Wall Street Stole My Smart Friends(jsomers.net)
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Wall Street Stole My Smart Friends
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22 comments
I don't think you can argue that excessive leverage is the result of low interest rates. LTCM, which was levered around 30 to 1, operated in an environment where the Fed funds rate was around 6%, not 1%. Likewise, Japan has had extremely low (even 0%) overnight interest rates since the 90s, but there hasn't been an explosion of Japanese hedge funds to the extent that there's been an explosion of American ones.
People have found ways to lever themselves rather through derivatives, rather than simple borrowing of cash... e.g. if you want levered exposure to a portfolio of high-grade corporate bonds, you don't borrow money and invest in cash bonds. You get an investment bank to structure a bespoke synthetic CDO tranche which, according to your single-factor Gaussian copula model, gives you exactly the risk and return that you want. If you want levered exposure to interest rates, you don't borrow money and speculate on Treasury notes; you pay (or receive) on an interest rate swap whose notional amount is far greater than the amount of cash you have. With the current state of derivatives regulation, people will be playing these games whether Fed funds is at 0% or 10%.
I will grant you that giving fund managers a call option on their returns isn't a great idea. It has the advantage of being cheap, since the value of a call option is less than the underlying. But at the same time, the value of a call option increases in value as the volatility of the underlying increases. So not only do hedge fund managers have incentive to get good returns, they have an incentive to get volatile returns as well -- this leads to perhaps more risk-taking than is necessary.
Edit: and the funny thing is that JWM Partners, Meriwether's post-LTCM fund, is supposedly down 20% this year. To be fair, they apparently did a pretty good job from 2000-2008 or so.
People have found ways to lever themselves rather through derivatives, rather than simple borrowing of cash... e.g. if you want levered exposure to a portfolio of high-grade corporate bonds, you don't borrow money and invest in cash bonds. You get an investment bank to structure a bespoke synthetic CDO tranche which, according to your single-factor Gaussian copula model, gives you exactly the risk and return that you want. If you want levered exposure to interest rates, you don't borrow money and speculate on Treasury notes; you pay (or receive) on an interest rate swap whose notional amount is far greater than the amount of cash you have. With the current state of derivatives regulation, people will be playing these games whether Fed funds is at 0% or 10%.
I will grant you that giving fund managers a call option on their returns isn't a great idea. It has the advantage of being cheap, since the value of a call option is less than the underlying. But at the same time, the value of a call option increases in value as the volatility of the underlying increases. So not only do hedge fund managers have incentive to get good returns, they have an incentive to get volatile returns as well -- this leads to perhaps more risk-taking than is necessary.
Edit: and the funny thing is that JWM Partners, Meriwether's post-LTCM fund, is supposedly down 20% this year. To be fair, they apparently did a pretty good job from 2000-2008 or so.
My point is that real owners of capital (i.e people who saved the capital) will not lend to create the kind of leverage these hedgies have employed. Imagine you are a billionaire. Will you lend to (which is different from having an equity stake in) Meriwether so he can lever up his fund 14x with your borrowed money?
Yet, banks have freely lent to them, because they could, in turn, borrow from the Fed. The Fed (i.e us taxpayers) have operated as the ultimate patsy in the system, providing a one way bet to the speculating class. The evidence of it is the relentless expansion of the total credit in the system (as a percentage of GDP). Literally, the Fed has allowed the creation of total system-wide credit at 2-3 times faster rate than GDP growth, for many, many years running.
No matter what happens now, most hedge fund managers got theirs. As has already been observed, 8 years of feverish levered returns followed by one year of total wipe-out of capital still makes the managers ahead!
Yet, banks have freely lent to them, because they could, in turn, borrow from the Fed. The Fed (i.e us taxpayers) have operated as the ultimate patsy in the system, providing a one way bet to the speculating class. The evidence of it is the relentless expansion of the total credit in the system (as a percentage of GDP). Literally, the Fed has allowed the creation of total system-wide credit at 2-3 times faster rate than GDP growth, for many, many years running.
No matter what happens now, most hedge fund managers got theirs. As has already been observed, 8 years of feverish levered returns followed by one year of total wipe-out of capital still makes the managers ahead!
Not quite true. The banks which lent directly to hedge funds -- prime brokers -- were not depository institutions and, until last week, they couldn't borrow from the Fed. These were institutions like Bear Stearns or Morgan Stanley. Besides, even depository institutions are reluctant to borrow at the Fed's discount window. Pretty much all bank borrowing is either through short term loans at LIBOR or overnight loans via the Fed funds system. (Note that the Fed funds rate is the rate at which banks borrow from each other using the Fed's system, it is NOT the rate at which banks borrow from the Fed. That's the discount rate.)
Regardless, it still makes plenty of economic sense for a bank to lend to a hedge fund, whether or not the Fed is involved. This type of lending is typically short term and rolled over as loans expire. If a bank lends to another bank, it only receives LIBOR, but if it lends to a hedge fund, it can charge slightly higher, say LIBOR + 40bps. Given that the bank itself can borrow at LIBOR, this is a decent way to make money. It's really no different than short-term lending to any other kind of corporation.
