long.

    I can’t wait until it goes into public domain and someone actually edits it and removes the Charles Dickenslike penny-per-word nonsense that serves as filler between her political/economic messages.

  21. @AtomikB: “Any community college economics course will be using a textbook from the 90’s”

    Oh please. The publishers don’t let us do that. Most of my students pay more in textbooks than they do in tuition. All the textbooks are up-to-the-minute or the publishers start cancelling contracts.

  22. mac-phisto says:

    this is why i would never make it anywhere near the street. i understand how leveraging works, but to take the same capital fund & borrow against it 30, 40, 50x – at some point you would expect someone to take a step back before things get this far.

    i mean, everyone gets carried away when the dice are hot, but the smart bettor always starts the draw down when the shooter gets choppy or the table goes cold instead of waiting for the miss.

  23. huadpe says:

    @guymandude: See, they’ve lent out $10,000 in your example, ($20,000 is not correct, with a 10% RR, you get a 10x money multiplier). But, what you fail to mention is that those loans are assets. Most of them will be paid back. If capital markets are working properly, a bank which has a run can go to Wall St. and say “I’ll give you these loans in exchange for some cash on the spot,” and then they can cover all of their deposits.

    The problem in the subprime crunch is that the guys on wall st. won’t take subprime backed loans at ANY price until they sort out how many will fail. It’s not even a huge problem if they get written down by 10%, but because there’s too much uncertainty, they’ve been written down 100%, even though alot of people WILL pay their mortgages.

    Also, the money multiplier is in practice around 2x, and it only affects new money. So only when the fed prints money will the multiplier happen.

    As for putting the printing of money in the hands of congress, I shudder to think of the inflation as they try to pump up the economy before the next election.

  24. Techguy1138 says:

    @DevPts: I guess I’m in the minority by agreeing partly with you.

    By allowing fractional reserve lending at such a high rate the congress of the people no longer has control of the economy. It is necessary to have fractional reserve spending but it needs to be a MUCH lower ratio. It is obvious from this mess that banks will use it to inflate their portfolios without thought of the implications.

    The Fed also seems to be vastly overstepping it’s mandate and is now dictating national economic policy. It really seems like an executive or legislative branch committee should be overseeing the broad deals that are now being made. The long term implications are huge.

  25. Wormfather says:

    @sleze69: I loved atlas shrugged, I loved Francisco’s d’Anconia’s speak in the part 1, I loved pretty much all of part II and part II. When I read the title of the chapter “This is John Galt Speaking” I squeeled (sp?) like a pig…70 mother f*cking pages later, (yes 70 pages of one person speaking) I put bandages on my eyes to stop the bleeding.

  26. Wormfather says:

    @sleze69: oh and it was well over 1,000 pages long, like 1,356 if I remember correctly.

  27. sleze69 says:

    @Wormfather: Fransisco’s speech about money was very good. But Christ, I found myself skipping paragraphs looking for someone to reach to him.

    Like I said. Cut 500 pages and reduce the labor it takes to enjoy the book.

  28. sleze69 says:

    “to reach him”

    I meant to say “to respond to him”.

  29. Silversmok3 says:

    A good read. It illustrates that Bear Stears was a modern-day bank run-and just like the 1932 runs, it was motivated by irrationality and distrust,not because of solid information.

    As soon as that one fund went under,investors started pulling their funds en-masse. Thus leading to more losses, then more investors then pull out, and so forth.

    And I , for one, and glad the Fed bailed them out. Why?
    Cause , like the 1932 bank run, if Bear had been allowed to crash, it would have led to a run on this bank, then that bank, and would have spread until it hit the big guys like Citibank, Chase, and so forth. Then Joe Blow’s paycheck and savings/investments would have been wiped out.

    Then the Fed would STILL have to make a Bailout.
    The bottom line is , the economy is too interconnected to just let banks fail without serious problems.

  30. Mr. Gunn says:

    Reading those confessions really illustrates the information gap between the average person here and the people directly involved.

