Diary of a Very Bad Year Chapter 5 - End of Year, End of an Era
This is part of my series retelling Diary of a Very Bad Year. Today we’re covering Chapter V.
It’s January 16, 2009. The Dow is at 8,281. Unemployment is 7.6 percent. Over 300,000 foreclosures this month. And HFM just spent his New Year’s Eve chasing bank traders on ski slopes to get year-end prices for his portfolio. Welcome to year-end closing on Wall Street.
Closing the books (while everything falls apart)
Every hedge fund has to finalize prices for all its holdings at the end of the year. HFM says December 31 is the absolute worst day to do this. Everyone is on vacation. You call the bank, the salesperson is gone, the backup is gone, the backup’s backup is gone. You end up talking to the most junior person on the desk, who is trying to reach someone on a cell phone in Vermont.
HFM sends lists weeks in advance begging his counterparties to have someone available. Every year the answer is: “Sorry, I’m skiing.” Or on safari. Or climbing Kilimanjaro.
His fund had a negative year. But here’s the thing. When he met with investors after year-end, they told him he did “decent.” That tells you how bad everyone else did. His fund survived because they ran neutral positions and kept a lot of excess cash. That cost them returns in good years but saved them in 2008.
Firing 35 percent of your company
HFM doesn’t use soft language for what happened next. No “involuntary redundancy” or “right-sizing.” His words: “We fired people. We fired people. Yes, we did.”
They cut about 35 percent of staff. Some departments were overstaffed and nobody had demanded efficiency. Some business lines they just shut down completely. About half and half.
But HFM admits something interesting. Even without the crisis, they had too many people. When a hedge fund makes good money and the partners aren’t greedy, it’s easy to let headcount grow. The crisis forced a correction that was probably overdue.
The human resource bubble
This is one of the most interesting parts of the chapter. HFM talks about how bubbles create other bubbles. The credit bubble created a bubble in the price of people who trade credit.
Before the crash, kids a couple years out of college were making several hundred thousand dollars a year doing basic Excel modeling. Senior people got guaranteed payouts tied to percentages of profits. To hire anyone experienced, you had to guarantee them huge numbers because every other fund was offering the same.
And it pulled talent from everywhere. Math PhDs, physicists, chemists, lawyers, even doctors were on the trading floor. HFM says there were actual medical doctors trading the healthcare sector. (He adds that they really didn’t like it when you asked them to diagnose your stomachache.)
His take: this was a misallocation of people, not just money. Some of these physicists should be doing physics. Doctors should be curing people. The finance pay bubble popping was actually a correction the world needed.
Detroit and the auto problem
The conversation shifts to the auto industry. Auto sales dropped about 50 percent, mostly because people couldn’t get credit to buy cars. HFM makes an important distinction: there was maybe some overcapacity in auto manufacturing, but not 50 percent overcapacity. The demand collapse was way bigger than any structural problem.
He’s angry at the auto executives though. They went to Congress and publicly said nobody would buy a car from a company in bankruptcy. Before they said that, plenty of people would have. People buy plane tickets from bankrupt airlines all the time. But after the CEO goes on TV and says it, he made it true. HFM calls this “tremendously irresponsible.” The executives were basically playing chicken: bail us out or we burn the whole thing down.
The TARP sequencing problem
HFM uses a great analogy here. He says the government was like a doctor who runs into a heart attack patient’s house, steps over the patient, opens the refrigerator, and starts removing fatty foods. Meanwhile the guy is dying.
The TARP plan was to buy bad assets from banks. Not a terrible idea long-term. But the immediate problem was that short-term credit markets had stopped working. That’s the heart of the economy. You have to restart the heart first, then worry about the diet.
Eventually the government figured this out. The Fed started buying commercial paper directly. They guaranteed money-market funds. They recapitalized banks. All the right pieces, just done in the wrong order.
And there were signs of a thaw. In early January 2009, big companies like GE Capital and McDonald’s were able to issue bonds again. That wouldn’t have been possible a month earlier. The heart attack phase was ending. But the damage to the rest of the body, the layoffs and GDP shrinkage, was just beginning.
“Everybody knew” about Madoff
The Madoff section is fascinating. When the news hit that Bernie Madoff was arrested, HFM had never heard of him. But a colleague who traded options immediately said two things: “I knew it” and “This is going to be huge.”
Another colleague, the black box trader, was equally unsurprised. He said there was no actual portfolio to unwind because it was obviously a Ponzi scheme.
People in the options world had known for years. Madoff claimed to use a “split-strike conversion” strategy. It’s not hard to simulate that strategy, and the math just didn’t produce the stable returns Madoff reported. Some people thought he was front-running customer orders (which is illegal but could explain the returns on a small scale). But not on $50 billion. That’s impossible.
The real damage from Madoff wasn’t direct market impact. There were no positions to liquidate because there was nothing there. The damage was to funds-of-funds, which are middlemen that pick hedge funds for rich investors. Several big funds-of-funds got caught in Madoff. And HFM makes a sharp point: many of them probably suspected Madoff was doing something illegal (like front-running) and invested anyway. “You cannot cheat an honest man.”
Obama, stimulus, and what scared HFM most
HFM wasn’t an Obama supporter but says he was impressed by the economic team appointments, especially Tim Geithner. He’d dealt with Geithner at the IMF and describes him as “a stubborn son of a bitch” who was very smart. But he wouldn’t want either the Treasury or Fed job. All you’d do is deal with crises and tell people things they don’t want to hear.
The stimulus worried him. Not the idea of stimulus itself. He thought it was necessary. His fear was that instead of pulling forward spending that needed to happen anyway (fix bridges now, build schools now, use idle construction workers), Congress would create permanent new spending programs. That kind of stimulus doesn’t just fill a temporary demand gap. It permanently changes the fiscal landscape.
His worst-case scenario: the U.S. takes on so much risk and debt that its own creditworthiness gets questioned. He points to Ireland, which guaranteed all bank liabilities and saw its sovereign credit collapse. If that happened to the U.S., there would be no one left to step in and calm things down. It would be “October times ten.”
He doesn’t think it’s likely. But the risk is real enough to keep him up at night.
The view from January 2009
The chapter ends with n+1’s interviewer saying he can’t picture what the real economy version of this crisis will look like. HFM’s answer is simple: remember New York after the dot-com bust? Lots of friends out of work, empty restaurants. Now imagine that everywhere, in every industry, for a long time.
That was January 2009. They weren’t even in it yet.
Previous: Chapter IV - How Bad Is It?
Next up: Chapter VI - Populist Rage, where Part 3 begins and people start getting angry.