16. Minsky Machines

Gradually problems emerged. Hedge funds did not consistently deliver alpha, and returns were disappointing—in some periods lower than the broader equity market.¹ Average returns dropped from 18.3 percent per annum in the 1990s to 7.5 percent in the 2000s.²

Investment genius was always little more than a short memory and a rising market. Edwardian novelist Max Beerbohm was vindicated: “The dullard’s envy of brilliant men is always assuaged by the suspicion that they will come to a bad end.”

But investors still chased yesterday’s returns. The focus now shifted to diversification, using hedge funds to balance the risk of traditional investments. Hedge funds were “a perfectly hedged financial institution [that] loses money in every conceivable interest rate environment.”³

Affinities and Curses

Clever people can make money if there are few clever people and lots of opportunities. Steve Cohen, owner of The Physical Impossibility of Death in the Mind of Someone Living, sounded a cautionary note: “It’s hard to find ideas that aren’t picked over and harder to get real returns and differentiate yourself. We’re entering a new environment. The days of big returns are gone.”⁴

There is also the problem of scalability—what works on a small scale may not work on a larger scale. Some strategies need liquid markets. If you exploit inefficiency, then other investors must supply it. To be alternative, there must be a majority; the alternative cannot be the majority.

Inflow of money into successful hedge funds eroded returns. Louis Bacon (of Moore Capital) observed: “Size matters. It is the bane of the successful money manager.”⁵ Size forces style drift. LTCM drifted from its métier, relative value trading in fixed income, into volatility trading, credit spread trading, and merger arbitrage. In 2006, when market neutral hedge funds losses mirrored the fall in the market, hedge fund managers explained: “Everything in the market was a compelling buy. We could find nothing to short.”

The market changed. Banks cloned hedge funds, replicating returns by using simple instruments, with lower fees and less risk of an Amaranth or LTCM.⁶ Investors were looking for grand masters at knock-off prices.

Smart money focused on incubators, identifying traders and seeding start-ups. After established with a track record, the hedge fund raised third-party funding. The original investors exited, retaining the real investment crown jewel, the interest in the fund manager.

In 2006, hedge funds, led by trailblazer Pirate Capital, started selling shares to investors.⁷ Used to timing for purchases or sales, the Masters of the Universe were astutely selling out at the top. Banks convinced themselves that they needed to own hedge fund managers. Holding trading positions in hedge funds was capital efficient. Hedge funds could leverage more than the banks. Hedge funds alleviated problems of attracting and remunerating star traders.

Wall Street and the City are bad judges of value. Having enjoyed the milk, in a moment of confusion they tend to over pay for the cow. An orgy of billion-dollar buying ensued.

Crowded Hours

Investment in just two types of funds—quantitative equity market neutral and long short equity—increased from $10 billion to $160 billion between 1995 and 2007. As returns fell, from 1.3 percent to 0.13 percent, managers increased leverage, from two times to ten times. Because of the limited opportunities, funds ended up holding similar positions.

In August and September 2008, increased volatility and changes in correlation between stocks led to losses. Forced selling caused the cheap or value stocks (which the funds bought) to fall in value, and expensive stocks (which they short sold) to rise. MIT Professor Andrew Lo used a nautical analogy:

We have so many boats in the harbor, you can’t whiz by at 50 knots without rocking a few boats.... In the middle of the ocean, your wake has no impact, but in a crowded harbor, a fast exit can cause quite a disruption.

Clifford Asness, founder of AQR, a $37 billion hedge fund, discovered: “There is a new risk factor in our world and it is us.”⁸

Everybody had borrowed money in low interest currencies to purchase illiquid investments paying high returns. Traders had taken on the same event risk—likelihood of low losses in mortgages, the emergence of the BRIC economies, higher commodity prices, and corporate actions (mergers, LBOs, and bankruptcy). Hedge funds leveraged up bets on the big stories using volatility swaps (bets on the level of volatility), correlation swaps (bets on correlation) and gamma or dispersion swaps (bets on both volatility and correlation). The concentration of risk meant that any event spread through the highly leveraged financial system, creating volatility that fed on itself.

Lack of liquidity affected market prices. Banks valued position conservatively, exacerbating already large losses and necessitating margin calls that the funds could not meet. Mark Twain’s observation held true: “A banker is a fellow who lends you his umbrella when the sun is shining, but wants it back the minute it begins to rain.”

