I traded mortgages and mortgage derivatives before, during and after the GFC

[thelads]

Hey Patmo,

 

In re-reading your question, I don't think I fully answered what you may have been looking for. In terms of emotions, or how it felt, to be honest, for the most part it sucked. You start out unpopular. Your remain unpopular and you end up publicly acknowledged but hugely resented. Winning while everyone is losing around you is not fun. And I felt little if no vindication. In theory it should feel great. In reality, I had a foreshadowing of how ugly it could get. There were a lot of relative innocents who get crushed who were friends and colleagues. Being anywhere where lots of people are fired and didnt see it coming is just horrible. I understand that in almost any other of the economy people had it far worse. But its different when you see it with people up close. Also, it went on for a while. The whole thing took years. And years on a trading floor feel like decades. The worst part of it was that the worst offenders suffered the least of the consequences. It was so unjust in so many ways. So I became a lot more cynical.

 

Another thing I think goes underappreciated is just how close to the brink things got. We were a day or so away from complete financial armageddon of the system as it was. It would have been incredibly difficult to remedy had GS and MS gone. I find it laughable now when people at either place say they weren't concerned. They were, they know they were and they knew they had no control whatsoever. So to me at least it is the height of bad form to claim the opposite. For the younger folks in those places they drink that kook-aid and its a disservice.

 

It's funny. There was a syndicate guy about 10 years older than me working on CDO's and other SPG at the last bank I was at. He had seen the spats I had been pulled into with a ream of senior management (the CDO business wanted mine killed off early on when I moved in as they saw it as cannibalizing them) and that I thought this would all end in tears. In late 2007 he pulled me aside for a chat. We had worked together at another bank and contrary to how many viewed him (as he was very muscular and acted like a typical frat boy in many ways) as fun loving and simple, he was one of the smartest guys around. He knew it paid to hide it. So anyhow he pulled me aside to warn me. "Even if you are right, you won't win. And if you are wrong, you're career is finished"

 

That was chastening. I knew he was right, and it shocked me that I hadn't really thought that way nor fully appreciated that point. It would have been different at a different institution perhaps, or if one or two of the management changes that came had been different. But I didn't want to believe him. I had a bunch of my promises in my pocket. He had heard these too and just laughed them off. He advised me to move on.

 

I met him a few years later and thanked him for the advice. He was a good guy, and he didn't have to tell me that.

 

When I look at things now, and at some of the buy side, especially in the credit arena, you see a lot more bad behaviour again in terms of risk taking vs likely reward (As opposed to nominal coupon or spread). I think its always a good measure to look at how people behave when things are going badly. I must say, looking at someone like Guy Spier, in that respect, I think you find few as honest and noble about their failing or acknowledging how difficult things are. I don't know if he will get the greatest results. But I am 100% confident he will never screw you, will be a learning machine and will treat you as he would his mother, father, sister or child. In my experience that is so incredibly rare, and it is really valuable. So many talk the talk, then will happily abscond with your money, even if it wasn't their original plan.

 

Related to that, having worked now at a few different funds, I think it's nigh on impossible to gauge who is honest/good and how the fund will be managed before the fact. It's really hard to get that right. That said, I think at least in credit world, one can ask a few basic questions relating to the segmentation of the book, looking at longs, shorts and changes in each seperately. But I am now very critical of my abilities to judge those things from the outside.

[WneverLOSE]

Since I don't understand 95% of the things discussed here my question will be more about your point of view then any specific experience or product.

 

Warren Buffett is widely regarded as the greatest investor ever. In your opinion does he really doesn't understand anything about those products and doesn't even bother with them or he is just playing dumb and he must have seen it coming from a mile away ?

I think it's interesting to think about it since if the answer is that he really doesn't understand such products what does it mean about other people in the field, do they really understand them and are able to find alpha by doing those complex analysis ? or are they betting after convincing themselves they did the work so they must be right. After all, if they are so smart to understand such complex products why can't they see the same golden nuggets laying on the street that Buffett sees and make huge returns on ?

 

Thank you very much for sharing and answering questions :)

[dr.malone]

Before thelads posts his answer, i'd like to offer my 2 cents to your question...

 

i'm of the opinion that WEB understands these products 1000% but just chooses to not participate. don't forget, he was willing to take on the whole LTCM portfolio, and from my basic memory, that had all sorts of esoteric and complex derivatives etc. the fact that he was willing to write a check for it tells me he understood totally and completely what was in their portfolio.

 

WEB portrays himself as a humble down to earth simple guy who's just trying to avoid doing dumb things (which is clearly true), but lets not confuse the facts. he and munger have close to genius level overall IQs, certainly genius IQ level ability with math and accounting and numbers, probability, statistics, etc, and when you combine the brain power of those 2 men, it is not at all surprising that you can achieve the results they have working together over the past 50+ years. its a statistical anomaly that they paired up and is likely to never be repeated again.

 

i always chuckle when WEB says that when you see greek equations in 10ks or grad school textbooks to run as far away as possible! but do you think he and munger cannot do the math themselves, or understand those concepts?! i most certainly cannot AND that is also why i have .000000000000000001% of the wealth as WEB, among other reasons for sure...

 

just my two cents...thanks

[Jurgis]

Before thelads posts his answer, i'd like to offer my 2 cents to your question...

