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All right. Hello and welcome to the yet another value Yet another value podcast monthly book club. I'm your host Andrew Walker with me today with my co-hosts from the diff, one of my favorite newsletters, Burn Hobart. Burn, how's it going?
Cool. Look, I I'm really excited to talk to you about the book we did today. Uh before we get there, I'll just remind everyone nothing on this podcast is investing advice. You know, we're we're talking about a book. We might talk about things that are happening in real life. I think everybody can understand. It's a book discussion, but you know, consult a financial advisor. Do do all that jazz. It's it's a book club. It's not a talking our book club.
I I I like that. That's a really good line.
Uh Bern, the book we're talking about on your recommendation, as so many of these are, and I don't mean that in a bad way. You've made some great Rex is Diary of a Bad Year: Confessions of an Anonymous Hedge Fund Manager. This is a book. It It's really interesting. It's kind of written over the course of two years. interviews from a uh N plus1 a magazine goes and interviews a hedge fund manager leading into and coming out of the crisis. Uh I'd encourage anyone to read it. I I had a really interesting time but a pause there. Overall thoughts on the books. I've got lots of thoughts and questions, but I'll turn it over to you to start.
Yeah. So I think the book is I read it as this really interesting meditation on expertise and the limits of expertise and operating under uncertainty because you you can read it and see that this um this anonymous hedge fund manager is clearly very smart, very thoughtful um and not just in his domain but he's he's willing to range over a pretty wide variety of topics. He's very much a systems thinker who's always asking what is the underlying reality here and then he gets you so he he gets a lot of stuff right about the crisis and then he gets a lot of stuff wrong too. And so I think it's just a good reminder that the people who really there are a lot of people who are really really well informed. They do know what's going on. They do actually make a bunch of accurate predictions and even then they are going to have egg on their faces over just a lot of different details.
You hit on the exact same thing that was like my first takeaway from the book. you read it and this guy is smart. There's no there's no doubt about it when you're reading it. He's pulling from all different sort sources. He says during the book, I think he says he had a humanities history and it's no surprise because he kind of pulls from himself, but you can't help but read it and notice and it was actually my first question to you. He's got egg all over his face from a lot of productions, you know, especially he's getting interviewed in March 2008 and I just pulled some quotes if I can find them really quick. He says, "Look, I think things I think the worst has passed. I think things will be frying. subprime looks contained. Uh Bayer doesn't have a solveny issue, you know. So, you have this really smart guy in the moment, and I guess my first thought to you, uh when you read this, and this is one of the fun things about reading like kind of in the- moment, uh diaries, especially if they're uh kind of wide ranging, do you think, um, you know, do you think when we look when we read this, do you think we're reading this and saying, "Oh, like Bear Sterns clearly was insolvent." Is that all of us having hindsight bias or do you think this is uh you know I I knew people I was I didn't know people but there were plenty of people March 2008 who were saying not just Bear Sterns who were saying Lehman not just Lehman Bank of America like go up and down the list like they were saying everything was in Solomon. So I just wanted to ask how much when you read this do you think oh we know the answers so we judge this person versus this is a really smart guy doing great work and he just made one wrong call.
Yeah. Like I I think one of the tests of that is just that Bear like all of the other big investment banks, they had lots of very short-term capital. They had lots of counterparty relationships. They were a prime broker. And so basically a lot of very sophisticated financial market participants including people who would have some kind of counterparty risk policy where they are not just uh not just looking at the credit rating but actually asking themselves how do these guys perform in a crisis. a lot of those people were still very willing to put their money where their mouth was and say that bear is trustworthy. So yeah, I think you know in in some ways a financial like it doesn't make that much sense to say that the financial crisis was obvious and everyone should have seen it coming because on a dollar weighted basis almost nobody saw any financial crisis coming like that is that is what makes it a crisis. It's not a crisis if we have this gradual understanding that residential real estate is getting a little bit overextended, credit is kind of weakening, and therefore we're all going to take some risk off the books. Like that that that kind of thing happens all the time, but it doesn't show up as a crisis because what happens is this industry is growing for a while, a lot of money is flowing in, and then the flow of money slows down because people decide that it's no longer worth the risk. So that's like that is the modal outcome for any scenario with this kind of setup. And then occasionally you get a case where there's some kind of feedback loop that keeps money flowing in for longer than it should. And um in that case we often don't really understand it until the very end. In fact, I think, you know, if you go back and do some kind of crisis revisionism, looking at um some of the some of the books that people love to site, you know, the big short or something, a lot of the people in that book, they got some things right, and