Bankers moved to reduce their risk by either requiring additional collateral which hedge funds did not have or forcing the sales of investments at distressed prices to pay their loans back. The experience of hedge funds now paralleled the organizers of Woodstock. Joel Roseman wrote in the Woodstock Experience that: “We had a pretty conservative banker.... Next to his desk was a fish tank containing a piranha and another tank containing goldfish, and as he put a goldfish into the piranha’s tank, he’d say, “Everybody repays their loans here at the National Bank of North America.”⁹

As investors began to withdraw money in response to investment losses, many hedge funds suspended redemption rights, known as gating. Managers hid in their fortresses and citadels behind high gates, as the perils of leverage and investment in complex illiquid securities were exposed.

Crime Without Punishment

In 2008, hedge fund returns averaged negative 20 percent. Even marque funds took large losses. Hedge fund investments fell by around $600 billion. Over 3,300 hedge funds out of 8,000 ceased operations. John Devaney, a hedge fund manager and bon vivant with a taste for high living, lost $100 million and was forced to sell prized personal assets—properties in Aspen, Colorado, and Miami, Florida, his helicopter, a Gulfstream jet, and his cherished 142-foot yacht Positive Carry.

Hedge funds tried to calm investors’ anxiety and anger with literary gems. Griffin’s Citadel Funds, which lost $8 billion and was down 55 percent, said: “We did not foresee the financial disaster that was to unfold in September.” Tosca moaned: “It is emotionally and financially draining that after eight solid years the fund should be so damaged by the failed global monetary system.” Oaktree took a different tone: “We’re grabbing at falling knives.... We consider it our job to catch falling knives—in a careful, skillful manner.”¹⁰ Another fund blamed regulators: “The next time anyone tells you, as the geniuses who run our financial system have done, that the ever-rising prices of homes should be counted in savings, you should lean close to his/her ear and scream: “IDIOT!”¹¹

David Harding, a London-based fund manager, defended failed models: “People aren’t going to give up their computers and go back to insider information and tips.”¹² An anonymous blogger provided useful advice: “You may want to re-calibrate your abacus, most all the ones I’ve used always have seven poles and ten beads on each pole, are you sure you have the right ‘model’?”¹³

Trader Paul Tudor Jones wrote that he would earn back losses, quoting polar explorer Admiral Richard Evelyn Byrd: “The mantle of leadership rests easily when the compass needle does not move.”¹⁴ After suffering a loss of 16 percent in the third quarter of 2008, David Einhorn, a famed short seller, admitted that: “In hindsight, our suggestion from last quarter’s letter to go to cash and go to the beach would have been the better option.”¹⁵

Large losses that would not be recouped quickly reduced the opportunity for hedge fund managers to earn performance fees where there was a watermark. To get around the problem, some managers simply closed the existing funds, starting new funds. An article on hedge funds asked: “Gaming the system: are hedge fund managers talented, or just good at fooling investors?”¹⁶

Not everybody lost money. Paulson & Co., run by John Paulson, made $3 billion from shorting subprime securities. For the first 10 months of 2007, Paulson’s Credit Opportunities fund made a gross return of 690 percent and a net return (after fees) of 551 percent. His Credit Opportunities II fund made a gross return of 410 percent and a net 328 percent. Paulson’s fund assets increased from $6 billion to $27.5 billion, entering the top ten global funds. Philip Falcone’s Harbinger Capital, Mike Burry’s Scion Funds and Lahde Capital, a Santa-Monica-based fund set up by Andrew Lahde, all recorded substantial returns.

Burry wrote to his investors: “The opportunity in 2005 and 2006 to short subprime mortgages was an historic one.” Lahde, a small fund, returned money to investors, recognizing that: “The risk/return characteristics are far less attractive than in the past.”¹⁷

The funds that profited from the collapse were generally smaller funds, outside the mainstream. Before the crisis, when asked about John Paulson, a banker at Goldman Sachs told a potential investor that he was “a third rate hedge fund guy who didn’t know what he was talking about.”¹⁸

One person noted: “In the hedge-fund industry the only bad thing you can do is lose people’s money.”¹⁹ Even that wasn’t strictly speaking true.

In 1999, after the collapse of LTCM, John Meriwether had no difficulties raising new funds for JWM Partners LLC (JWM), a lower risk version of LTCM. In 2008 the $2.3 billion JWM fund found itself in trouble. In a familiar message, Meriwether told investors: “We have sharply reduced the risk and balance sheet of the portfolio.” JWM closed its main fund after losing 44 percent between September 2007 and February 2009.²⁰ Subsequently, in 2010, Meriwether opened his third hedge fund venture—JM Advisors Management. As Mark Twain pointed out: “All you need in this life is ignorance and confidence; then success is sure.”