I won't deny that credit has greatly expanded lately. I just don't think the expansion of credit to hedge funds has much to do with the Fed.
Regardless, it still makes plenty of economic sense for a bank to lend to a hedge fund, whether or not the Fed is involved. This type of lending is typically short term and rolled over as loans expire. If a bank lends to another bank, it only receives LIBOR, but if it lends to a hedge fund, it can charge slightly higher, say LIBOR + 40bps. Given that the bank itself can borrow at LIBOR, this is a decent way to make money. It's really no different than short-term lending to any other kind of corporation.
I won't deny that credit has greatly expanded lately. I just don't think the expansion of credit to hedge funds has much to do with the Fed.
Speculative bubbles have always and everywhere been about inflation of the money supply. Dutch tulips, south sea bubble, mississippi company, 20s stocks, nikkei, dot coms -- it's ALWAYS been about the money supply.
Here is why finance has changed so much and become such a big deal since the early 90s: http://www.mises.org/content/nofed/makegraph.php?tms=true...
Here is why finance has changed so much and become such a big deal since the early 90s: http://www.mises.org/content/nofed/makegraph.php?tms=true...
What change does the graph illustrate? Each 10 year period is double what it was before. It's not a linear function but it wasn't in the first place. Thanks.
There is an inflection point in 1995 when reserve requirements were dramatically lowered, permanently as it turned out.
What's the methodology and data behind that graph? The fact that it refers to "True Money Supply" rather than established measures like M1, M2, M3 has me rather skeptical.
I did a search and found the chart in context:
http://www.mises.org/content/nofed/chart.aspx?series=TMS
The TMS is heterodox measure, but it has been in use for years.
http://www.mises.org/content/nofed/chart.aspx?series=TMS
The TMS is heterodox measure, but it has been in use for years.
This is going to sound stupid, but could you (or whoever) explain what leverage means? I'm plenty good at math but i'm a super newbie at the financial sector lingo.
5:1 leverage means trading with 5x borrowed money and 1x real money. This drastically multiplies potential gains, losses, and overall risk.
As someone who works on Wall Street, I'm getting a kick out of etc. etc....
I don't think it's quite true. Most of the people I work with are pretty smart, but I haven't come across too many geniuses (I am certainly not one). Wall Street draws different types of people: the type of "talent" attracted to a corporate finance/investment job is very different from the type of "talent" attracted to trading. Different kind of intelligence, different tolerance for risk, different personality.
One thing is for certain: investment banks and hedge funds aren't going to be hiring as many people in the next year or two.
I don't think it's quite true. Most of the people I work with are pretty smart, but I haven't come across too many geniuses (I am certainly not one). Wall Street draws different types of people: the type of "talent" attracted to a corporate finance/investment job is very different from the type of "talent" attracted to trading. Different kind of intelligence, different tolerance for risk, different personality.
One thing is for certain: investment banks and hedge funds aren't going to be hiring as many people in the next year or two.
From my experience, I wouldn't say the guys on Wall Street and in the City are "out there dancing". Most of them are in there, working 16 hours a day, up to 7 days a week. Think about supply and demand. Would they be getting such high salaries if the job was actually pleasant and fulfilling?
There are exceptions, of course, but the average fresh-out-of-college Wall Street employee isn't having much fun.
There are exceptions, of course, but the average fresh-out-of-college Wall Street employee isn't having much fun.
It depends on the subfield. I've heard that I-bankers work crazy hours - 16/7, as you say. But my hedge fund friends usually work a pretty standard 9 hour day, 5 days a week (well, occasionally they'll be researching financials on a weekend, but it's because that's what they like to do). And they take pretty frequent vacations.
There's an element of risk-transference in the high financial industry salaries. When times are good, lots of money flows into the financial industry, which props up salaries. When times are bad, firms go under, people get laid off, and salaries drop. However, the loss is never entirely born by the employees - after all, somebody out there lost all their principal because Bear Stearns imploded. So on average, Wall Street employees will make more than people in steadier, more risk-free jobs.
Same goes for entrepreneurs, for that matter. If the company does well, they get multi-million-$ payouts. If the company folds, their investors bear part of the loss. So on average (mean), an entrepreneur will do better than an equivalent employee, even though on average (median), the entrepreneur ends up with nothing.
There's an element of risk-transference in the high financial industry salaries. When times are good, lots of money flows into the financial industry, which props up salaries. When times are bad, firms go under, people get laid off, and salaries drop. However, the loss is never entirely born by the employees - after all, somebody out there lost all their principal because Bear Stearns imploded. So on average, Wall Street employees will make more than people in steadier, more risk-free jobs.
Same goes for entrepreneurs, for that matter. If the company does well, they get multi-million-$ payouts. If the company folds, their investors bear part of the loss. So on average (mean), an entrepreneur will do better than an equivalent employee, even though on average (median), the entrepreneur ends up with nothing.
The investment bankers are certainly working 80-100hrs/week and mastering BrickBreaker on their Blackberries. It's not so bad in trading... 5 days a week, ~12hrs/day.
"is a society that sends so many of its brightest college graduates into a capital markets monkey pit maximizing welfare?"