    I like the part where he pointed out that the “bailout” of BS wasn’t really a bailout at all, because if it was, people would have gotten their money back, instead of losing 90% of it. I also liked how he pointed out the role of the investors in inflating the subprime bubble. People here love to blame the people taking out the loans, and certainly they’re at fault too, but how many of you had subprime exposure, i.e. helped inflate the bubble, that you didn’t even know about? *raises hand*

    I also liked his conspiracy theory about how the whole $2/$10 offer scenario came to pass, and how quantitative finance is like an ecosystem lacking any genetic diversity, since it all goes back to the ideas of a handful of guys in the ’70s.

    Overall, a fascinating story which really shows how much we don’t know about what goes on in the upper reaches of finance.

  31. iMe2 says:

    It’s interesting this has taken on a debate about the Fed’s actions, as opposed to the inaction of Congress to regulate investment banks’ risky forays into exotic markets. I think the real question is should Bear have been allowed to leverage itself so heavily, regardless of how much money they were making? Since this did warrant Fed intervention, the fair answer is “NO.”

    @Silversmok3: A rational person would leave their money in Bear/ a Depression-era bank while it’s being run on?

  32. Canoehead says:

    While philosophically, I hate government intervention and bailouts, you don’t want the cure to be worse than the disease. At the end of the day, Bear shareholders lost a ton (especially employees who were paid a large part of their compensation in stock) and one of the great Wall Street Investment Banks has basically lost its name and the management team will forever be known on the street as the guys who sunk it. On the other hand, if Bear had formally gone under, its depositors would have had to be paid out by SIPIC and all of the stocks and ADRs for which Bear acts as marketmaker would have had huge problems, hurting those companies and their investors even though they did nothing wrong – that’s a pretty high price to pay to teach the street a lesson.

  33. stinerman says:

    If letting Stearns fail and letting the chips fall where they may was a bad idea because the entire financial system was dependent on unregulated investment banks…then we have a problem.

    This recent bailout will eliminate any moral hazard associated with these unregulated banks. We’ve all heard the “funds not insured” spiel on the commercials for these places. Apparently the funds are insured so long as the customers all make really stupid decisions.

    With all of the profit still private, but the risk being shouldered by Uncle Sam, I don’t see why we should keep our money in regulated banks.

    @Canoehead:

    It’s a high price to pay, but it act as a disincentive to engage in this behavior again. Now that Stearns has been bailed out, if a similar situation arises, everyone will expect the same deal, which only encourages it to happen again.

  34. pal003 says:

    For years and years we keep bailing out these banks and investment firms Silverado (Bush brother Neil), Lincoln S&L (Keating), then we keep deregulating banking and investment, which is how these fake-money derivatives were created. They refuse to be regulated but we have to keep bailing them out.

    And then there was the hedge fund Long Term Capital which I remember Bear Stearns refused to be part of their bail out. So Bear Stearns better not come back to life after this, because this deal is pretty shady and secretive, and there is a theory that Bear Stearns may not have to be completely folded under JP Morgan.

    As for the Fed – thanks for the tanking dollar!

  35. guymandude says:

    @huadpe: Sorry… that was a slip. It was supposed to be 10K. But I do not find your rebuttle credible. Not all loans are secured by collateral and calling a loan an asset when it is a liability is just lawyerly double talk. A loan is a liability or else you wouldn’t need to put up something to borrow against. Also, collaterals value varies with the market. If I have a brand new Lincoln town car is that collateral worth anything in 5 years? So there is a public perception involved. So there isn’t any such a thing as an objective value on that. Also you say that “If capital markets are working properly…” things would be ok. Are they operating properly right now?
    Now… if the Fed puts bills into circulation don’t they debase the value of the currency unless they can find a way to get that money back out of circulation? What is it called when you have a disproportionate amount of money in circulation relative to the performance and consideration it can buy? If there are more dollars than goods and services that is basically inflation by definition.
    As for putting the money in the hands of congress… the constitution says that is exactly what needs to happen and the Federal Reserve board of Governors can’t be voted out of office if they screw up. The united states was an international creditor unitl the federal reserve act of 1913(or was it 1916?). Ever since we have been in international debt. Care to explain how it has benefited the country?

  36. Snarkysnake says:

    @AtomikB:

    Time to change the tinfoil in your hat.