 

i'm of the opinion that WEB understands these products 1000% but just chooses to not participate. don't forget, he was willing to take on the whole LTCM portfolio, and from my basic memory, that had all sorts of esoteric and complex derivatives etc. the fact that he was willing to write a check for it tells me he understood totally and completely what was in their portfolio.

 

WEB portrays himself as a humble down to earth simple guy who's just trying to avoid doing dumb things (which is clearly true), but lets not confuse the facts. he and munger have close to genius level overall IQs, certainly genius IQ level ability with math and accounting and numbers, probability, statistics, etc, and when you combine the brain power of those 2 men, it is not at all surprising that you can achieve the results they have working together over the past 50+ years. its a statistical anomaly that they paired up and is likely to never be repeated again.

 

i always chuckle when WEB says that when you see greek equations in 10ks or grad school textbooks to run as far away as possible! but do you think he and munger cannot do the math themselves, or understand those concepts?! i most certainly cannot AND that is also why i have .000000000000000001% of the wealth as WEB, among other reasons for sure...

 

just my two cents...thanks

 

+1.

 

Couple more points:

 

Someone working in structured finance does not necessarily has interest, knowledge or expected alpha to switch to value investing. They may be getting great money in the big bank while even if they demonstrated alpha in value investing, they might not get huge AUM and huge monetary rewards. They might not be interested in business fundamentals. I think it's rather simplistic to assume that someone super smart to understand complex products somehow automatically should be able to do great in value/Buffetty investing. I think it's also rather dismissive to suggest that if they don't that they are somehow inferior to value mavens.

 

I'm sure there are other reasons why smart people in structured finance might not go out and setup value shop. 8)

They may never become multibillionaires like Buffett, but then pretty much all value investors won't either.

 

Buffett's stock picks have not been super great lately - stocks are expensive and even he can't find great investments. So even if someone tried to move to Buffetty way, they'll probably not find "golden nuggets laying on the street" (sic) and "make huge returns on".

 

I'm sure there are exceptions. Some people may move to value investing and make great money. Maybe thelads has some stories about that. ;)

 

Peace.  8)

[dr.malone]

i most certainly cannot AND that is also why i have .000000000000000001% of the wealth as WEB, among other reasons for sure...

 

 

Or as thelads would most likely tell me...

 

"And that is why you are doing equities in Tokyo (with apologies to the fine people in Dallas)..."

8)

 

[Green King]

Did you guys miss the point of this story? Slaying dragons and being seen outside the herd is a very dangerous activity. Look at what happened to Burry. Most likely Buffett didn't know about it.

 

If he did there are multiple layers of hidden risk involved in the trade. There is a reason Buffett presents himself the way he does. When you look at his moves you know he is the GOAT. Imagine the blowback if he did the trade.

 

Thanks to thelads. Things that happened to me makes more sense now. 

[thelads]

Hi WneverLose/dr.Malone/Jurgis,

 

Thanks for the fascinating question. I must caution, this is all hypothesis on my side, as I have never spoken with Mr Buffett. So this is all an educated guess based on his public disclosures on derivative experiences, and the few trades I heard of Berkshire doing when I was on the sell side.

 

So, first things 1st, does he understand these products? Absolutely yes! These are all just securitizations. In the modern guise he saw them come into existence and popularity around the RTC crisis and knows the various versions very well. It's natural given some of the businesses he owns. For example, he bought Clayton homes after the collapse of the manufactured housing securitization market. I am sure he would have seen what drove that, and that was a good foreshadowing of what was to come in Subprime. I would have to believe he looked at some CDO prospectuses and I am certain he did for subprime and other products. Just reading a few of those you get a good idea of how things work. And there aren't that many variations on structure. What he may not have appreciated early was the size of the CDS market in that stuff. He knew the product existed, but the growth in size was stunning over 2 years.

 

I don't think he was buying protection for the reasons cited. 1st the reputational risk just wasnt worth it. Buffet makes billions on people losing their homes? That would seem to fail the WSJ test immediately. I am sure he saw what I did. AIGFP was a big competitor taking on the SS, so it would have been shown to Berkshire. In fact, I know it was. ANd he wouldn't touch it. I am guessing he inverted and decided that it was better to be on the other side. He knows correlation well and knows it can go to 1, so this was a no go. His remark that a CDO squared encompassed (if looking to the underlying) over 15k pages of reading wasnt a random estimate. He had calculated that. 2nd, in his business he takes the premium up front, and doesn't post as pricing moves. These contracts were akin to insurance or re-insurance and he knows that better than anyone. So why pay out small sums and take enormous counterparty vs the banks. If he is right on housing, the banks are likely worth zero. It gets messy fast, and then you are in a restructuring, and the best investor in the world helped to take the bank under....I can see him saying no thanks to that. So I don't think it was a lack of understanding. I think it was quite the contrary. Interestingly, Jim Chanos avoided that trade for the same reason. He loved the payoff economics, but was concerned about the CP risk. Hence he does listed stuff instead.

