Greg Lippmann – The Big Short and Structured Credit at LibreMax (Capital Allocators, EP.270)

Greg, great to see you.

Sure. Well, I don't know how far we want to go back. Ted and I went to high school together and people are the same. My parents were cleaning out my bedroom when I was about 25 and they gave me some papers, and included in that was my second grade report card. I was just then at the same time getting my review from my employer at the time, Credit Suisse vs. Boston. And you put my 25-year-old employment review next to my second grade report card and the strengths and the weaknesses are the exact same. So people are who they are. You can work harder to be a better person or be happier or calmer or whatever it may be, but we each are the person that we were sort of made to be. And I haven't changed that much. So it's sort of interesting that you have some knowledge or memory. We went to a small high school, so we certainly knew each other. And to this day I remember the names of your brother and your sister, so yeah, we know each other.

So it's kind of ironic or funny story, I guess, which is that my family was in the real estate business, small-time real estate business. I assumed I would go into real estate business. And I graduated college in '91, which was one of the times that was hard to get a job. So two things happened: one, it was hard to get a job, and two, I read the book Liar's Poker by Michael Lewis and I said, 'Wow, this sounds amazing.' And I had never heard of really a Wall Street career. It just didn't come from a background where that was talked about or I knew anyone who did that or anything. So I read the book and I thought this is interesting. And while still sort of trying to get jobs in real estate, I tried to get a job on Wall Street as well. And although I was magna cum laude, I graduated unemployed because '91 was a bad year. I remember going to interviews and people saying, 'Wait, you're magna cum laude in economics and you're unemployed?' Like I had a 2.5 GPA and I majored in biology and I got a job in M&A banking at Goldman Sachs secretary of college. I'm like, 'Yeah, well, you graduated before the '87 crash and I graduated after, so it was a different time.' Just trying to find a job, living at home after college, trying to find a job and taking any sort of interview I got. And you know, some of it is luck. And then eventually I was hired in a middle office type job at Credit Suisse. I started November 4th, '91. And at the time there was no Bloomberg really. Bloomberg existed but was a very, very minor thing. And all the banks had their own internal mortgage-backed security departments and whatnot. And so there was a huge demand for people to call up the mortgage servicers and find out how many loans were delinquent and just really rudimentary type of stuff. And so I started there and I got really lucky. I think one of your questions at the end, because I'm a fan of your podcast, is you know what were some of your mentors. So I'll jump to that. Which is that one of the people that was working in the structuring group, I was really eager, I asked him a bunch of questions, and he said, 'You don't know enough to ask me questions. So I've taken the liberty of circling which of the training program videos you should watch because you weren't in the trading program since you started in November. And I've bought you a copy of the Fabozzi Handbook of Fixed Income Securities and I've circled the chapters you should read. When you read this book and you see all these videos, then you will know enough to ask me questions. But until then, don't ask me any questions.' So that tough love really helped catalyze my thing. And then I also was lucky that the group that he was in merged with the group that I was in, so then I was part of more of a front office type of role. And at the time there was something now called Intex, a lot of third-party software providers that didn't exist back then. And so each firm had their own internal modeling software. And basically what it meant was somebody had to read the documents, understand how the plumbing worked in each of these securitizations in terms of if different things happen, which bonds got paid, which bonds got losses, things like that, and type that into an in-house computer language and put their name on it so if there was ever a mistake you knew who made the mistake. And even though I graduated, I didn't know anything about computers because right before the big computer wave. I learned how to do this in-house language and I was really good at it right away. And I knew then that this was something that made sense to me, how these things worked.

So I found that the trading people seemed to have a more interesting job and maybe they made more money than some of the other people, and they weren't working the crazy long hours like I was just an analyst. So what I decided to do is every day I worked on the 18th floor and the trading floor was on the third floor, so I would go downstairs and if anybody was traveling for work or out sick or on vacation, I would just sit in their desk and I would do my job and I wouldn't say anything to anyone, but I would just sit there and do my job. So one, people would see me; two, I would hear them talking and pick up something. And I just thought I would be this way top of mind if they ever thought something. So when the BPS trader at the time needed a second person, I was sort of the logical person to do it. One, I was known for being really good at my job and I looked up in the database and I had structured more of these deals than all the other four people put together. And two, I was always around. So I was invited to join the BPS desk, which was this sleepy or backwater part of the business. It wasn't really flow trading, there weren't a lot of trades. We sometimes didn't even do one trade in a day. But it was more about really understanding the risks inherent in these structures and the leverage in them. And it was not portfolio management. We would buy things not really knowing who we would sell them to or when we would sell them to, as opposed to somebody who's trading in more of a flow product. And I sort of thought of us as like the track team in that the agency mortgages were sort of the football team and they were doing tons of trades and everybody wanted to be around, and the sales people were the cheerleaders if you will, and they all wanted to be around the agency pass-through traders. Those guys were doing huge trades and whatnot. And the AAA mortgage, the non-government guaranteed mortgage, they were maybe the baseball team. They were also doing these big trades and everybody wanted to talk to them. And we were kind of these guys in the corner doing these very small trades. But because the trades were complicated, because they were illiquid, because not that many people did it, our margins were really big. And so even though we weren't doing as many trades as some of the other areas, it was still pretty profitable. And I always viewed it as, I used to say to people, in some ways what we were doing were more like being art dealers than two-year Treasury traders. And that appealed to me, the intellectual aspect of it appealed to me.