At the time of the creation of JWM, a member of the banking consortium that bailed out LTCM stated that Meriwether’s re-emergence highlighted “the ongoing vitality of the Wall Street system.” F. Scott Fitzgerald was wrong when he said there are no second acts in American lives. For hedge fund managers, there are second acts, third acts, fourth acts, and fifth acts. Potential investors seem to take comfort in physicist Niels Bohr’s observation: “An expert is a man who has made all the mistakes which can be made in a very narrow field.”

Fast Cars, Slow Hedge Funds

The Masters of the Universe were even beaten at their own game by a German carmaker Porsche Automobil Holding SE (Porsche). Porsches are synonymous with prestige, luxury, and performance, making them the conveyance of choice for hedge fund managers.

Porsche is majority owned by the Piëch and Porsche families. Ferdinand Piëch, the grandson of the founder, dreamed of uniting Porsche and Volkswagen (VW). In 2005 Porsche, led by Wendelin Wiedeking, CEO, and Holger Härter, the chief financial officer, announced it would become the largest shareholder in VW by purchasing a 20 percent stake. In April 2007, Porsche crossed the 30 percent threshold, requiring it to submit a takeover offer for VW. Porsche’s supervisory board announced it would raise its voting stake in VW from 31 percent to more than 50 percent. Porsche was trying to gain control of a company more than 80 times its size as measured by sales.

Call options, the right to purchase VW shares, were central to the acquisition strategy. The options protected against higher VW share prices, while enabling Porsche to mask its exact shareholding in VW.

In a weakening economic environment, hedge funds believed that VW shares were overvalued and bet that the share price would fall. As Porsche’s share purchases and option activity pushed up VW’s share price, hedge funds sold VW shares short, looking to buy them back when the price fell. Some funds sold VW shares and bought the shares of other car companies to capture the correction in relative prices. Merger arbitrage funds sold VW shares and bought Porsche shares, betting that the prices would converge. Others shorted VW ordinary shares and bought the preference shares trading at a 50 percent discount to ordinary shares, betting that the spread would decrease.

Around September 2009, Porsche announced it intended to lift its shareholding to 75 percent, allowing it to enter into a domination agreement, giving it effective control of VW. Earlier, on March 10, 2008, Porsche had dismissed suggestions that it was going to increase its shareholding to 75 percent as “speculation.” On September 16, 2008 Porsche stated that its shareholding in VW was 35.14 percent, ignoring the options.

At 3:00 p.m. on Sunday, October 26, 2008, concerned about the level of short positions in VW, Porsche disclosed that it held 42.6 percent of VW’s ordinary shares and also 31.5 percent of outstanding VW shares via call options. Designed to hedge its risk to higher prices, the options did not entail Porsche physically buying the shares. They would be cash-settled when the contract expired. But if Porsche acquired the shares underlying the options, then its total stake in VW was 74.1 percent.

Traders did some basic arithmetic. Lower Saxony, the German state, owned 20.1 percent of VW. Porsche owned or controlled 74.1 percent. Investment funds tracking the German market index, the DAX (Deutscher Aktien IndeX), owned an estimated 5 percent. All this added up to a simple fact—the less than 1 percent of VW shares available to trade, the free float, was substantially below short positions in VW of over 12 percent of outstanding shares. As one hedge fund manager described it: “I was on a wet walk and checked my BlackBerry—I ran like a madman back to my house. I assumed the numbers were wrong, but when a broker told me he’d had a dozen panicked calls already, I knew it was true.”²¹ There were insufficient shares available to buy back the hedge fund’s short positions.

Panicked hedge funds rushed to close the short positions at any price. On October 28, 2008 VW shares briefly touched €1,005.01, up four-fold from €210.52 on 24 October, making VW the world’s most valuable company—its market value greater than Apple, Philip Morris, and Intel combined. The shares fell back to €512 on October 29 and by November 26 were at €300.05. Porsche’s shares went up to €62.60 on 23 October before falling to €52.95 on November 26, well above its low of €37.61 on 27 October.

Porsche made €6.83 billion gains on the options, a large part of overall profits of €8.6 billion for the year. Lower Saxony was another winner, its 20.1 percent of VW was worth €47 billion. Hedge funds betting on VW’s share price falling lost €10–15 billion. Unable to hedge their exposure under the options and exposed to hedge funds that they financed or traded with, banks also took losses.