then they weren't talking very much about what actually led to a real financial crisis versus banks taking one of their periodic write downs on some category of lending that got out of hand. And the actual crisis was that the financial plumbing seized up and it was there was this um liquidity crunch and it was just very hard to source very short-term dollars. That was like a second order effect of we don't know what's in all of these complicated securities. And he does actually talk about that in the book. So he he does talk about how it becomes this information problem of you have a bunch of AAA rated paper but now you're not sure if AAA means money good or means it's probably going to be 95 cent probably worth 95 cents on the dollar. And if you're financing that and you're only putting up 3 cents of collateral per dollar, then um suddenly you can't do that for anything. You have to put up much more collateral. So that that dynamic, I'm not sure if any of the people who called the subprime part of it well, if they figured out that entire implication, I'm sure there was somebody out there who connected all those dots, but that was that was part of just what made it such an extreme event. and um and not just here's another case where the credit market overheated for a while and then kind of fixed itself book read because the interviewer who is maybe he's dumbing himself down but he in my mind he's not that financially sophisticated you know he he asked things like hey could you explain the hedge fun manager at one point says they got carried out and he's like carried out what is that and I was kind of like I feel like you would know that even if you were in finance but what it was interesting because sometimes he'd back up and have them and what you're saying one of the things that really stuck with me was the hedge fund manager says, "Hey, one of the ways big blowups happen is when there's an assumption and that assumption gets proven incorrect." And in this case, it was the assumption Moody's rate something AAA, you are getting your money back and that turned out to be incorrect and everything implosed around that. And the uh the interviewer says, "Oh yeah, kind of like we assume that the water will run when it when it comes on and when you turn the tap and the water's not there, like all of a sudden your entire world is out of you." You know, one thing that was interesting, and I guess on that assumption point, one thing that was interesting to me is when I read this, there so many of his worries and so many of his concerns. Now, maybe you could just say everything goes in cycles, but they play so hard into what we've seen or what we might be seeing over the past two to three years. You know, I we could start with an easy one. The assumption that AAA rated paper is good. uh you know you start thinking about SIVBB first republic the uh flagstar NYCB disaster there was the assumption that AAA rated paper was money good and we can just hold it on our books until it matures and it turns out no if you hold enough of it and it goes down enough or for NYCB you know if you have these loans and opex keeps going up while your rent regulations are your rent is getting limited you could have a lot of issues there so I'll pause there and there's a lot of other ones I want to discuss
Yeah, like I think a lot of credit cycles, you know, you never run through exactly the same credit cycle twice, but then in retrospect, you do find a lot of commonalities between different credit cycles. And it is often often what's going on is people are slightly mispricing risk. Like that's I think that's that's one of the interesting things about credit versus equity market extremes is that with equity, when equities get mispriced, it's really really wild mispricings. You look at a bunch of companies at their peak 2021 valuations and you say either this company was trading at literally 10 times what it should have been trading at or you say this company was worth billions of dollars.
I'd add a zero to what? I'd add a zero to that 10x there burn.
Right. No, but I mean even, you know, even for some of the companies where they're growing really fast, but there is a point where if you're paying 30 times, you know, 30 times revenue two years out or something, you just need a lot of things to go very very right for that to be even remotely possible. Then with credit, it's often that people make fairly marginal mistakes. You know, they should have they should have lent at 7, they did it at 6 and a half. And what happens with those is they just compound really fast because when you're in a credit market, you're often in a market where it really really scales once there is access to capital. So if there's some category of borrower who through some indirect means is able to borrow at a little bit less than they should and they're able to put that into some asset that they think has some return that is suddenly at the acceptability threshold because of this cheap credit then they do a lot of it and then your credit book is always going to be skewing towards like B yeah if you're running a credit book it always the natural skew is always towards the people you should not be lending to and that's going to be the case in um if you're running a large bond fund that the people who most want to issue bonds are the ones who can't believe that they're able to borrow money at such a low rate. And then like in consumer, you know, consumerf facing financing, it's always like people who realize people who get their first um credit card or BNPL and they're like, "Wow, this is free money." Like this is a cash windfall, credit limits 5K, so I'm going to spend another 5K. Um so you always have that automatic selection for that. And then the whole business is um trying to mitigate that kind of selection effect. um trying to trying to find what are the signs that this borrower is uh just not suitable even though they seem to be in some statistical sense.