During the period of time between when I first started and we got to that trade, I became sort of known for doing all of the sort of unusual esoteric trades. So securitizations really are just backed by cash flows and you can do securitizations backed on mortgage bonds or credit card loans, boat loans, really anything. And one of the things we had worked on was after the big tobacco settlement, the tobacco lawyers didn't want to wait for their money for many, many years from the states, so they securitized their future rights to get these payments. So securitization really can do anything. And I was involved in a lot of the more esoteric ones. So I always consider myself like a thinker, an intellectual. And because the B pieces in general and really structured products specifically, even the AAAs, each bond is somewhat unique. And even the AAAs where there's maybe a big chunk, maybe it's $100 million, the ability to short something when there's no borrow doesn't really exist. So it was always the case that you just really thought about well, how much do I like them? Do I like them or do I love them? But you couldn't really hate them. And then with the emergence of these derivatives in '04 and '05, it became the case that actually you could bet on no. And you never could bet on no before. So considering myself an intellectual, I wanted to do the work to find out well, how much do I like them? And I'd really never thought about it before, to be honest. So the first thing I did is I worked with a colleague and I said, let's break America out into quartiles at a zip code level based on home price appreciation and let's look and see what the defaults look like. And so we looked at the 2000 vintage because this is back in 2005, and five years was about enough time to really know what would happen. The 2001, 2002 vintages were slightly less seasoned, and certainly the 2003, 2004 you couldn't really discern much from them. So what we found was for the 2000 vintage, the top 25% of American home prices generally corresponded to California, Florida, places like that where the loan balances were higher than other parts than say the Midwest. So they were 25% of the loan balance but they were about 62% of the bond balance because the houses are worth more. What we saw was that after six years, the default rate in places in the top quartile where homes were going up 12 to 14% a year, the default rate was still 6 or 7%. Now it's kind of amazing that people are defaulting even though their house has gone up by more than 50% in value. That was sort of shocking to me, that you have an asset that's way in the money and you still default. What was also interesting was that there was a small loss taken when those people defaulted. So you have an asset where just for simplicity's sake, person buys a house for $100, they borrow $80, the house is worth $140, $150, and we're only getting $70 back. The guy borrowed $80, we're getting $70, we're losing $10. So there was gigantic slippage on this and that was alarming. But if you looked at the bottom quartile for houses, they were going up 3 to 4% per year and 28% of the people were defaulting and we were losing 50 to 55 cents on the dollar when they did because of the similar type of slippage. So I saw that and I said, 'Geez, you know, someday home prices are going to go up 3 or 4% a year in California and apparently when they do, maybe it won't be quite as bad as Ohio or whatever these other states were, but it's gonna be bad.' And these bonds that are backed by them, the triple B, triple B minus tranches, just to oversimplify it, if the losses are 8%, the bonds get a hundred, and if the losses are 9%, the bonds get zero. And so if you assume a sort of a 50% severity, you're talking about 16% of loans defaulting and the bonds are covered, and 18% of loans defaulting and the bonds are zero. And we already know that the bottom quartile of America, like 28% of the people were defaulting. So I looked at this and I thought, after I got the shock over, eventually these bonds are going to default. But what I know right now is they're paying somewhere between 6 and 10 to 1 to bet against them. And I think the chances of it happening are maybe 3 to 1 against me. And if you spend your whole life looking for things that are 3 to 1 long shots that pay 6 to 1, two out of every three times you walk away empty-handed, but if you look in your pocket it's really full. And that was what attracted me to it.

2005 in earnest, maybe a little bit 2004. I mean, I know that we put the short on in a meaningful way in late '05.

Well, like no one. Because first of all, the only way to be short it was to actually have these derivatives, so it was a nascent stage of the derivatives. There weren't that many that were outstanding at the time and it's all over the counter, so it's possible that somebody had a gigantic short and I knew nothing about it, right? But for every short there had to be a long, so I didn't think that many people were involved, but I certainly can't say that for sure.

Well, 2006 was a year where it didn't work in the sense that as everyone knows the adage, right? In the short run it's a voting machine, in the long run it's a weighing machine. So the year of 2006 was a year where it was a voting machine. And there were people, I'm sure remember the conundrum that Greenspan talked about, and that rates were low and people had to those excess savings glut and whatnot. So worldwide people were looking for spread products and so on. So 2006 I would say was a year where the voting machine won and the price of these assets, even as the fundamentals began to deteriorate, didn't move.