Like their precise handling cars, Porsche had cornered the market perfectly. The hedge funds had been caught in a classic short squeeze. Analysts questioned whether Porsche made cars or was a hedge fund with a few car plants. The company explained the difference: “We make money from hedging and building cars. The difference is that hedge funds don’t make cars the last time I checked.”²²

Fast Cornering

Hedge funds complained that Porsche manipulated the market in VW shares, taking advantage of inside information to profit at the hedge fund’s expense. Porsche denied the allegations, blaming the hedge funds that chose to take positions. Porsche argued that it had used derivatives to hedge the price of the planned purchase of VW shares, in compliance with German laws.

The surprise of the hedge funds was surprising. Porsche repeatedly stated its intentions regarding VW publicly. Porsche’s financial statements disclosed its option trading. On October 8, 2008, a Morgan Stanley analyst, Adam Jonas, warned against playing “billionaire’s poker,” drawing attention to the size of the short position on VW relative to the free float. Earlier, on February 27, 2008, JP Morgan identified the risk of a short squeeze, predicting that Porsche would continue to increase its stake in VW.²³ Porsche made disclosures, giving investors who short sold VW the opportunity to manage their positions and risks.

When their arguments did not gain traction, hedge funds argued that the trades, while legal, were not within the spirit of the law. They argued about the “lack of transparency” and “reputational damage” to the German financial markets. A trader complained that: “This sort of behavior by a public company wouldn’t be allowed in the UK or U.S. But we can’t expect help from the German authorities—this is pay back.”²⁴

One analyst reported: “I have hedge fund managers literally in tears on the phone.”²⁵ Putting a brave face on the loss, Larry Robbins, the chief executive of Glenview Capital, wrote to investors that the fund was “committed to maintaining the short exposure for the eventual recoupling between the stock and its intrinsic value.” David Einhorn told investors that it expected to profit as “on a fundamental basis, we believe that Volkswagen is highly overvalued.”²⁶

Bundesanstalt für Finanzdienstleistungsaufsicht (BaFin), the German financial regulator, launched a market manipulation probe, investigating the circumstances around Porsche building its stake in VW. Hedge funds and investors commenced legal proceedings, alleging that Porsche, Wiedeking, and Holger misled investors and lied about the positions and intentions with respect to VW. In December 2010, a U.S. federal court dismissed the lawsuit against Porsche and two of its former managers.

Contemptuous of hedge funds and private equity investors, Germans were secretly pleased. Wiedeking and Härter were folk heroes who beat the London and New York hedge funds at their own game. The headline from Neues Deutschland, the former East German newspaper, read: “Porsche eats the locusts.”

Porsche’s victory was pyrrhic. When the options expired, Porsche’s option gains were the difference between the guaranteed price and actual market price for VW shares. Porsche still needed money to actually purchase the VW shares. As the financial crisis hit and banks became reluctant to lend, Porsche was unable to raise the cash to complete the takeover. In May 2009, Porsche dropped its takeover plans, announcing plans to merge with VW. In June 2009, Porsche announced the Gulf State of Qatar would take a 25 percent stake in the combined company to reduce its level of debt.

In November 2009, Porsche revealed losses of €4.4 billion before tax and announced that it expected a further multibillion euro loss the following year. The company would eventually become just another marque brand in the VW range. Wiedeking, who turned the near-bankrupt Porsche in the early 1990s into one of the world most profitable carmakers, left the company.

The whisky-drinking, cigar-smoking Wiedeking was one of the highest paid managers in the world, taking home a reputed €60–80 million. Accepting an award in 2003, he joked that at Porsche: “We produce nothing but superfluous things. That is very rewarding because superfluous things cannot be replaced by even more superfluous things.”²⁷ Superfluous things had come to be dominated by the ultimate superfluity, extreme money.

One investor thought that Porsche would: “struggle to sell 911s to hedge-fund managers for years and years to come.”²⁸ Wiedeking showed no Schadenfreude at the losses of the hedge funds: “We all have to get used to the fact that quick money is not a healthy business. Values played no role in what happened.”²⁹

Children of Privilege

The economist Hyman Minsky theorized that in the early stages of a business cycle money is only available to creditworthy borrowers, known ironically as hedge finance. As the cycle develops, financial conditions look rosy and competing lenders extend money to marginal borrowers, a phase known as speculative finance and ultimately Ponzi finance. The cycle ends in a Minsky moment when the supply of money slows or shuts off. Borrowers unable to meet financial obligations try to sell assets, leading to a collapse in prices that triggers a spiral of economic decline.