 

With regards to LTCM and Buffet, again he knew those trades. Those trades in general were not that complex by todays standards. They were nearly all relative value trades. Ironically, the most developed private label mortgage product was CMBS. They were enormous in that space, and spreads went from 35bps to over 140bps as they were being liquidated. The trade LTCM had there was just AAA CMBS vs Swaps. Nothing more. Not complex. They were just levered long spread. ANd their margin was inside of 5% apparently. So incredibly levered. The had the on the run/off the run treasury stuff. Nearly all their trades were variants of this. They had some more complex interest rate stuff, but nothing folks here couldn't figure out over a week or so. Buffet knew these guys and their trades from Solomon, and knew it well. He had also been pitched on the fund early in its life. So he could turn it around super quickly. In virtually none of the positions was there any principal risk of loss. It was over levered, and to win a buyer needed only reversion to the mean. He really couldn't lose on that had he won. But he understood this stuff as well as the guys at LTCM, I would argue better. He had a simpler way of evaluating it. To my mind, his point was that using all of the models and historical info told you didly squat about the propensity of spreads to widen beyond where they are in your data set. He thought that was asinine and understood that if you become the market, and change the nature of it, historical reference is meaningless. He often cites Graham as saying more money is lost on a good premise than a bad one, as it sucks in smart people. This is the case here. And I am sure its one of the reasons he tell people to study history.

 

Munger clearly also understands the derivative markets very well. One other thing on Buffett, he befriended Janet Tavokali in 2004 or so. She had written a bunch of books on credit derivatives. He had her fly out to Omaha. She wrote a book about this. I think he knew very well something big was coming. But why say it in public, beyond derivatives could have a big negative outcome. He doesn't want to be seen as the siren. No upside to that. So he could definitely see the trade as well as anyone. He just chose not to participate, and for very good reason. Had he been starting out, or much smaller, I think he may have acted differently.

 

He and Munger do seem close to genius to me. And I think the main part of that is in knowing what not to do, and when not to press. It's an amazing skill. It's one thing to understand human foibles and failings. It's another thing to actually avoid falling into their traps. I still find it remarkable. I must say, I agree 100% with them on geeks bearing formulas. It becomes a crutch, and you can rationalize anything. People often do. Add in massive asymetric incentives and you have a cocktail for disaster.

 

As an aside, I should have mentioned earlier, post crisis, or mid, the group that impressed me most in terms of rushing in as other ran out, was Baupost. They were absolutely brilliant. Got amazing results, behaved ethically. They were just masterful. It was a tour de force, and they kept it relatively quiet. I tried to get a job there. offered, via a couple of salespeople to go there and work for free (who wouldn't), but apparently I was too expensie. :(

 

Jurgis, on your point "Someone working in structured finance does not necessarily has interest, knowledge or expected alpha to switch to value investing. They may be getting great money in the big bank while even if they demonstrated alpha in value investing, they might not get huge AUM and huge monetary rewards. They might not be interested in business fundamentals. I think it's rather simplistic to assume that someone super smart to understand complex products somehow automatically should be able to do great in value/Buffetty investing. I think it's also rather dismissive to suggest that if they don't that they are somehow inferior to value mavens"

 

I could not agree more. They are completely different disciplines. Both utilize DCF, and you may use the principle of margin of safety and things like that. But it is not valuing a business. It has nothing to do with that. And that is critical to participating in buying companies. I think it is far easier to be a value investor and go into structured products and do well, than the reverse. Baupost is a good example of that. So I moved to join a value fund in the past year or so, because I want to learn that. While I know corporate credit, in my experience, most people in credit (with some notable exceptions) are just terrible at business valuation. To learn that I think you need practice and need to value a lot. Preferably around people with experience and frame of reference. So I have taken  a huge pay cut to go and learn that. I dont know if I will be any good. But I am loving learning it. And that is most important in the end I think.

 

One last thing about that and all the stuff above. I think that narrow specialization, while fantastic for maximising pay early on the sell side, and buy side is a barrier to great investing over the long haul. What you gain in one narrow niche and reputation and confidence is great. But you have no sense for opportunity cost of capital. This is one of, if not the biggest of the problems in the credit world. For them opportunity cost is very low, so it is easy to justify almost anything. That was true in structured product world in 2002-2007. People there don't really see or understand the alternatives, beyond a very very superficial level. Buffet and Munger look across everything. And they spend exactly 0% of their time marketing. At other big funds you need the head/CIO to be ultra focused and do the opp. cost calculation. In certain places that works very well. Blackstone for example, or Elliot. But in my experience those are the exceptions. You would be shocked at how much time goes into marketing and other crap at a biggish fund for the CEO/HEAD/CIO. Often its 70% of the time or more. And over time they become more distant from positions, the market, liquidity. Its not hard to see why they start to underperform. I know the latter point on liquidity may offend some in the value community. But if you don't have permanent capital, not paying attention to liquidity is a cardinal sin.

 

So for me, I really want to learn valuation and learn it properly. And for me that means starting at the ground up. It's a little humbling to go back to the beggining. But humility is a good thing, and I am really enjoying it. I am hoping to become a little better than average. ANd I must say, my prior knowledge does act as a good and differentiating point on evaluationg cost of capital. Also, some things on the valuation side come a little easier given my past than I think they do to some of the competitors I see. But who knows how it will all turn out.