February of 2007 the prices started to move and I began to have a little bit of notoriety for the trade. So I had been involved in the trade for over a year before it worked in any sort of meaningful way.

It was a really fascinating experience in that people do all different kinds of things. You had people who would say, literally a couple hedge funds said, 'Well, this is a 3 to 1 long shot. I only do things that I think make money.' And I would say at the beginning of each of these meetings, 'My goal at the end of this meeting is to convince you that this is no worse than a 3 to 1 long shot. I'm not even saying that I think it's a 3 to 1 long shot. I might actually think it's gonna happen, but I just want to convince you it's a 3 to 1 long shot and explain to you why it's a 6 or 9 to 1 payer.' And there was the odd person who was like, 'I don't do 3 to 1 long shots.' I'm like, 'But you understand it pays way more than that.' So people who clearly didn't really understand what I was saying but understood, 'Hey wow, this is a 6 or 9 to 1 payer, this guy's really excited about it, he seems kind of smart, I'm just going to throw a little bit in.' To people who got really in the weeds and really understood it almost to their detriment, because what you could do is the names that the broader market thought were good, there was an infinite supply of those names. The names the broader market thought were not so good, there was less of a supply. So the guys that almost got too smart for their own good, they were focused only on shorting the worst ones, of which there was a limited supply. So it was fascinating to see how people reacted.

Well, it didn't feel like all of a sudden it was on the silver screen, for sure. What was an interesting experience was sort of fighting to maintain a position and then just a few weeks after that being on the cover of the Wall Street Journal. So I went from being Chicken Little to cover of the Wall Street Journal in just a matter of maybe not days but certainly not more than weeks. So that I would say the time to Mr. Gosling playing me in a movie, that was a little bit longer than that. And how does that feel? I mean, it's certainly there's a lot less appealing people to play you in a movie than Ryan Gosling, so I guess I'm grateful for that.

Being where I am now, I understand it more deeply than I did then. I mean, I had to maintain my position at the bank and not everyone at the bank agreed with it at all times. I ultimately had to, if anything, say, 'You know, I'm not taking it off. Fire me if you want, but I'm not taking it off.' But as a hedge fund manager, it's a lot harder, right? Because people just send in a redemption notice and they say, 'I'm not talking to you. I don't want to hear what you have to say. I'm just redeeming.' So I would say that in some ways it was easier for me. I mean, in some ways it was harder because I had one investor and they had daily liquidity, so that's different than a hedge fund where it's quarterly and you have a variety of investors. But I saw the people every day that were my investors, and in some ways it was easier to maintain than when you have investors all over the world who don't necessarily want to hear from you.

Well, I think patience is one of the most important things for an investor to have. So I think not trying to hit a home run all the time is an important skill and discipline, and not one that everyone has. So that would be the first thing I would say. And ultimately, look, I think that in the same way that the short was a time where you said there's an asymmetric reward in terms of being short them because you could only lose so much and you could make a huge amount. And when the bonds were trading at 20 cents, 40 cents on the dollar, it was an asymmetric reward the other way, which was that they're not worth zero because they pay some amount of interest. They're not gonna be worth nothing. And if actually the defaults are not 80% but 40%, this bond that I can buy at 30 cents on the dollar, worst case it's worth 15, best case worth 70. You sort of start to say, 'I'm either going to double my money or I'm going to lose half my money, and I think the chances of me doubling my money is much greater than losing half my money.' You're supposed to do those trades.

Sure. I think basically it had always been a small insular side market. And then as a result of what happened during the Big Short, lots of multi-strategy funds heard about structured credit and in many cases did the short, so they understood it now in a way. Then they hired people. Now it became something that used to be completely unrelated to broader markets and had its own little group of people that invested in it and they were only tangentially interested in what happened to other markets, to something that became more integrated. And when you think about these large multi-strat funds where they're buying high yield, they're buying equities, they're buying emerging markets, they're buying structured products, and so they're looking constantly at the relative value of the different things. And so I think that our market has become more integrated in other markets and therefore the price moves are somewhat more connected and correlated than they were back then.

I think one of the things that makes it exciting to do it right now and I think the reason that there's a lot of alpha that can be mined there is you can sort of slice the universe a bunch of different ways. We have four sector teams and each of them is manned by a person. So our sectors, the way we describe them, are consumer ABS, RMBS, CMBS, and CLOs. And that's sort of one really simple way to do it and say, 'Hey, we're 25% RMBS and we're 35% CMBS or whatever the case may be.' And a different way to look at it would be to say, 'Well, how many of your portfolio is double B rated or single B rated or triple B rated or what have you, regardless of the type of collateral that it is?' Right? So that's a different way of slicing it and thinking about risk which is not collateral based but ratings based or leverage in the capital structure. Another is seasoning. Some of the deals were issued 10, 20 years ago and the way those structures have evolved over time and the loan to value ratio of the underlying collateral is very different. So a double B that was issued in 2012 and it's still rated double B for whatever reason doesn't look anything like a double B that was issued in 2022, but they're both double B's. So if you ask me how many double B's do you own, one answer is, 'Well, I own two.' Another is, 'Well, the 2012 one, it has none of the same characteristics as the 2022 one.' So there's all kinds of different nuances in the space to express one's interest in investing.