Hedge funds are Minsky machines. They borrow to purchase assets, a strategy that works in moderation. Increased borrowing to buy assets artificially boosts asset values, generating profits that allow further leverage until the supply of money ceases. When the asset price bubble eventually bursts, the pressure to liquidate assets triggers losses, triggering a run on the funds, leading to larger losses and failure. Minsky machines are creatures of stable, benign environments that through their actions create the conditions for instability and their own demise. Ian Macfarlane, the former governor of the Australian Central Bank, observed: “Hedge funds have become the privileged children of the international financial scene, being entitled to the benefits of free markets without any of the responsibilities.”³⁰

Hedge fund managers themselves take few risks. As Alan Howard, co-founder of Brevan Howard, a large London-based hedge fund, put it: “I have no interest in getting excited or upset.” After an accident, Howard, known in London’s trading community as “Mr. Bond,” gave up skiing. He does not even drive, to avoid the dangers of London traffic: “I see all these nutty drivers.”³¹ In a “heads I win tails you lose world,” only investors and lenders are at risk.

In 2008 Warren Buffett, the CEO of Berkshire Hathaway, bet $1 million with Protégé Partners, a New York fund of hedge funds, that even a rigorously selected portfolio of hedge funds would not beat the return on the market over 10 years. Buffett argued that large fees mean that hedge funds have to earn substantially greater returns than the S&P 500 index to match let alone beat its performance.³² The Buffet bet paralleled a $20,000 wager between Lotus founder Mitchell Kapor and futurist Ray Kurzweil that by 2029 no computer or machine intelligence will pass the Turing Test, where a computer successfully impersonates a human being.

In 2010, Stanley Druckenmiller, who had been one of the traders at Soros’ Quantum Fund that broke the pound, announced that he was closing his fund Duquesne Capital Management. Druckenmiller confessed that increased volatility following the global financial crisis made it difficult to make money. It suggested a difficult outlook for Minsky machines.³³

Make Money Not War

Known as “Woodstock for capitalists,” Berkshire Hathaway’s annual shareholder meeting in the Qwest Center in Omaha, Nebraska, is characterized by folksy, comic wisdom. Hedgestock, the “Woodstock for hedge funds,” was short on such self-deprecating humor.

Investment banks sponsored Hedgestock, their way of “putting something back.” Proceeds went to the Teenage Cancer Trust. The image of hedge funds needed to be softened, brought into line with societal norms.

Knebworth House was chosen as the location because of its history of legendary concerts featuring Led Zeppelin, Queen, and Oasis, and its proximity to London, the hedge fund capital of Europe. Entry to Hedgestock was £500 plus VAT (value added tax) and limited to 4,000 guests. The original Woodstock was attended by around half a million, most of whom simply turned up and did not pay anything.

There was talk of vintage Woodstock-era VW camper vans, costumes, and dress codes of the psychedelic 1960s. On the day, hedge fund managers turned up in Porsches, BMWs, Mercs, Ferraris, and the odd Bentley. The preppy cool dress code was out of The Graduate. Only the organizers wore tie-dyed shirts and jeans. BlackBerries and mobile phones were conspicuous.

Hedgestock’s house rules were new age. There was a 10:30 p.m. curfew. Drugs were verboten but the Pimm’s and champagne bar traded actively. There were raincoats to counter risk, the UK’s fickle weather. As for promiscuity, there were debates on “Esoterica—new risk and new returns for consenting adults” or “Insourcing or outsourcing—how saucy are you?” or “Multi strat versus fund of funds: strange bedfellows.”

The original Woodstock is mostly associated with rain, mud, and bad acid (LSD) by the few people who were there and can actually remember it. Hedgestock promised alternative entertainment—poker tournaments and other forms of betting—to allow the hedge fund managers to exercise their natural animal instincts, testosterone, and considerable egos.

The entertainment draw card or kick asset concert was The Who—at least, its surviving members: Pete Townshend and Roger Daltrey. The occasion did not however rival the memory of the band’s legendary performance at the original Woodstock. One reporter observed of the audience: “I’ve seen more passion at Waitrose [a UK retail grocery chain] on a Friday night.”³⁴

Woodstock’s anthem was “make love not war.” Hedgestock’s less catchy mantra was “make money not war.” As John Kenneth Galbraith, the American economist, noted: “Wealth, in even the most improbable cases, manages to convey the aspect of intelligence.”

The 30-year history of financial alchemy is the rise of private equity, securitization, derivatives, and ultimately the Masters of the Universe and their Minsky machines. The growth of these instruments owed everything to financial fundamentalism.

Woodstock marked an end, not a beginning. It was a celebration and high watermark of the counterculture. Within a few years, its iconic stars, Jimi Hendrix and Janis Joplin, would be dead. Hedgestock, too, may have marked an end—the high watermark of financial alchemy.