 

Dr. Malone, I kind of wish I had done "Equities in Tokyo" it must have been a blast!! Speaking of liars poker, just by chance, I got to know a few people in the book, though indirectly only to the more colorful characters. The human piranha worked with one of my colleagues for years. Apparently a great guy, though not someone to be trifled with. But if you knew your stuff, he was like a blood brother. Also, another friend from outside of the industry got to know Alexander (the genius friend and trader of Michael Lewis in the book) really well. His life took a few interesting turns you wouldn't expect. THough I don't feel at liberty to share those.

 

Green King, you are absolutely right (especially on Buffet and the reputational risk). What I was hoping to get across was how hard it is for people to step outside the box. Had the crisis come a year later than it did (and it really could have) then I was a dead man. Lippman was about a month away from the bullet in my opinion. And if you ask people in the know, nearly all would agree on that. They were interviewing everyone for his job. I think he knew too. It is so so hard to be out of consensus like that. People don't want you around and don't want to hear it. It is not good for your career, even if you are right. In some places, you do this and you get paid well. That gets a lot of press. Other people get none. There is huge selection bias in the reporting of it. If you are in your own shop, or a true independently thinking place, sure, you will do great. But finding those places is so so hard. Most funds talk a good game. But when push comes to shove, they will shove you under a bus. I dont mean to sound bitter or anything. I ended up doing just fine, and most had it much worse. But given the experience, would I do the same all over again? probably not. And the thing is, young people on the street grow up watching these things. Its very much monkey see, monkey do. The lessons, though never explicitly spoken could not be more clear. Nothing bad happens when you blow up, you may get another job (again, this is not really true, but gets a lot of press, and is near religion on the street) and I get killed for being out of lockstep. Politically if nothing else. So then people wonder why this happens over and over. It's human behavior, bad incentives, and a lack of persecution of real offenders. I think the regulational limits will constrain anything too dire now. Though the lack of liquidity in corporate credit, when needed, is sort of stunning.

 

Sorry for the super long-whinded answer. Hope I didn't put anyone to sleep. If I missed any sub question, let me know and I will try to answer it.

[Patmo]

Don't apologize man, that stuff is great, thanks for posting.

[CanadianMunger]

Thank you for taking the time to share. 

 

Your writing style is superb and the content is very interesting!

 

-CM

[WneverLOSE]

I very much appreciate your thoughts, thanks for answering my question.

I guess that the tricky part is understanding vs understanding.

I agree with you 100% that he understands the structure or the products but does he understand how will they perform ? does he have an ability to make a determination on macroeconomics subjects

like that ?

 

I guess not since he says so, in his testimony about the credit rating agencies he says it was a big bubble that nobody was able to see beside a few people like Michael Burry, he didn't saw it (and he adds, would I hold Moody's at 60$ if I knew what was coming ?)

 

Secondly regarding his performance I can't really share specifics but I know that his personal returns are WAY above the market, sorry I'm not able to be a bit more specific but you can get a feeling by looking at things that he publicly stated he did such as the Korean net nets, SRG, LEE and other private holdings he had during the years.

 

One thing i'm interest to hear is your opinion on future returns of major indices, interest rates levels and inflation. I don't think people think about this enough when evaluating potential investments, sure 10% may sound good but it may be a horrible investment if the market will return 15%.

[thelads]

My pleasure Canadian Munger. Thanks for the kind words. I really appreciate it. Thanks to you too WneverLose.

 

On your point on Buffett. I hear you. I spent a lot of time listening to the FCTC (or whatever it was called) interviews also. I must say, I do think he understood the products, the mechanics, and the risk reward. What I tried to convey in the prior post though is that I don't believe he appreciated the extent of growth of the market in subprime and other MBS credit derivatives. It was extraordinary, far outpacing growth in any other new product I have ever read about. So for him to not see the scope is very possible, as it is not a product he would have been trafficking in or likely monitoring. The real problems came with the scale of CDS. The other aspect of this I think he missed (but to be fair so did many of the CEO's of the banks) was how much of the worst risk was retained by the banks. He is on record in 2008/2009 at the meeting saying he couldn't believe that part. Traditionally the sell side was in the moving business, not the storage business. Being honest, from the outside it was nigh on impossible to see how much the banks had. They didn't disclose it until it was already far too late. The super senior crap that blew up all the places started life as Level 1. Then went to Level 2, finally to Level 3. Then Nouriel Roubini starts piping up and others pay attention. But what was in Level 3? People didn't know. So I think the scale of it, and the sheer stupidity caught him off guard.

 

But not understanding the scale of a market that has grown like that, where the companies don't disclose, is hard to fight. I don't know how he would have done it. You could say as he was concerned about the real estate market he could have researched it, but hindsight is so easy. I do think however it is important to distinguish between the mechanics and risk reward of certain securities vs the structure of a market, especially when you don't traffic in it. I hope I am clarifying what I see as the distinction clearly here. Had the CDS market been 1/5th to 1/10th the size, or if the super senior risk had been sold, such that they didnt destroy bank tier 1 capital and thus have a huge multiplier impact, the consequences and subsequent events would not be as famous as they are. Make no mistake, this mess required lots of bad decisions in a row, at multiple places. The leverage, poor incentives and weak characters of the most senior people involved, in addition to healthy doses of arrogance, hubris and outright ignorance allowed a catastrophe to occur. To some extent, his business and life is set up so he doesnt get impacted hurt by such events. In fact, such events allow him to pull relatively further ahead. So he wasnt missing something that was gonna hurt him materially.