Sure. My father was a small businessman. I always had a certain amount of interest in starting a company. I think inertia is a very powerful thing, right? You have a job at a bank, it pays a relatively good salary, none of the risk is yours. If you lose a lot of money, you just get fired. You don't lose any money. You don't have the hassle and the risk of setting up a company. Was really for me in the beginning for a while and still to this day, like this desk, I own this desk. And if we ever close LibreMax, like I'm going to sell this desk for something. And when you work at a bank, you own nothing. And so that was different. But the inertia of not starting it is one: I have a good salary, two: I don't actually have to go find desks to buy, I don't have to rent office space, I don't have to hire a compliance department, I don't have to do anything. So while I had this sort of interest in starting a hedge fund for a long time, the inertia of working at a place where most of that stuff is taken care of for you is powerful and you're making an income and whatnot. And then after the Great Financial Crisis, we had one had a certain amount of notoriety that I thought could raise money. Part of the Michael Lewis's book too. We thought that the asset class was really attractive in the aftermath of the GFC, that returns would be sort of easy in the beginning. And those two things put together: we'd have an opportunity to raise money and we'd have good returns for a few years and then you're off to the races, right? A lot of institutions want to wait until you're three years in business. And so we thought we'd get off the ground and we'd have at least three good years and then we'd see where things went from there. Truth be told, I just got to a point where at the bank I felt I wanted something less bureaucratic, I wanted less red tape, I wanted to see what I could do as an entrepreneur and take the chance of seeing how it went. When I started my fund, I went to many of the people who had done the short with and sort of said, 'Hey, I'm starting this new business. You're a big hedge fund guy. I made you some money back then. Could you put some money in my fund?' And quite a few people did. But if you had given me the list of say 40 people I called and you told me write a list of the 20 most likely and the 20 least likely, I would have got like three right. Like three of the 20 most likely gave me money and 17 of the 20 least likely gave me money, which was really an interesting psychological experiment just to see how people repay a good turn and who does and who doesn't, things like that.

One of my pet peeves is people call structured products a trade as opposed to an asset class, which I disagree with. And I think that first of all, I've been doing it 32, 33 years, so it's been a life for me, not just a trade. When you start something, you can dub yourself whatever you want and either people give you money or they won't. But one thing I've learned in the 12 years, it's very hard to then change. You can claim anything you want to claim, but afterwards if you try to change that, people say, 'Well, that's style drift.' So we said if we're focused on what we do, we'll attract assets. Not really thinking that down the line if we'd said, 'Hey, we're really smart people and we could do anything and we could buy Greek bonds if we want and we could buy Malaysian equities,' we can't do that now because we didn't say back then that was something we would do. We were very focused on structured products. And we think there's this great opportunity in mortgage-backed securities right now. You can buy them to a 12 or 14 yield to really onerous assumptions that have a lot of convexity to being better than worse. You were buying them to a 12 yield to 85% of people defaulting on their mortgages. Could it be more than 85%? Maybe. But like, not everyone is going to default. And as it turned out, like 40% of the people defaulted. A lot. But what you learn in investing is it's not if things are good or bad, it's all about are things better or worse than expectations. And at the time, the expectations for mortgage-backed securities we felt were just too conservative and there was a lot of room for things to get better and a lot of likelihood that things would be better and not a lot of room for things to get worse. And so when we started, we were very focused on the RMBS trade and we told people we would expand across structured products, which is what we've done.

So I would say, I mean, there's two different things. One is the focus on our original hedge fund and growing the business, and two on the asset classes. So like when we started, RMBS was maybe 75% of our assets and it's mostly been somewhere between 15 and 30 for the last handful of years, right? As the RMBS trade became less attractive relative to other things, we moved into other things. I'll give you one example. Student loans really lagged the recovery. And we looked at the student loan opportunity a few years after we launched the company. We said this sounds like subprime. In the subprime case, people said no one's going to pay these mortgages, 80% of people are going to default and we'll recover nothing. And there was a period of time where people said all these student loans are bad, everybody owes $200,000 and they work at Starbucks. Again, it's not a question of good or bad, it's a question of how bad. So we first of all increased significantly student loans. At one point they were 30% of our master fund and they were like zero when we started the company. We at one point did one of the first of our sort of bespoke funds where we did a fund that was just on student loans. It was a private equity more kind of structure in terms of like locked up capital with a date certain on it. We were able to raise some money for that which was returned profitably with returns in excess of the original hurdle and whatnot. So we've built a business over time that has a variety of different funds, some single investors, some single strategy with different types of liquidity. So as the mortgage trade evolved, we were always looking for other interesting trades to do.

