Hedge Funds 2007-2009: A Bubble In People
From n+1 Oct. 21:
Today, JPMorgan closed a $13 billion
settlement with the government, putting an end to federal investigations
into their questionable mortgage practices. The following piece is from
Diary of a Very Bad Year and was first published on our website on June 23, 2010.
In the fall of 2007, after two Bear Stearns-owned hedge funds
trading in subprime debt suddenly went bankrupt, I sat down with a
friend of a friend who worked in finance to see if he could explain it
to me. That conversation became the first in a series, which we began
publishing at n+1. The conversations continued through the
crisis and after, following the trajectory of one financier facing the
hardest days he’d yet seen. This week HarperPerennial is publishing Diary of a Very Bad Year,
the book that resulted from those conversations. We hope it’s a
valuable contribution to the growing literature on the crisis. —KG
n+1: I want to talk about hedge fund culture a little. You were saying last time that there was a problem with the pay structure.
HFM: Before
the labor market changed? Look, bubbles create other bubbles, they’re
like derivative bubbles, so to the extent that there was a bubble in
credit or a bubble in the mortgage market, that created a bubble for
people who could trade those products. There was a misallocation of
resources not only into mortgages, let’s say, but also into the trading
of mortgages, and it sucked talent into those areas that probably should
be deployed other places. And the way talent gets sucked into those
places is by a price signal, the compensation going out. So what was
happening was that the pay scale for finance was just—incredibly out of
whack. You had guys who were literally just 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: It
was kind of crazy what people were being paid. And for the more senior
people, the kind of deals they were getting—because their pay tends to
be not just a number range but a percentage of the profits they
generate—they were getting very high percentages of the profits, and
very high guaranteed income. The decision to pay those kinds of numbers
was motivated by the fact that other places were paying those kinds of
numbers, and their ability to pay those kinds of numbers was motivated
by the fact that there were huge amounts of assets coming into hedge
funds, and hedge funds are able to charge a management fee for the
assets under management. So if you had tons of assets coming in, you
needed people to manage those assets, you had to get quality people, you
had a ton of money to spend, and everybody was looking for people who
had a resume that singled them out, or that identified them as qualified
to work at a hedge fund—there was just tremendous competition for those
people, and it drove prices to ridiculous levels. It changed people’s
attitudes—there was a palpable cockiness that one sensed from employees.
And there was a lack of distinction I think between people who were
really good, who you would want in any environment, and people who you
could just fill a seat with because they had a resume that stamped them
as minimally qualified.
n+1: And was there a point when you noticed this happening?
HFM: I
mean, it’s been building over the years. It probably became craziest
post-2005, and continued in 2006, and then started to ebb in 2007
because we did start running into problems in 2007, and 2008 turned it
around 180 degrees. Look, as a boss it was kind of a good thing. You can
distinguish between good performers and poor performers a lot more
sharply when the price to get somebody to show up is some ridiculous
amount of money. And it’s society-wide—I mean, it’s funny, I worked in
finance through the internet boom, right? And the internet boom, it was
the same thing, it was a price signal pulling people into a sector,
because it was evident to people how much money you could make if you
created cheesesandwich.com and sold it for a couple of million. It was
like an exodus from finance—I can’t tell you how many times I would call
up to do a trade and someone would say, “Oh, yeah, this trader, he
quit, he’s going to join a friend at an internet startup.” And then the
internet bubble popped and all those people filtered back into finance.
Then
finance started sucking people from all over. You’d walk around our
trading floor and there were guys who were math PhDs and physics PhDs,
and chemists, and lawyers, and doctors—there were doctors on our trading
floor, who trade, you know, the health care sector. The bubble in
financial assets had a derivative bubble in people. Some of these
physicists should be doing physics; some of these computer scientists
should be doing computer science. Doctors should be curing people! It’s
not a bad thing.
n+1: If someone had had a heart attack on the trading floor, you could have—
HFM: You
know, they really don’t like it when you ask them to diagnose you. If
you’re like, “You know, I have a stomachache, and uh—” They don’t like
that.
n+1: I was reading this book, about Long-Term Capital Management.
HFM: Ah,
I know Long-Term Capital Management. I got many lectures from my boss
in the mid-90s about, “Why can’t we be as good as Long-Term Capital
Management? We need to be able to generate the same returns Long-Term
Capital Management does.” Then they blew up and we stopped hearing about
Long-Term Capital Management.
n+1: There wasn’t a lot of skepticism toward them?
HFM: There
wasn’t enough, apparently, given how it turned out. But people didn’t
have a very long experience with hedge funds, this is before the
explosion of hedge funds, and LTCM were very
secretive. So all you really saw about these guys was the returns, and
who was involved, and the people who were involved all had a really
fantastic business and educational pedigree....MUCH MORE