 

On your point about not thinking about macroeconomics, I hear you. But then he goes and buys silver, or trades currencies. I think he thinks about it a little, though it rarely moves the needle on the economics. For these securities when they became distressed, he could certainly have understood them. The bet became simple by 2009, will prices of houses drop another 50% in california and florida? stay there for a decade? If so, I make 4-5%, if better than that, I make a lot more. He loves that stuff. Baupost did a lot of this. I'm not sure why buffett didnt. I am guessing he had great opportunities elsewhere, or maybe he just didn't want to get his trader mired in that market (he has an execution trader who does all his fixed income). Or, as you suggest, maybe he just didn't understand the stuff.

 

Good question on the indices. It depends where you are and which index you mean. I think Europe can do better than the US here. In the US at these prices, I think you might end up getting 3-6% return (over the next 10 years), depending on how things play out. It may be a little better, but could be a good bit worse, depending on how rates move. In credit I think you are in the 2-3% range, with plenty of immediate downside risk (1-3 years). Europe might be 1-2% better than the US at these prices. This is just looking at multiples, inverting and then factoring in some growth. None of this relating to equities takes into account the path risk and potential for large drawdown. You may not care about that. Though I find most people who say that feel strongly that way, until the drawdown occurs. Myself included. Within EM, for equities, it could be ok, though if you have a credit event in that space, the equity market in each area there will get crushed. Given the dynamics of those markets, and the lack of potential buyers in the credit world when things get messy, equity could and I think would get ugly very fast. I think 10% in indices will be very tough given where we are with rates and margins and taxes for corporates. 15% would blow my mind. That said, can someone without a ton of capital get those numbers? I think absolutely, but you need to turn over a lot of stones and I think be very opportunistic.

 

Of course the above are just my subjective opinions and they are worth exactly what they cost you!! :) For the indices return, I like the Buffet/Greenwald shorthand of just inverting the PE, then adding some growth as a quick and easy proxy. For Credit I feel a little better informed, but that may make my guesses even less valid. But there at least you can see where nominal spreads and coupons are. You won't do better than that if you hold to maturity, and you could do substantially worse with defaults and restructurings if and when rates rise. Not to mention the path risk in MTM on your holdings, nor the material risk in those markets (below investment grade) should you see large flows out of the marginal fund managers. On that point, nearly all equity managers calculate and know their position size as a % of average daily volume (and its high and low). In credit, nobody has a clue, which is disturbing in it's own right. I am guessing, that if funds tried to measure this, it would look horrible compared to equity. The opposite was the case 10 years ago. End investors in these funds have heard stories on the liquidity issue, but in my humble opinion don't appreciate it even nearly enough. This is no issue if you have term matched money. who cares in that case as long as you beat your cost of capital. But as I said in another post, if you don't, you are certain of a lot of trouble. It isn't a question of if, it's a question of when.

[dr.malone]

One other thing that I totally forgot to add about the incredible long term compounding record of WEB/Munger, and which in my opinion, is the hardest to copy/follow/master, is the emotional discipline they have. The ability to sit on your ass and do nothing when that is the best option is awfully hard for alot of people.  Esp in the asset mgmt/broker world. As thelads can surely attest to, if you came in to work and decided to just sit back in your chair and read all day, you prolly wouldnt last very long! i've seen analysts do 6 months of work on a company, develop models that break down cash flows 10 years out, buy the stock and when it drops 10% in 3 months, they sell! like really?! you did all that work and when its 10% down on really no news, you decide to bail?! the career risk that grantham as talked about is so real in the industry. and this all ties to emotional discipline and patience.

 

thelads, because i own some BDCs, what is your opinion of Apollo and Blackrock? i'm sure you've interacted with them in the credit space. are there smart people working there that are hard working and have integrity? or should i be looking to sell AINV & BKCC?!

[thelads]

Hi Dr.Malone,

 

Thanks for that. You are spot on in career risk. In my experience it is what people think about first, 2nd and last. Other things enter the frame also, but it is paramount. That and over specialization can lead to real problems. Take an analyst who covers two sectors. For arguments sake, say energy and TMT. His pay is linked to his performance, and he can only get performance if he has names in the portfolio. On that alone he is incentivised to have risk on at all times, or risk no compensation. It's silly, but that's how it works. That alone may not be considered a strong enough incentive. So let's add another wrinkle. Let's say he has a colleague who took a lot of risk last year and lost. But this chap is friends with senior management and the PM. So he isn't fired and gets paid ok. However, everyone else in the group who may have done well gets paid less than expected as the fees from performance were reduced by that colleagues losses. Further, let's say the year before that, the colleague who lost a lot, won big, and was paid handsomely.

 

In this scenario the whole group will start to lose its mind, become angry and embittered and stop behaving as a team or putting the overall performance first. It's a small insidious thing, and it may sound childish, but I have seen this so many times. In hedge fund world it is netting risk. You get paid a % of your pnl, unless one of your colleagues blows up. Different places try and deal with this in different ways, though most fail.

 

When you see this in action, it is stunning. When it happens repeatedly over 2-3 years the atmosphere becomes poisonous. The analysts who stay are often mercenary, and will bet the farm given the chance. They are playing only for option value, as they see the place as dishonest and that as their one chance at getting paid, getting performance, and getting out to a better seat.