Sure, it's a great question. I would say first of all, the derivative market is a shadow of what it was back then. I think people sort of learn like if somebody wants to bet against something, they might know more than you. So we are now at a place where the majority of our hedges are more macro-like than micro-like. There's certainly the odd time where you can buy a residual and buy puts on the company that their main asset of the company is the residual that they own pro rata with you. So there are specific bespoke trades, but mostly the hedging is more macro than micro at this point. That's one thing that is different. So it's back to the sort of how much do you like them on the long side? Like them or hate them, I guess. What I would say is one thing that is really attractive about the space is the esoteric nature of it. It remains somewhat resistant to the quantification of most of investing. Some of that relates to each deal is different, so it's a little bit harder to do that because where it is in the capital structure, the specific loans backing it and things like that. The other is it remains an over-the-counter market, which basically means there are situations all the time where a bank in Japan or an investor somewhere in the world or the U.S., they need to sell an asset and they call an investment bank and that investment bank calls for the people that they think are most likely to buy it. Whereas if Facebook stock crumbles or the ten-year note soars, everybody knows that and so no one can sort of maybe you can be right or wrong but you have no knowledge of a situation that no one else does, right? So here, banks that show you assets enable you to buy things potentially at prices that are really, really attractive because of the lack of number of people looking at it. It's also the case that there's a lot of regulation remaining in our space. Some of that relates to Dodd-Frank, some of it relates to leverage on banks. Our team is mostly investors who worked at banks. We know how banks work in terms of aged inventory policies, regulatory capital charges, things like that. So there's lots of situations where people are doing things for non-economic reasons. They're saying, 'Hey, if I don't sell this aged inventory, I'm going to get a huge penalty. So it's cheaper for me to sell it cheap today than to get this huge internal penalty,' right? So we live for situations where people are doing things for non-economic reasons because of capital charges or aged inventory or where we can be the partner that responds quickly and favorably to banks. 'Hey, there's a seller of this' or 'We have limits on our risk because of Dodd-Frank and whatnot, so we can't position this. This bond's really cheap, this guy's desperate. If you can be quick with a reasonable price, you can buy it.' So that permeates the whole business and that has nothing to do specifically with RMBS or CMBS or double B or single A. That has to do with just there's a lot of inefficiencies and opacity in the market and we try to position ourselves to one, have the relationships to source those assets; two, to behave in a manner that people want to work with us; and then three, to have the internal technology to run the stuff quickly and be able to give people answers fast enough that enables them to do their job.

One of my partners, Glenn Parillo, runs an analytics division for us. And so we have a team of computer quant people that are building models that can quickly sift through the loans now. And I mentioned this before, back when I started each bank had their own internal software that valued these bonds. Now there are companies that sell those. And the good news about it is that everybody is looking at the same thing. And occasionally our guys are able to identify that there's a mistake because somehow they've read the document and the way that this structure works in this third-party software is not consistent with that. And that's obviously great if we see that. Well, it's really great if actually the bond is worth more than the third-party software says, and it's great to know it if the bond's worth less and to not buy it. So we have a robust team that builds models that can sift through the loans quickly and make different kind of AI-related predictions about defaults, prepayments, whatnot. And so that model will say, 'Hey, this bond's worth 80 or 90 or whatever the case may be,' and we know where we can buy it. We're not a quant shop in the sense that we don't take that price, but what we use this for is a sifting mechanism, right? So we'll put 10 bonds through the system and that system will say, 'Hey, I think you should buy these five and you should avoid these five.' Then we'll look at those five more closely and see what the humans think, right? So we're not the machines help us figure out which opportunities to look at. I think a key part of success is which opportunities should we look at. So first of all, do we think the price is probably attractive? How competitive is the situation? How big is it? How long is it going to take us to have confidence in what we're doing? Right? So if we can't make a lot of money and it takes a lot of time to do it, we should skip that one.

I think that's a combination of acumen and experience, right? So the team is reading the documents for themselves. The team has their own anecdotal view about different collateral types, loan types, geography. So we really like multi-family in the Southeast and we hate malls in the Pacific Northwest or whatever the case may be. So the model also reflects that, but the human has a view of that as well. And then it's at the sector head level looking at the panoply of potential returns and saying, 'You know, we feel good or bad about the upside and the base case and the stress case,' if you will. And then there's the direction from me on high about the things that I want us to look at at any given time.