It's not "Society" that is sending people into jobs in banks, it's individuals making individual decisions to accept individual contracts. That's their right, as it should be and there is no act of theft involved.
I don't understand why this chap feels that he should object to that. Nobody's forcing him to do it.
The paragraph that begins "It helps that investment banking has a low barrier to entry" doesn't make a point, nor does the one following.
It's not "Society" that is sending people into jobs in banks, it's individuals making individual decisions to accept individual contracts. That's their right, as it should be and there is no act of theft involved.
I don't understand why this chap feels that he should object to that. Nobody's forcing him to do it.
The paragraph that begins "It helps that investment banking has a low barrier to entry" doesn't make a point, nor does the one following.
Well, the nice thing is that the author may be getting some of his smart friends back, now that Wall Street has overreached.
Perhaps some of the statisticians will come back to work on fundamentally (as opposed to monetarily) interesting problems, more of the sharp deal-makers will again be available for non-financial-sector positions, and the equilibrium to which the author alludes will briefly allow for a bit of overcorrection in favor of societal benefit.
It's a bit optimistic, to be sure, but not impossible.
Perhaps some of the statisticians will come back to work on fundamentally (as opposed to monetarily) interesting problems, more of the sharp deal-makers will again be available for non-financial-sector positions, and the equilibrium to which the author alludes will briefly allow for a bit of overcorrection in favor of societal benefit.
It's a bit optimistic, to be sure, but not impossible.
Any Wall Street hackers reading this? I heard that while you earn big chunks of money at investments firms (nice 200-500k bonuses if you are really good), you are still seen as a second class citizen to the actual people that deal with the money stuff.
Is it possible to attract such talent in NYC through a great start-up working environment (like described in Joel on Software) while paying less, or are money and prestige too though to beat?
Is it possible to attract such talent in NYC through a great start-up working environment (like described in Joel on Software) while paying less, or are money and prestige too though to beat?
"But I'm left to ask: is a society that sends so many of its brightest college graduates into a capital markets monkey pit maximizing welfare?"
This is the part of the argument with which I take issue. Allocation of investment is the heart of a capitalist economy. In a socialist economy, investment is dispensed from a central location. In a capitalist economy such as ours, where there are many competition-driven individual firms, we benefit from each of them making wise investment decisions.
Investment firms literally decide how we spend our accrued wealth. I can't think of a better place to send our best and brightest.
This is the part of the argument with which I take issue. Allocation of investment is the heart of a capitalist economy. In a socialist economy, investment is dispensed from a central location. In a capitalist economy such as ours, where there are many competition-driven individual firms, we benefit from each of them making wise investment decisions.
Investment firms literally decide how we spend our accrued wealth. I can't think of a better place to send our best and brightest.
> Allocation of investment is the heart of a capitalist economy.
Allocation of capital is at the core of a capitalist economy. That's not what most people in finance are doing. They are speculating with funny money. There isn't really that much actual capital involved; savings rates are abysmal after all.
Allocation of capital is at the core of a capitalist economy. That's not what most people in finance are doing. They are speculating with funny money. There isn't really that much actual capital involved; savings rates are abysmal after all.
Excellent point. The result of financial speculation of recent years was the allocation of credit to the real estate industry, distorting the real economy in multitude of ways, by pulling resources in an unsustainable fashion.
In 2000, there were 100+ optical networking companies in the 10 mile radius around Palo Alto. That was the result of that period's credit bubble, which worked its way through credit -> stock market/debt market -> telecom companies -> start-ups.
In 2000, there were 100+ optical networking companies in the 10 mile radius around Palo Alto. That was the result of that period's credit bubble, which worked its way through credit -> stock market/debt market -> telecom companies -> start-ups.
I worked in finance here and there.
There are a lot of smart people there, but also many people with advanced degrees that are more book smart than street smart. So they sell book-smart snake oil, or help others do that indirectly via a stable of credentialed eggheads. (Cf Nassim Taleb on derivatives shenanigans.)
Street smart is a lot more important than book smart on wall street.
Too bad I'm so book smart :)
There are a lot of smart people there, but also many people with advanced degrees that are more book smart than street smart. So they sell book-smart snake oil, or help others do that indirectly via a stable of credentialed eggheads. (Cf Nassim Taleb on derivatives shenanigans.)
Street smart is a lot more important than book smart on wall street.
Too bad I'm so book smart :)
That kind of leverage is the direct outcome of the 1% interest rates the Fed ran for a while (banks borrowed at 1%, lent to the hedgies at 4-5%, pocketing a nice spread, and the hedgies used that cheap money to run their own leveraged speculation ...) They get 20% of the upside if they win, and get to walk away if they lose.
The net result is a transfer of wealth from productive classes of society towards speculative classes. This is what primarily caused the heightened inequality we witnessed in the last several years. I say all this as an entrepreneur with a libertarian bent.
From an individual point of view, it is perfectly rational to speculate this way. It is the Fed policy that created the incentives to speculate.
My point is that Wall Street riches have not been fairly earned in a capitalistic marketplace, but in an artificial environment fostered by the Fed.