 

It all stems from poor management of people on the way in, favoritism and a lack of vision from senior leadership. In fact I would say poor management is one of the biggest issues in finance. Everyone presents well, and knows what to say. But their statements and actions rarely correlate. I never cease to be amazed by how much waste of talent there is in the industry. Your story of the guy doing 6 months work, only to puke when down 10% is shocking, and also, disappointingly, shockingly common. I think often how a simple, rational consistent place, that was honest from the off could do so much better in that regard.

 

I'm so glad you brought up career risk. It's so important and so under appreciated.

 

As to your question on Blackrock and Apollo: blackrock is excellent. I would say best in class for fixed income on the mutual fund side, with really wonderful people, and a fantastic infrastructure. Apollo is more a mixed bag. They have a good record and some good people, but they can and do fly close to the sun on certain issues reputationaly. They are very aggressive on certain things legally, not that appear illegal to me, but certainly on the borderline ethically. So for me I would probably demure on that basis alone. This is more based on anecdotes than anything else, so please discount it heavily. But even on some small issues with some of their pe investments where they have fought with bond holders, there have been some strange/bizarre decisions made that have prompted some people to ask how the judge made them. I have no idea. I presume it is just an honest opinion. But there have been a couple that are headscratchers. But again that's all speculation and I don't know how reliable the sources are.

[james22]

... you should write a book ...

 

I'll buy it.

[thelads]

Thanks James22 and Dr.Malone,

 

I thought about it in the past. I just wondered how to leave names out. I often think some of the things are still really misunderstood about the crisis, with too much effort spent on vilification, rather than understanding. I was active in keeping my name out of any stories that came out, as I thought there would only be a downside (I love privacy). To do so I had to agree to do some verification on some stories for a few authors. Others had recommended me as a source and, fortunately for me, been complimentary about my results and behavior through it all. One guy won the Pulitzer, and the work was excellent. However, I was a little saddened, as a key part of the story was left out, as they couldn't find another source to confirm the part. It was a real shame, as it was one decision that had just enormous ramifications. And the motivation for the decision clearly came from the reptilian brain and was done in a panic. So I always wanted to get that out somehow. Other than that, there are some genuinely funny (at least to me) stories that can humanize a lot of this stuff.

 

I also think that some of the stories glorify certain individuals and tout the complexity and impenetrability of the products that were used. But to be honest, after a little upfront work, I think anybody on this forum could have very easily understood them. The structures behave in many ways like a corporate capital structure, but with explicit rules, so in that sense it is easier to project. Moreover, the tools available for analysis, and for scenraio analysis are so good and detailed, that with a couple of days of instruction, I think anyone here on this board could do very well. Especially before and after big moves.

 

I just thought the subject matter, and my style of writing would bore people to death. But maybe its worth revisiting. In any event, I really appreciate you guys saying it.

[Spekulatius]

Interesting story and good lessons here.

 

Not that it matters, since I am a layman, but I followed the financial crisis closely and also could not fathom the extend of it in the beginning. I was not surprised about a few hedge funds blowing up or Countrywide blowing up etc. Living in CA at that time, it was quite clear that there was a lot of froth and fraudulence in subprime. What I did not get is that so much of the same stuff was going on in our core financial institutions and how interrrlated the credit markets are, as well as the issue of reflexivity.

 

It appears to be a result of how the people operate and how in incentives are structured and all the former attractivjng a certain crowd of people that is willing to do almost anything to earn money fast. As long as that is in place, it is all but assured, that those thing will recoccur, but of course I do not know when and the extend of it. We did see quite a bit of panic in the credit markets for energy in late 2015/ early 2016 for example. I think OP's opinion about the EM credit markets is a good one, since we know that these markets can become illiquid really fast, which means that everyone is going to run to the exit, if they see fire or smell smoke,

 

I would love to read theLads book too, should he ever publish one.

[writser]

Yeah, sounds like you can write a book. Or some articles for a weblog / magazine. You have some interesting stuff to tell. Also, is this your second, anonymous account on this forum? Or are you a long-time poster already.

[thelads]

Hi Writser,

 

This is my only account on here. I have had an account for a few years, and use to visit from time to time. More reading than anything else. For whatever it's worth, in my opinion this is a very high quality group of people, both in terms of knowledge and acumen and in terms of civility to each other. I have learned a lot here, so I felt it only fair to offer to share some experiences, for whatever they may be worth to anyone. If any of this helps anyone get a better context, or just an insiders view on how things worked, I will be very happy.

 

Spekulatius, I think you summarize it all very well. It's a complex interaction of facts. Reflexivity is certainly a big part of it, and probably the best way to describe it actually. I find it interesting for instance that people rarely investigate what prompted people to buy bonds/Sell insurance on Subprime and other products? Why take the opposite of the Paulson trade on CDO super senior? These guys (who did that trade) were no fools. They were very well educated. Were generally amongst the most experienced. The head trader at MS prop being a great example. So why did they do this. Most of what I have read just says "idiots" - but it's hard to learn from that kind of lack of explanation. I have my pet theories as to why, and it relates very much to reflexivity and what margin/IA was for these products. Also, I think Jim Chanos made an incredibly pertinent observation on Wall St. as a whole when he said that the people who end up there have been living on a positive reinforcement wheel their whole lives. They excel and get positive feedback their entire lives. By the time you rise to a reasonably senior level that starts to get absurd. Moreover, people are less and less inclined to give you bad news. GS is somewhat unique in drilling that out of people. But as a whole, this point holds true, and on the buyside too. So mix that in and you often get people dealing with problems only when its very late. And the default response is denial and inaction. The Ostrich approach to risk management; comforting but futile.