There's a lot of ways to slice and dice the portfolio into constructed. And so we some of the computer system stuff helps us to stress test and shock the portfolio and see where does in aggregate the portfolio do well or do poorly. And we're always trying to figure out, can we modify our risk more cheaply internally? And what I mean by that, so simple examples are some mortgage bonds do well when prepayments are high and some mortgage bonds do well when prepayments are low. So if you can buy the ones that do well when prepayments are high from people that are afraid prepayments are low, and the opposite, you can get to a situation where you now have two bonds: one does great when prepayments are high and the other one does great when prepayments are low, and they both do decent when prepayments are middle. If you can fuse those two together cheaply, you now own something that is somewhat indifferent to prepayments. So we're looking across collateral type, rating, structure. Are these bonds that do better when things are faster or slower from a prepayment, from a default perspective? One interesting trade to do in commercial mortgages is to buy interest-only securities where if there's a delay in the refinancing of a property, the value of those soars because they only get interest and as soon as the property is refinanced they're shut out. Whereas if you can put some of those together with things that are more credit sensitive in a time where it's hard for properties to be refinanced, that's bad for the credit sensitive bond, it's great for the interest-only bond. So what's exciting about structured products is there's this huge array of different types of bonds, both collateral points in the capital structure, how leveraged they are in the capital structure, the things that make them go well and go poorly, and try to fuse that together. So what we want to make sure is two things: we want to love every bond we buy, we want to make sure that we don't always love the same kind of bond because if we love the same kind of bond then we haven't insulated ourselves from that kind of risk. The way that things get into our portfolio are two ways, right? There's top down and bottom up, right? So the top down is me and the PM and the chief risk officer getting together with one of the senior traders on Mondays and we go through each of our funds and we set targeted gross, whether we want the gross to be higher or lower than it was last week, and then for each sub-sector whether we want to have more or less, more or less double B CLOs, more or less single B CLOs, et cetera, et cetera. So that goes out to the team for every fund, right? So that's a top-down view of this is what we want. The bottom-up view is, and I've alluded to this many times before, what's really exciting about the space is it's all over the counter. So even though we have this top-down view, it may come to pass that a bank calls us up and says, 'Hey, we really need to move this bond today and it's at a price that you would never have thought of when you guys gave that top-down directive,' right? So the team will come to us with, 'Hey, here's something that we can buy. It's not part of the top-down directive but it's really attractive.' So what we'll think about all the time is we only want to buy bonds we love. We also want to understand how they fit into the rest of the portfolio. So what ends up happening anytime a bond comes that's particularly attractive, we either have to A, increase our gross, B, you have to sell something else. So if you like this bond enough, one of the other CMBS bonds you own, for example, you have to sell one of them. Or C, we like it so much that we're going to tell the ABS person that they have to sell a bond. So what we say all the time, the team is like the master fund owns about 200 positions. If you want to take it from 200 to 201, it should be like one of the top 25 to get into the portfolio. It's got to be one of the better ones. So every time that happens, we're like, 'Okay, this is definitely one of the better ones. Do we want to go from 200 to 201 positions or do we want to cut one of the other ones?' And so the way that we're set up is each set, nobody has dedicated capital. We're not a pod shop. If somebody wants to buy something, I'm deciding if we just increase our gross, if they have to fund it with a different bond that they own, or if we're going to fund it elsewhere. But no one can say, 'I have X dollars of capital and I'm sort of doing whatever I want with it.' So you can see over time there's some amount of evolution in terms of, hey, our gross is changing all the time and B, the relative weightings among the four asset classes is changing all the time.

One of the things that's great about the space is because it's so data heavy, it's a pretty expensive business to run. So when you compare it to say equities, where anybody can start a hedge fund with $300,000 from their uncle sitting in their apartment and reading Barron's and if they're good they can eventually have a huge fund, we spend millions of dollars a year on data and on a team to sort of process that data and then on each of the sector heads where they're reading the documents and they're parsing these structures and understanding this. So it's really difficult to do what we do under $500 million of AUM. It's pretty much impossible in my opinion to do it properly. And to do it properly is to pay for all this data. What's interesting about it is none of it's insider information, but it costs money. Anyone can buy it, but it's not free. So that's very different than like reading 10-Ks or other stuff in the equity space which is free for anyone to read. So we have a certain amount of barriers to entry in the space. I think therefore there's only a handful, a dozen people really. And obviously you have giant firms like PIMCO that certainly do what we do and in some ways they have a lot of resources we don't have. In some ways we can be more impactful on a specific trade than they can be to a fund that we're managing. So that is I would say our relative edge. So we have a big enough team to do this appropriately, we have enough AUM to do that, and that is part of the business.