    Ever heard of the panic(s) of ’33 , ’47 ,’ 57 , ’73, ’93 ?

    Those,of course were 1833 , 1847 etc. The fucking 19th century when your beloved money WAS gold coin.(And people in America were dirt poor by todays standards)It doesn’t matter what you are calling “money” at any given moment.What matters is the way human nature ALWAYS causes borrowers to get overextended at some point.When that happens, the Federal reserve that you despise so much can be another source of liquidity to keep things from going boom all at once. Do I like bailing out the asshats that engineered this mess ? Fuck,no. But the alternative is even worse. If you ever get your precious gold standard back,I hope that I won’t be around to see it.If you think that bankers and financial types have too much power now,just wait until J.P. Morgan -types have all (or most) of the gold under their control. That’s when your ilk will start a movement to undo the shitstorm that you created.

    For God’s sake ,think for yourself instead of spouting all of this nonsense…

  37. TonyTriple says:

    @huadpe:
    so, uh… the blurns are loaded and it’s the bottom of the blurn? The count is 3 blurns and 2 anti-blurns and the infield blurn rule is in effect?

    My head spins…

  38. civicmon says:

    Good article, but this stuff isn’t difficult to understand. Just need a basic understanding of declaring bond income on a balance sheet and an even smaller understanding of how assets are valued: Solely by what people will pony up for the asset.

    Obviously, they weren’t able to sell their bonds or get their loans paid off…. bad combo there.

    Good stuff on Bear Stearns. They were begging their best clients to go on TV and stand up for them on the Thursday before the bailout. I’m not sure the Fed should have facilitated the bailout but now that’s neither here nor there.

  39. mac-phisto says:

    @guymandude: actually, you have it a little backward. loans are assets on bank books & deposits are liabilities.

    but a lot of these investments were “off the books” anyway, so talking about whether a loan is an asset or a liability is kind of pointless.

  40. Wormfather says:

    @sleze69:

    I loved that speach because the phrase “money is the root of evil” was a phrase I heard all my life, I never felt that way and that whole speach validated my feelings about money being good and such.

    “When money ceases to be the tool by which men deal with one another, then men become the tools of men. Blood, whips and guns–or dollars. Take your choice–there is no other–and your time is running out.”

    So true.

  41. AtomikB says:

    @Snarkysnake: Whoa there tiger, who’s talking about the gold standard? Did you read those words somewhere on this page? I only see them in YOUR post.

    To get back on the subject at hand, crises like this are endemic to the modern financial system, and will continue to be so until the system is reformed. I don’t think returning to the financial system of the 20th or 19th centuries is very practicable at this point, nor would that constitute a “reform”.

  42. mac-phisto says:

    @AtomikB: what exactly is your solution then? it’s easy to point at this specific event in time & say “things aren’t working”, but is that an accurate statement?

    as for fractional reserves – i don’t think this is the issue so much as the size of the institutions in question. the impact of a bank failure at a single top 10 BHC would be greater than the impact of 1000 small banks failing (<$200 million in assets). the top 10 BHCs boast a combined asset size of almost $8.6 trillion ( [www.ffiec.gov] ), with the 3 largest BHCs boasting more than half of that ($5.4 trillion total) – $2.2 trillion (citi), $1.7 trillion (bac) & $1.5 trillion (jpm) in assets respectively. for a little perspective, compare that to a federal budget of $2.7 trillion for FY2007.

    why are we allowing these institutions to grow as large as they have? consider this article from 17 years ago: [www.iht.com]

    banks have been on a buying binge for almost two decades, creating massive wealth for investors & the economy as a whole. but what happens when the steam runs out? banks fail. & the more bloated they are, the more it will hurt in the end. banking regulators should have realized this before approving mergers that displaced wealth & power within the banking industry & concentrated it almost entirely in pier 1 banks (assets over $10 billion).

    stop approving large mergers, start breaking up large banks (or tax the piss out of them to force them to start selling down to a more acceptable size). that’s my solution.

  43. MCShortbus says:

    The core of the problem is this: These people want a laisez-faire system but don’t want to deal with the consequences. They have the money and the influence, the people don’t. They get what they want and we get the shaft. Yipee!