[dr.malone]

thanks for your feedback thelads. but i think we certainly do want to be careful here and not insinuate that jabba the hut or anyone else at APO has been bribing federal judges!!

 

from my upper left field seat of the buyout firms, i've always thought highly of leon black. he comes across as honest and straightforward in the interviews i've seen him talk or read. he's clearly one of the brightest minds in finance, or else milken wouldn't have named him head of m&a in his early 30s at drexel. their PE business gets most of the headlines, some not so positive, but that business is much smaller than their credit business ($45 bill vs $141 billion). the reason why i choose to invest with them is kinda similar to what you wrote. they are tough, and difficult to deal with when the s*it hits the fan (Caesars Reology etc). but thats exactly why i want to be on the same side as them when that happens knowing they are fighting for me and i am more than happy to pay them the mgmt and incentive fee when things work out well. i will also say they are by far the most value oriented and contrarian of the PE shops (more so than oaktree). they regularly boast of their deals done at roughly 6-6.5x leverage whereas most PE shops do them closer to 8-10x. i choose to invest in AINV due to their ability to co-invest alongside the parent in deals and leverage those relationships etc. the loan they did to Westinghouse was an example of the power of the broader APO platform and how AINV, in turn, can benefit.

 

thank you for the feedback about BLK as well. Larry Fink is a man of impeccable character. I got to know his son Josh and the apple doesnt fall far from the tree. Strangely enough, its BKCC that has severely underperformed in the BDC space and last year BLK took full control of the mgmt and i am hoping that now that it is fully under the BLK platform, things will improve in terms of sourcing, control, mgmt, fees etc. So far, things appear to be headed in the right direction.

 

i could keep reading/writing about this thread for a long time more! keep it coming!

[thelads]

Hi Dr.Malone,

 

Sorry, I didn't mean to insinuate that at all, though re-reading I can see how it came across. I was just passing on some chatter that was going about. But you are absolutely correct, I shouldn't be repeating idle chatter. I seriously doubt the veracity. I guess its a function of the HY/Distressed space. It is an elbows out business. With regards Leon Black, the guy is absolutely fantastic at what he does. I always found Milken very impressive also. I have never met with him directly, but I worked for one of his other proteges for a while, and he was a sounding board on some ideas from time to time. He has a penetrating mind and the views he expressed on themes in markets were stunningly adroit and prescient. He didn't discuss such things often, but when he did, it was always informative and pertinent. So I could not agree more, if he is a fan, it is worth paying attention.

 

On BLK - yeah - they really are great at what they do. They were revolutionary in many ways for a long time, and in a positive way. I know one of the earlier employees there, and someone who went there Post Crisis for about 4 years, and both tell the same story. Very different personalities, and very different times to be there, so for both to say that speaks volumes I think. I don't know what they have done in the BDC space to be honest, which is shameful on my part. The only thing that is an issue for BLK in general is their sheer size. But if anyone can manage that well, it is them. It's just personal opinion of course, but when I look at who they hired and who PIMCO hired over the last 10 years, in the areas I know of, they always hired far far better. And it was often counter intuitive. I am sure you will do very well with both.

 

I am curious dr.malone, what do you think of the move to passive/ETF funds and the implications for the likes of Blackrock and the market as a whole?

[Brett]

What errors do you see young analysts make? Or maybe just things you wish you did differently when you started out?

 

Any book recommendations?

 

This has been really interesting. Thanks.

[dr.malone]

hi thelads,

 

i think the shift to passive/ETFs is here to stay. being a natural skeptic anytime someone says "this time is different," i was initially skeptical that this shift would be permanent. but i think by now, the average investor realizes, esp in a low return world, how important fees are to his return, and also, more importantly, how bad his fund manager has performed relative to the benchmarks. its been a double whammy to the average investors investment goals and my guess is alot of people are at the tipping point where they say i'll just invest in different passive etfs to achieve my goals (say 25% in s&p 500, 25% in small/mid cap, 25% in msci eafe, 10% emerging, 10% real estate/commodities, 5% fixed income, etc).

 

i think when people see WEB in the news making statements like "90% of my wifes assets are to go into the s&p 500 etf when i die" people take notice of that.

 

so this should further strengthen the moat of companies that have scale and infrastructure in the passive etf space like a vanguard, or blackrock, state street etc.

 

having said all this, i also think ironically, the shift to passive etf space is likely to bring a more inefficient market and investment opportunities for those that are able to do the analysis and have conviction etc.