A lot of talented people have left the street and set up their own shop. Some people have left the street and worked for these big multi-strats, which is a different kind of business model. There's maybe a dozen, two dozen hedge funds that do what we do, and a handful of mutual funds that are very sophisticated in this space. Another thing that's interesting to talk about is the secondary versus the primary market. Think about insurance companies, pretty active in our space in the primary market, not really active at all in the secondary market. When you buy a primary market asset, you're buying it, it's freshly rated. If it doesn't work out in the long run, you can sort of say, 'Hey, when I bought it, it had just been rated whatever by Moody's.' One of the things I've made money on for 30 years is that the ratings are very, very stale. And sometimes they're stale too good, sometimes they're still too bad. But if you're somebody who's a new issue buyer and or your sort of incentive structure is different than ours might be, you don't really want to buy secondaries because secondaries now the credit rating is on you as opposed to on the rating agency. So a lot of times some of these more esoteric and illiquid things that were purchased by a small number of investors when they were bought, if somebody has to sell that investment in the future for whatever reason, or the person left the firm and the new person just wants to clean house and they want to start fresh and they want to get out of whatever was bought before them, there's only a handful of people that actually bought it originally. And then a small number of people were like, 'Hey, I'm gonna do the work to understand this thing that was issued eight years ago, two years ago, whatever it may be, and try to really understand how it works and how has it been working,' meaning how is the collateral performed during that period of time. And so those can be really attractive situations where there's a seller for any of a number of reasons and there's only a couple of people that are willing to buy that asset.

It's a great question. One thing that's scary about this is anybody can listen to this at any point in the future and so it's scary to think you know for sure at some point whatever I say right now is going to be wrong, even if at other times it's going to be right. So I would say that I'm pretty excited about the opportunity right now in securitized products. And the reason I say that is I think that the structure of the market of the consumer writ large and structured products in general related to regulations post the crisis and whatnot is the U.S. consumer, he, she, they look a lot more like they did in 2000 or even at other points in history. And I would say the corporate sector looks as sort of levered or fragile as ever. People always fight the last war, as the saying you hear all the time. So I don't know that the last war was the covered war, but the last war being if you say the GFC was the last war, the GFC structured products, particularly mortgage-backed securities, were sort of the worst thing to be in, right? They blew up and they took a lot of other things down with them. But if you go back to the 2000 crisis, that was one where high yield blew up and tech stocks blew up and structured products kind of muddled along and they did okay. And if you were long structured products and you were short high yield with some equity options as sort of a hedge kicker like I am now, you did amazingly well because structured products did all right and your hedges did phenomenally well because they went down, right? And that's actually kind of what happened in the first half of this year, which is that structured products did okay in aggregate. They were down a little bit, but the S&P was down a lot more, high yield was down a lot more, right? So if you were long structured products and you had hedges on, you could have made money. We were profitable in the first half of the year because of that. We made more money on our hedges than we lost on our longs. So when you asked me what I'm worried about, I think predominantly I believe that structured products, if the first six months of this year was not the end of the correction as some people say but was the beginning of the correction and it's going to be more like 2000 to 2002, which was like a three-year correction of markets going down and recovering and then going down again and recovering, if we're in the beginning of that, I think that our strategy of being long structured products with hedges is going to do fine because I think our long book is going to do okay, somewhere between modestly up and modestly down, and our hedge book is going to be modestly flat to modestly down if our long book is up modestly, and it's going to be up a lot if our long book is down a little, which is kind of what happened in the first half of the year. Now when you ask what worries me, the world that we just came out of, the '09 to 2021 world, is not a good world for structured products. So a world where the Fed is focused on propping up financial assets is a world where our hedges are not going to work. If we have a weak economy but strong financial markets, that's not going to be a good one for us, right? Because ultimately when you think about our assets, there's some hybrid of real economy, financial economy in the sense that in the short run their pricing is generally driven by the pricing of other assets, right? So if high yield is going up, there's a positive bias in our assets to go up. If it's going down, there's a negative bias on our assets. But in the intermediate term, what matters for us is unemployment, home prices, things like that. And so if we have a world where the economy is doing okay but financial markets are doing poorly, which is kind of what happened from 2000 to 2002 and what's happened so far this year, then we're gonna have a world where our longs are going to be buffeted from time to time by the sell-off in broader markets, but ultimately people are going to look at the delinquencies and losses, they're going to say these assets are going to be okay, and our hedges are going to do well. So I'm pretty confident that because of what's happening with inflation and geopolitics and reassuring that the Fed is moving away from a role of propping up financial markets to a role where they're going to be fighting inflation, to a world where the federal government is going to be more focused on helping regular people through a variety of programs which they've already done, gas tax holidays and things like that, those are environments that we should do well. But if we have a situation where unemployment soars and the stock market still goes up, that's a bad one for my strategy. And so I think we're entering into a more of a volatile time in the economy right now. And like I sort of alluded to, where the Fed is going to be instead of a force for lower vol, they're going to be a source of higher vol. You're already seeing this with the waffling about different things about are they going to ease next year or not. And obviously not a year ago today they said they weren't going to tighten at all in 2022. So what happens is these bonds are generally pretty levered. We're talking about we mostly buy subordinate parts of the capital structure, so bonds that have not binary outcomes exactly but really levered outcomes, right? So bond's trading at 50 and if this, that, and the other thing happens, it's worth 75, and if things are a little bit worse than we thought, they're worth 25. So constantly you have, if you can put yourself in a situation where you feel confident that the odds are skewed in your favor, so either it's 50-50 that it's either you buy something at 50 cents and it's 50% chance it's worth 100 and 50% chance it's worth 25, that's a great place to be. Or conversely, we say, 'Hey, I bought it at 50 and there's a 75% chance it's worth 75 and there's a 25% chance it's worth 25.' That's a different way of the same thing, right? It's a different way of saying, 'Hey, the odds are in my favor.' And because of the esoteric nature of it, because of how leveraged they are, because the fact that there's so much uncertainty right now about the path of interest rates in the economy, are we having a recession or not, is it going to be a minor recession or a massive recession, because of the regulations on the banks about holding these assets from a capital charge perspective and Dodd-Frank, there's opportunities for us to be a liquidity provider. So I think one thing that's very different today is we're running a much lower gross than we were before. By before, I mean before this year. We historically as a firm were kind of 120 to 140 gross. And when you're 140 gross, it's difficult to be a liquidity provider when things go wrong. Our gross now has been more in the neighborhood of 90 to 110. And we're at a place where we feel strongly that if June wasn't the low, if there's another bout of selling and whatnot, that we'll be able to be a liquidity provider and make a lot of alpha there by being able to respond quickly, by having capital. And as the firm has grown, we have lots of different funds that have the ability to call capital at different times. If you can call capital when people are selling, and as a regular way hedge fund that's a difficult thing to do, right? As a regular way hedge fund, actually your investors can call their capital back whenever they want, right? So when things are going awry, really ramping up your gross exposure is a tricky thing to do unless you've got it all right. So we've tried to address that as a firm by raising capital that can be called as opposed to can be called away from us, that we can call investors to give us that money. And we did that somewhat successfully with some of these types of structures in 2020.