What you said is exactly the reason why the scariest thing in finance is a fast growing financial, right? Because you start lending to people at six and they should be at seven. You're going to have literally unlimited demand for that. And the real issues with that isn't going to show up till you know 3 years later when you start seeing the defaults or more likely when kind of you have a downturn and then all of a sudden oh that's why we should have been charging them probably nine instead of six and uh everything's just imploding all around you.
You know, one really interesting thing I was sh not shocked but uh a through theme of the book is the HFM, the hedge fund manager, talking about how the financial crisis is a misallocation of resources and talking about how the bubble is a misallocation of resources. And all of us know I I mean you've written a book on booms and busts and what they can do, but uh all of us know that a financial crisis is a misallocation of resources. But I was just surprised that someone who's like in the- moment trading, you know, he says, "Most of my trades are on done on a 6 to 12 month time horizon." I was surprised by how much he focused on the consequences of the misallocation of resources. A house that shouldn't have been built getting built here. Uh uh metal that shouldn't have been mined getting mined here. I was just a little surprised by that. I don't disagree with it. I think that's a pretty common worldview of booms and busts and euphoria, but I was surprised that he was so uh focused on that. So I just wanted to get your thoughts on that.
Yeah, I mean sometimes sometimes just asking yourself what is actually the underlying economic activity that's being funded here. It's just it's a really clarifying question. So, um, back in 2021 in a different corner of financial markets, I had some friends who got really into yield farming in DeFi and I kept asking them who like what economic activity is being funded by the 20% yield that you're earning on something that is a dollar pegged asset like what is actually going on such that the person who borrows $1,000 from you has $1,200 in a year. And it turned out the answer was that this is like the the highest risk slice of some giant stack of leverage that is all being used for margin lending um decentralized margin lending. And you know once once you see that that's what's actually going on, you just know that um this can't actually go on forever. But if you do find that where all the money is going is towards some kind of productive thing, then feel a little bit more comfort at least you have some kind of underlying economics that you can start trying to underwrite. I think part of there's also this thing where sometimes it is just interesting question to ask just where did the money go but if you ask that about equities where you know the equity market was worth this many tens of billions and now it's worth some smaller number of tens of billion or trillions sorry tens of trillions like where did the money go is kind of the wrong question because it's not like people actually had that cash on hand. It's just that is that's the number you get when you multiply last trading price by shares outstanding. And particularly in a case like um the dot era, a lot of these companies had pretty high insider ownership. Um they were fairly fairly new companies and so they'd sold a big chunk to VCs and then founders and employees had a bunch of money. So a lot of that money disappeared but it was paper wealth. It wasn't money that was being spent. But then in credit you can't actually say that like in credit if someone if there is a um a subprimebacked CDO and it um raises however many hundreds of millions of dollars like that money did actually flow into some kind of real world activity like it bought actual specific assets or it led to those assets being constructed in the first place. So the money did have to go somewhere. And um and you still have the the paper wealth dynamic where the question of where did the money go is partly this house used to it used to be that um it was funded with 10% equity but now the house is worth 30% less. So it's uh that's where the money went like that's that's why the bond is not actually able to uh able to pay off at uh at the price or the at the principal value that you expected it to. So, like, but then you do still want to ask like someone had money, that money got to someone else, it went to somewhere else and somewhere else and somewhere else and so on, and now it's it's gone. And um I thought some of his answers to that were actually pretty good of like this if like some of the money turned into what would have been productive activity if there had been more real underlying demand for it, whether it's cutting down the trees or building the house or whatever. And then where did that money go? Well, if the marginal worker was a recent immigrant who's sending a lot of money back home, then that that spending got like the the credit availability got recycled into investment in housing and that some of that got recycled into um remittances and then into consumer spending in poorer countries in the world. And then then you start to realize, okay, that's that's why we're not getting the money back is like we'd have to go to, you know, go to somewhere in rural Mexico and seize the used car that someone's mom and dad were finally able to buy because their son worked really really hard building houses in suburban Phoenix for a while and was able to send much money home. Like, we're not doing that. I don't I don't think there's actually a very good moral case for doing that. Even though you can be you can be annoyed that the bonds um that there were defaults and things, but I I think that's that's part of what he's going for. And I think cuz he this was actually one of the interesting things that I wondered about this when I I wrote in um in the newsletter a couple weeks back that I had reread the book in ahead of this call. Um and one of my readers asked me if I could figure out who this guy was because there has to be a pretty short list of people. But then cuz he he does a bunch of different things and he talks about a bunch of different things his fund does and to some extent you just have the vibe of this is one of those funds that probably started in the 80s or 90s doing some like one strategy probably convertible arbitrage that's what a lot of them started doing and then by 2007 it's a huge sprawling fund with lots and lots of different strategies. So he he seems like the kind of person who'd be getting just lots of questions from lots of different people about just what's going on and being able to go back to what is the underlying economics like that is it's just a really good use case I think especially for he talked about doing emerging market stuff including emerging market sovereign credit and just asking yourself yeah like what you know if if you buy a Brazilian bond what is the Brazilian government doing with this money is it a useful thing to do like is it going to make their GDP grow so that they have a larger tax base so they actually um pay the interest on this bond or is something else going to happen?