 

based on your writings to date, i'm gonna guess you were at merrill during the GFC! no need to confirm or deny that on the board.  ;) fyi, semerci and i lived in the same building in tokyo. i saw him around alot but never spoke with him. he didnt seem the kinda guy that enjoyed small talk etc. i'm pretty sure even if you werent at merrills, you would have an opinion of him...lol

 

peace

[thelads]

Hi Brett,

 

In terms of book recommendations I think two that aren't regularly recommended are "Bull" by Maggie Mahar and "Traders, Guns and Money" by Satjayit Das. They are very different but I think offer interesting insights and perspectives. You will get a better idea of the abuse and motivations relating to derivatives from the latter. The former speaks a lot to how markets can dramatically underperform for long periods. I don't know why it doesn't get more accolades. Beyond that, maybe "Fooled by Randomness" as it gives a good perspective on behavioural aspects and is told in an easy way. There is another book more about trading and its impact on the person doing it called "The hour between the dog and the wolf". This deals with the physiological stresses and the long term impacts neurally of taking a lot of risk, or dealing with extended uncertainty. It is focused on professional traders, but the lessons apply to everyone. In short it warns that we don't always know how stressed we are. And under extreme stress decision making starts to get bad quickly. He attempts to show why, and gives some recommendations on addressing these issues. It's not an easy read, but I found it wortwhile. Beyond that I would try and read as many books on financial history as possible. There is a book called "inventing money" by Nicholas Dunbar, chronicling the rise and fall of LTCM. I actually prefer it to when genius failed, as it goes into more detail, and more importantly gives better context to why some of their backers on the banking side agreed the deals they did. In particular Swiss Bank. It also gives context to some of the markets they were in. In general, I would focus more on books that have more detail and devle deep into peoples motivations. For example in the Swiss bank case Dunbar investigates the internal politics.

 

I am loathe to give you any career advice, as I don't know in what area you will be working, what your plans are, and in general, I just am not sure any advice I could offer would be helfpul. There aren't many things I would do differently in terms of taking risk or learning. In that respect I read more than my peers and got to know the verticals and horizontals tangential to my business. What drove the buyers and sellers. What drove the buyers and sellers of the buyers and sellers. Were those relationships stable. Was their a point of failure/weakness, or a weak dependency that could have huge feedthrough impact? That I observed was done less than anything else, so I focused on that. I was weaker in other areas, but given where I was in place and time, it won out. I don't know if that would apply to you. But I would try to get a handle on that in any situation. As a rule I try to be as informed as possible, and am always willing to ask the Dumb question when I don't understand. It may be embarrasing in the short run, but it's cheaper in the Long Run. On a career basis, I wish I had negotiated more strongly when I was in a position of strength. I took promises about compensation and responsibility at face value. I am far less inclined to do that ever again. Also, if you see or seriously suspect any hint of fraud or questionable behavior, say something. If it is ignored, find a way to exit quickly. whether it goes horribly wrong or not, you will be under a lot of durress and its just a long and painful distraction.

 

Finally, I would just make sure you have a good attitude. Be open to learning, be willing to do some of the menial stuff. We all had to, despite being well educated etc. It's a small thing, but a good attitude and humility seems to be getting rarer. Sorry if all of this is vague. Like I say I am not sure any advice I offer will be useful.

 

Dr. Malone, thanks for your view on that. It seems very sensible and quite likely I would think. I agree with you on the potential opportunity / inefficiency that this migration offers. In that sense it is quite exciting.

 

No comment on where I worked :) - though I can tell you in a PM. I know Semerci yeah. Sort of an epic error to put him in that role and fire Kronthal at the exact top of the market. I know from people there it was greated with horror. I have a couple of funny stories on that if you want them in PM let me know. In general I hear he was ruthless, organized but ultimately clueless about risk. He was the wrong man in the wrong seat at the wrong time. I am not a fan.

[racemize]

I just finished reading FIASCO, and this reads like a continuation of that one, almost. What are your general impressions of that book and Liars Poker, e.g. in terms of accuracy, representativeness, etc?

[thelads]

Hi racemize,

 

Thanks for the questions. I thought Fiasco was very good. I liked his next book, infectious greed, even better. He was very honest about the process. His experience was different from mine in nature of role (he was structuring, but not managing the risk thereafter) and time. His time was earlier when these were more often custom idiosyncratic trades. So in terms of dynamics (turnover vs margin) it was different. But in terms of how bizarre it was, the ability to play games, and the lack of reliability. That stayed largely true. The market for that stuff is smaller now, relative to other products, I think. Liars poker was fantastic. In terms of how people behave, and way a trading floor operates, I think it was very representative. Things were a little more sanitized by the 2000's than in that story, and there were probably more quants on a proportional basis. But people still do play liars poker on those desks. People do gamble on silly things, and there is definitely a lot of one up manship. Also, it's an incredibly profane place to work. I sound worse than a drunk sailor now. It's hard to unlearn.

 

I must say, despite the stress, it was a fantastic thing to do. There was rarely a boring day, it's a perpetual challenge and you do get exposed to something new and interesting every day. So I was glad to have done it. I think it would be interesting to see a retrospective on where people from Liars Poker ended up. The Human Piranha was still selling bonds until the late 2000's. Alexander ended up being a lawyer, if you can believe that. A bunch of others moved in other directions. It's crazy because in reading the book, the impression I had was that Michael felt Debt markets had reached their peak. Obviously that turned out not to be the case. But so interesting to see that perspective. I was drawn to the profession for many reasons, and Liars Poker was one. It just looked like it would never be boring. So I can see the appeal to a young man. I went for it. The more insidious aspects of it, and the amount it takes out of you over the years though just adds up. Not to mention the short termism.