Well, first of all, the experience is not over. And I still to this day occasionally get emails from people who were like, 'I read the book or I saw the movie and I want to be your friend' or 'Can you give me advice?' And I sometimes forward them to Mr. Lewis. So the beginning of the book The Big Short, he said, well, he wrote Liar's Poker as a cautionary tale. He didn't want people to go into Wall Street is what he thought. And people read that book, including me, and said, 'This is exactly what I want to do,' right? So at the beginning, the forward to The Big Short, he said, 'Well, that's why I wrote Liar's Poker, to get people to not do it. My hope is with this book that people won't want to go into this industry.' And so when some of the more interesting emails that I get, I forward them to him. I'm like, 'You did it again. You wrote another book.' So I'm married, I have four children. I'm not really interested in being particularly famous or anything like that. I don't have a big media presence. And it's weird at times when I'm checking in at the airport and the person next to me hears my name and they say, 'Oh, you're the guy from The Big Short.' Like I said, I get sort of emails from people that I've never met. I don't love that the parents of my children's friends feel like they already know something about me when we first meet. I don't love that. But I certainly don't think I was portrayed as somebody who wasn't smart, and so that I can't complain. And like I said before, you can't really complain if one of the sexiest men alive plays you in a movie. It's hard to complain about that.

Well, for kids it's hard to have that much outside. I love exercise, I love reading, I like listening to podcasts while I'm exercising.

Intellectual dishonesty. When people sort of pitch something that's the downside is still a fantastic return. What do you not understand that you think that this can't go wrong? Right? Because we invest in generally below investment grade assets, so they're not guaranteed to work or they wouldn't be rated double B.

I would say my father, who taught me the value of hard work and being honest and never forgetting where it came from. He wasn't really my boss directly, but a tough love from someone in the bank who taught me indirectly: you gotta figure things out for yourself and you gotta manage your own destiny. And I'd say this when I met people when I was at the bank or even here, like this isn't summer camp. Like we're paying you, you're not paying us. So like figure out. And that's what I learned from him. Figure out how to add value. And then along the way we'll train you, as opposed to it's our job to train you.

I would say short, complicated, illiquid that yields a lot. So where we feel that we can understand the risks and the risks are more than amply rewarded because of the complexity and because of the illiquidity.

I'm more focused on what can go wrong than what can go right. So it's important to understand the upside and maybe there are times where I eschew things that have great upside because I'm focused on that they also have a big downside.

Never forget where you came from. Treat everybody the same. My father was great at that. He was conceived in Germany, he was born here, he grew up speaking German in the home. And eventually he had a modest amount of success and he never forgot where he came from and he treated everyone the same. And I try to do the same.

Yeah, I would say two things that are like the opposite. One, as it relates to investing, and I think I exhibited the opposite of this during the subprime time, but like if you have convictions, sort of stick to it. And maybe earlier I wish I had stuck to some things before. As it relates to running the business, I would say, you know, don't be afraid to make changes. I think in some cases we gave people more time than we should have to sort of blossom.

Pleasure. Thank you.