Interview with a Hedge Fund Manager

From time to time, the dollar’s been very weak; from time to time, it’s very strong; and unfortunately what tends to happen is people tend to just extrapolate. But in reality, over the very very long term, currency processes tend to be fairly stable and mean-reverting. So the dollar’s very weak today, but that’s no reason to believe the dollar’s going to be weak forever or that, because it’s weak today, it’s going to get dramatically weaker tomorrow.

I think that in the end the way that you make a ton of money is calling paradigm shifts, and people who are real finance types, maybe they can work really well within the paradigm of a particular kind of market or a particular set of rules of the game—and you can make money doing that—but the people who make huge money, the George Soroses and Julian Robertsons of the world, they’re the people who can step back and see when the paradigm is going to shift, and I think that comes from having a broader experience, a little bit of a different approach to how you think about things.

The problem is that the DNA of a lot of these models is very, very similar, it’s like an ecosystem with no biodiversity because most of the people who do stat-arb can trace their lineage, their intellectual lineage, back to four or five guys who really started the whole black box trading discipline in the ’70s and ’80s. And what happened is, in August, a few of these funds that have big black box trading books suffered losses in other businesses and they decided to reduce risk, so they basically dialed down the black box system. So the black box system started unwinding its positions, and every black box is so similar that everybody was kind of long the same stocks and short the same stocks. So when one fund starts selling off its longs and buying back its shorts, that causes losses for the next black box and the people who run that black box say, “Oh gosh! I’m losing a lot more money than I thought I could. My risk model is no longer relevant; let me turn down my black box.” And basically what you had was an avalanche where everybody’s black box is being shut off, causing incredibly bizarre behavior in the market.

What tends to happen in financial markets, is bad things happen when you really divorce the people who take the risk from the people who understand the risk. What happened is that that distance in the sub-prime market just increased and increased and increased. I mean, it started out that you had mortgage companies that would keep some of the stuff on their own books. Sub-prime lenders, it wasn’t a big business, it was a small business, and it was specialty lenders, and they made risky loans, and they would keep a lot of it on their books.

 
But then these guys were like, “Well, you know, there are hedge fund buyers for pools that we put together,” and then the hedge fund buyers say, “You know what? We need to fund, we need to leverage this, so how can we leverage this? Oh, I have an idea, let’s create a CDO and issue paper against it to fund ourselves,” and then you get buyers of that paper. The buyers of that paper, they’re more ratings-sensitive than fundamentals-sensitive, so they’re quite divorced from the details. Then it got even more extended in the sense that vehicles were set up that had a mandate to kind of robotically buy that paper and fund themselves through issuing paper in the market...

And we all, a
number of us thought, “This is just crazy. We should be short. This
is a bubble waiting to be popped.” But the person who was the
expert, the person who ran the sub-prime business, who traded
sub-prime paper and issued the CDOs, he was a true believer in the
paradigm: “In 2003, people said that the credit quality of the
average sub-prime mortgage was deteriorating, and now look, those
mortgages have performed fine. The sub-prime market works.”

And,
hey, he was the expert—you defer to the expert.