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A Hedge Fund Manager Talks Candidly About the Financial Crisis

Date: Monday, July 5, 2010
Author: Matt Phillips, The Wall Street Journal

Over at MarketBeat, we’ve got a theory on what caused the great financial crisis of 2007-09. It wasn’t just excess leverage, subprime housing hysteria or computer models gone wild. It was — on its most basic level — a failure to speak clearly.

Remember credit default swaps? We all know what those are now. So why did we invent an obscure sounding acronym like CDS? Because if it was called what it essentially is — insurance — it’d need to be regulated like insurance.

Jargon has proven incredibly expensive to U.S. taxpayers. We were reminded of this pet theory of ours while tearing through “Diary of a Very Bad Year: Confessions of an Anonymous Hedge Fund Manager,” a series of interviews between a nameless hedgie, referred to as HFM, and an admittedly ill-informed inquisitor, who originally transcribed and published the interviews as part of the literary magazine n+1. The interviews took place as the fabric of the financial system was stretched to the brink from late September 2007 to summer 2009.

Presented Q&A style, the book is a highly readable refresher on the financial crisis. But beyond that it’s a fine piece of financial journalism, in which the interviewer fearlessly asks the “dumb questions” that many — and this goes for regulators and those inside major financial institutions — failed to ask in the run-up to the debacle. Amazingly — and largely because of the anonymity he’s granted — the nameless hedgie gives straight answers. Take this interchange on compensation system in the financial world before the blow-up:

HFM: The pay scale for finance was just — incredibly out of whack. You had guys who were literally a couple of years out of college maybe they’d done a year or two at an investment bank, making several hundred thousand dollars a year doing pretty low-value-added Excel modeling tasks.

n+1: What does that mean?

HFM: They do financial models on Excel.

n+1: I know Excel.

HFM also does an amazing job of clearly explaining how out of whack the debt markets got during the height of financial euphoria. It was a classic case of the tail wagging the dog. Demand for high-yielding debt — supposedly safe and rated AAA by the ratings agencies — began to drive the creation of mortgages.

HFM: They said, “Oh well, I have money, okay, I want to earn more with it, what should I do? Oh well, you know, I can buy this asset-backed paper that’s rated triple-A and get a nice yield on it.” Well, what’s the other side of that? The other side of it is that somebody says, “I gotta make that. There’s a bid for this paper, I need to manufacture it. What do I do? I need to go out and make loans. I originate loans. I turn that very notional asset, that promise, somebody’s promise to pay you in a long time, into real assets.” So the person promises to pay; that creates money. That money is used to pay somebody to build a house. So effectively it turns into a house.

The book isn’t all wonky, big picture financial system talk. It also zeroes in on the day-to-day hassles and less-than-glamorous details of life as a hedge fund manager. Some of the more interesting involve the “extrajudicial pressure” hedgies bring to bear to get deadbeat borrowers to pay up.

n+1: How do you do it?

HFM: Sometimes it’s planting articles in the press. We obviously talk to journalists a lot, and they love to hear stories about financially struggling companies. Sometimes it’s PR that relates to shareholders: it’s embarrassing for controlling shareholders of a company to have it be known that they are not able to pay their debts. It affects the ability of their other companies to borrow because there’s like a whiff of doubt. Sometimes it’s dealing with their customers or buyers and letting them know that we’re going to be able to create legal problems, maybe outside the local jurisdiction, in terms of the ability to import. Maybe shipments will get seized or payments will get seized.

n+1: You tell the customers?

HFM: I call them up. We know who their customers are, and their customers aren’t individuals, they’re other companies, so we can talk to them and say, “You better be careful — these guys have stiffed us and apparently there are deeper problems. We’re pursuing all the legal remedies we can and maybe that’s going to interfere with your ability to get paid by them.”

n+1: That’s not very nice.

HFM: Well, it’s not very nice to borrow money from people and not pay when you really can.

Don’t get the wrong impression from that last passage. While HFM comes off as a bro you don’t want to mess with, the book is packed with plenty of humor. In one instance, after explaining how he was in Argentina for the 2000 financial collapse and witnessing Argentines standing in front of shuttered banks protesting by banging on pots and pans, HFM turns his attention to one of the dicier moments of the financial crisis. That was when a famous money-market fund — the Reserve Primary Fund — broke the buck, meaning investors would take a loss on their supposedly super-safe and stable money-market accounts.

HFM: A money market fund, like a bank, is not run on the assumption that everyone will want their money  back on the same day. Then the Reserve Primary Fund has to say, “We’re suspending redemptions, we have to wait for what we own to mature,” and that freaks people ou

n+1: They’re standing with pots and pans …

HFM: Well, in financial centers like New York the average person doesn’t cook that much. They get takeout. I don’t know if they have pots and pans.

n+1: They can bang their Chinese take-out boxes.

HFM: Yes, their Chinese menus. Or the extra chopsticks that they accumulate.

Matt Phillips is a reporter for the Money & Investing section of The Wall Street Journal. He’s the lead writer on MarketBeat, a blog focusing on financial markets.