No, I you you hit one of the questions. I was wondering as I was reading it like who is the hedge fun manager because a he talks about so many different things and you know I initially thought this guy for sure is a macro trader, right? And I think by the end of the book when you read and you he talks about his different strategies, he even says it seems like he's a real val. So, you know, probably the early days of the the the prop tra the prop trades or something. He's a real val emerging market player is what it really seems like which does make some sense right like he's very broadly read he understands how financial crisises go through but I was surprised it's just a really curious question you're like hey like what firm was he at where he talks at one point about hey we have to shut down our blackbox trade and he seems to have his pulse in a lot of different his fingers and a lot of different pies and his uh the pulse of a lot of different markets so it was really curious did you have any guesses I I certainly do not to give you my idea
Yeah like if I had really good guesses I probably wouldn't I wouldn't want to share that. I would probably try to email this person and say, "Hey, is that you? I love your book." You know, um did you uh did you feel very seen? Cuz that a I think you could eliminate it down if you like if you're like my life's work is to figure out who HFM is. I think you could eliminate down based on he does give in a lot of descriptions and he moves to Austin at the end. But my question to you was did you feel seen where he's like, "Hey, I'm burnt out. I'm going to Austin." He's he's an early comer. But did you feel seen by it?
Uh it was it was something I thought about a little bit. Um I think it just it has it has a different connotation pre and post pandemic and these things always shift a little bit but yeah it's I think certainly if you're in an environment where the way your life has changed over the last 10 years is that you're trading different asset classes and you might be at a different um slightly different part of Midtown while you're doing it and then you do move to Austin. Like that is a huge shift. But, you know, for me, the Austin shift was I I've spent several months mostly inside what is increasingly feeling like a very very small apartment, and I could go somewhere with a backyard. And uh so that's that's what I ended up doing. So, yeah, different different set of trade-offs. Did feel seen.
Um yeah, we chose this book because especially at the beginning of March, I I think we're recording this what what's the exact date? We're recording this March 26th. At the beginning of March, things were feeling like really dire. You know, you had the mo the Russell was down like 12 weeks in a row when I was starting to get the I I feel like I need to create a timer based on when I'm starting to get like what I call my therapy session emails from some of my friends versus like, hey man, are you seeing any opportunities just my therapy sessions? But, uh, I was feeling very seen because like, man, this is really stressful. Markets keep going down. And then I've got a kid and I was like, hey, Alicia, like taxes are high. May we I did a podcast where I was like, we I'm thinking about moving. We're thinking about moving. And then I read this book and the guy's like, "It was stressful running through the uh GFC, which today is not the GFC, but it was stressful. New York City taxes are high and he's getting married versus I have a kid, so he's moving to Austin." I was like, "Burned it. I'm thinking about doing it." I was just feeling very seen by it. And at the beginning, they mentioned he talks very fast and very passionately. He's hard to keep up with, which I think we know two people who do the same there as well.
Yeah. like he it did the one of the things that makes it hard to track this person down is that there is this archetype of just someone who is in in the market. They have their specialty, but they're just generally interested in the ways that people make money. And some of that is just this practical thing of okay if all of my income stems from whether basically from are emerging markets doing well relative to the US or not. Um which is in a lot of cases like yeah you can hedge but often the expectation is if if emerging markets are really hot you're probably getting a good bonus that year if that's your the main thing you trade. Um so you know he's like there there could be this practical argument of okay all of my income is based on this very this thing that I'm probably not going to hedge. So, I should at least understand how other things work. Maybe I should invest in a fund my friend is raising or something and I want to know how they make money and so on. But it's also just it it pays off to be generally curious about things that are not directly related to the way you make money because they often end up being the bottlenecks or the exogenous risks to the things that actually do make money for you. In fact, part of the financial crisis, like part of what kicked it off was that it turned out a lot of um a lot of strategies were more correlated than people thought because you had the same diversified fund that is running all these different strategies and because they're uncorrelated, the fund can lever up. And then suddenly you find out that when mortgage back securities start to weaken, suddenly Statar goes through this in like nightmarish couple weeks in um in August of 2007. And as far as I know, no one's been able to trace that to anything other than there were funds that were doing a lot of SATA arb and that were also doing a lot of mortgage back security stuff and that when one started going badly, they had to degross and that forced everyone to degross. And since it was August and a bunch of people were on vacation, that degrossing was a little choppier than it had to be.
