Thursday, September 18, 2008

A Hard Rain



A Hard Rain

It’s not a-gonna fall, it fell in sheets over the last few days. What a spectacle over the weekend on Wall Street as golf games were canceled all across Greenwich and town cars crowded the streets outside the once imposing towers of capital. I just spoke to my old college roommate over at Lehman, who described the scene. He said that he entered work this morning through a gauntlet of reporters, and that most employees did actually show for work. The place is very, very quiet. Some minimal trading is being allowed, mostly to wind down positions. People are quietly speaking on their cell phones, trying to figure out their next moves. Most won’t have one. Whatever jobs there were on Wall Street were taken by people from Bear. Ironically, screwing up first turned out to be an advantage.

Ok, so maybe his call was a little early…

How horribly wrong things have gone. Personally, I normally pay the doomsayers little heed; as a matter of probability they are almost always wrong. The key word here is almost, because this time they got it right. As I watch AIG shares falling 40% this morning, it is clear this is no longer contained to the housing market or Wall Street.

Having said this, the pain is going to be felt much more acutely on Wall Street than Main Street, at least for now. Unlike the dot com bubble, the wrath of which was felt by speculators everywhere, this one is a direct hit on the New York tri-state area. Let’s look at just four companies, all based in Manhattan, and look at the amount of wealth that has been destroyed:

A hard rain, indeed. Consider that large percentages of the above losses were taken by employees of the firms. It was standard practice, particularly at Lehman, to award much of compensation in restricted stock, locked up for as long as five years, and as a matter of course most hold on to their stock even after they didn’t have to. That is – was - the culture. If this sounds familiar, it should, because Enron employees did much the same thing, although the scope of this is considerably larger. The tax base in the tri-state area is about to go to hell, as is the real estate market. Oh, I forgot that already went to hell. Well, it’s going there again.

I have been pondering Wall Street’s problems for some time. On one level, it’s a complicated thicket. On another, it’s not. It seems to me that the entire mess boils down to two issues: leverage and “other people’s money.” Perhaps you remember an historical survey I did recently on hedge fund blow-ups. The conclusion was that once you accounted for the small number of frauds, the rest blew themselves up with too much leverage. The story is no different with firms like Bear and Lehman. Both were levered about 30-1. A 3% move against you and - poof! - your capital’s gone. It’s not complicated.

One of the principle causes of the Crash of 1929 was equity leverage. Back then, you could borrow 9 dollars for every dollar of equity. This was rectified later by Regulation T, which limits borrowing to 1-1. The problem is, there’s never been any similar cap on leverage in the credit area. You might remember that last January I wrote that a real problem in 2008 would likely be something known as the “credit default swap.” The CDS market has grown from zero to $44 trillion in about a decade. It is loaded with counter party risk and unfettered leverage. That market is coming home to roost, particularly with the issues at AIG, which was a big factor in the CDS market. (Incidentally, where Lehman is concerned, I don’t think the systemic risk is large. My understanding is that people have been reducing their counter party risk with Lehman for months.)

I am no fan of increased regulation, but there need to be reasonable limits on credit leverage, whether it’s mortgages, credit default swaps, or fixed income arbitrage books. Some sort of macro, top-down regulation is vital. What I’d hate to see is the sort of overly wrought, intrusive regulation often written by clumsy politicians in times of crisis.

The other issue at the heart of this is “OPM,” – Other People’s Money. Simply, you’re not as careful with it as you are with your own. Imagine you are a trader at Merrill Lynch. Merrill has allocated a certain amount of capital for you to manage, none of which belongs to you, or for that matter, the managers who allocated it. It belongs to Merrill Lynch shareholders. How will you invest the money? Prudently? The problem is, your interests and Merrill shareholder interests are totally different. There is a well-travelled path that makes you rich in the short-run and Merrill shareholders poor in the long-run.

Any number of strategies will do. I have written about this in the past. Typically, you might choose some “risk averse” arbitrage strategy and then apply gobs of leverage. The resulting flight path is, statistically, several years of robust profits followed by a crack-up. You, the trader, get a big chuck of the profits during the fat years but lose nothing when things hit the wall.

Now take this model of a single trader and imagine it’s a whole investment bank and you have some idea of what’s been going on. This never happened in the days of private partnerships because it was partner money. Billy Salomon would have come down to your desk and fired your ass. Unfortunately, we can’t go back to the private partnership model because the capital demands of the global financial marketplace are too great. Someone smarter than I will have to come up with a working model for the 21st century. But OPM and easy credit have proven a toxic cocktail.

Is there any silver lining? Perhaps. For one, there are still deep pockets of liquidity in the world, particularly in the sovereign wealth funds. Back in the 70s, the last really long funk for the U.S. economy, no one had two nickels to rub together, and no one had ever heard of sovereign wealth funds. (Note of discomfort: all this liquidity is in the hands of foreigners, so expect them to keep buying up choice U.S. assets.) Second, people sometimes forget that the housing market, the source of all our misery, has built in support that no other market enjoys: 300 million people have to live somewhere. No one has to own stocks. That doesn’t mean we’re done, it’s just means that there’s a natural floor somewhere.

For the hedge fund industry, it looks like this could be the worst year on the books, although not catastrophic, by any means. I would argue that 2008 is a great argument for hedge fund investing because in the middle of the biggest financial crisis in decades they have managed to preserve capital, at least for the most part. Few alternatives have come close.

The pain this year is in the drip, drip, drip. The last really bad year for hedge fund was 1998 when the industry lost about 5%. This loss was due entirely to a very sudden drawdown in one month when Long Term Capital roiled markets. The slower, drawn out losses are in many respects harder for investors to take.

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