Uh there were a lot of things, I think I mentioned this earlier, but there were a lot of things in the book that I read and I was like, damn, this this is really striking me as a parallel to something that we've seen over the past few years or a parallel to some of the worries that people are having in the market right now. I'm happy to uh lob a few your way, but I I was wondering if any one or two jumped out particularly to you.
I should look at my because I had a bunch of highlights in the book and um I had not realized when I read it. So I when I originally read it, I I was one of the people experiencing the very slow recovery in employment and wages after the financial crisis, but I happened to be working at a company that um for non-economic reasons had decided to get an office right on Union Square. So every day at lunch, I would just go downstairs, eat a really quick lunch, and then um go to the Barnes & Noble two doors down and just read for half an hour. And this was one of the books that I read in a series of Barnes & Noble, you know, lunch hookie playing escapades. Um, but then I when I was reading it on Kindle, I realized, wait, I have highlights in here. I at some point had downloaded it on Kindle and reread it um years ago. And yeah, the highlights were often things where I was like, hey, that sounds really really familiar. Um, and so one of them, one of the things that that actually stood out to me, which is kind of adjacent to this, is sometimes he would talk about things where it feels like he's really really forward-looking. like he at one point name checks Huawei as one of China's higher value added export businesses and you know it was a big company back then certainly but it was not a company that I think everyone had heard of to nearly the same extent that they have now um so that was one um let's see he oh the the AAA um the US credit rating he did actually versus um yeah yeah he's saying downgrade just a downgrade yeah yeah yeah that he he he was right that the US could get a downgrade. He thought this would be a really huge deal. Um it turned out not to be. But I think that was just a sequencing thing where um if the US had gotten if US credit rating had gotten downgraded in June of 2008. If Moody's had said, "Look, you have this huge economy. It's an oil importer. Clearly demand is not responsive to higher prices. Therefore, the US has just this gaping oil liability and we don't think it'll be creditw worthy long term, etc." Um maybe that would have actually been what sparked the financial crisis. But since it happened afterwards where everything had already been recapitalized and um Europe had become more of the problem area, the US was still a safe haven. You know, the US credit downgrade grade was certainly really embarrassing, but it was uh it was one of those things where at that point it is probably at least bullish USD in the sense of everyone decides, hey, the world is even more chaotic than I thought. I better make sure I have dollars so that I can deal with my dollar denominated liabilities in the future or just because dollars are safe in a case like that.
I think another interesting thing just to play off what you said there is because it was post 2008 the banks and regulators were probably a little bit easier to work with each other on risk capital and how to account for things. Whereas if it happened before 2008, you know, I could imagine a world where where bank regulators are really slow to respond and you get a US you get a downgrade there and banks say, "Oh crap, like you know, we had zero risk waiting on our US Treasury holdings. Now we have to go raise capital to cover the US treasuries and regulators say our hands are tied. It's not AAA anymore." And then you have like a uh as you said the financial crisis expires even more out of control because you have you have to raise capital to cover your subprime losses and you have to raise capital to cover your uh to cover your treasuries. Like I could imagine that world. So in some ways maybe it happening after the GFC actually helps with it a little bit. I don't know.
Yeah. So, another one um as I skimmed through my my notes on this was um direct lending and private credit where he talked about being more in that space. And I do get the impression that maybe that was just the spreads in the tradable stuff had gotten so narrow that he realized this is just not a good way to make money. It is, you know, they've you switch from picking up nickels in front of a steamroller to picking up pennies in front of a steamroll and at some point you just it's not worth it. So he switches to private credit and then um seems to be a very early adopter of really sharp elbow tactics in private credit. So he has this whole extended riff about how he lent to some company, they he he doesn't they're not paying him back. He knows they could. And so he starts calling up their customers and their suppliers and saying, "Did you know that this company doesn't pay its bills?" And uh uses that to force them to actually give him his money back. So that that felt a little bit forward-looking. It seems like more may I don't know if more of that happens now, but it's at least better known that the the private credit people do not mess around.
