As usual James Surowiecki has an excellent piece. Excerpt:
Fund managers get bonuses at the end of each year, and they keep those performance fees even if the fund eventually goes south. So if a billion-dollar hedge fund rises twenty per cent in its first year and falls twenty per cent in its second, its investors will have lost money, while the fund’s manager might earn forty million dollars in performance fees. Hedge funds do have a rule that’s meant to deal with this problem: when a fund loses money, it yields no performance bonus until investors get back to even. The catch is that nothing prevents a hedge-fund manager from simply shutting down after a bad year and walking away with the fees he’s already accrued…Because fund managers reap large rewards on the upside without a correspondingly punitive downside, they have a much greater incentive to take big risks than ordinary investors do.
Managers, or for that matter ordinary investors, may not under normal conditions have enough incentives to take risk. Remember the Kenneth Arrow argument that not all private financial risks amount to equivalent social risks? Who cares if you lose money, provided that no real resources have been destroyed? Yet a risk that pays off, say with a new product, does not in general return the entire social value of that product to the entrepreneur.
With hedge funds, are we now above or below the optimal amount of risk? The answer of course is "we are taking the wrong kinds of risk." We are finding more and more ways to (implicitly) write naked puts in highly leveraged forms. Yes this has brought us new products but it all seems to be new mortgage products. Could those products possibly justify the financial carnage we have seen? That is the critical question but I suspect the answer is "no," that in this sphere we stepped beyond the bound of optimal risk-taking.
The junk bond revolution of the 1980s involved some "excess" risk-taking, but I believe those risks were more closely connected to the real economy, and more likely to bring real economy benefits, than the recent spate of mortgage-related risks.
Okay, something puzzles me.
Last time I looked at a mutual fund, I looked at the cheapest set of fees, and worked out that if I invested $10,000, after the fees were accounted for the fund would have to make a return of 6.3% (nominal) in order to make as much money for me in the first year as if I’d just stashed the $10,000 under my mattress. Which means I would have lost about 2% to 3% of the value of my $10,000 in real terms by the end of the year.
6.3% was on the high end of their nominal rates of return over the last five years.
My calculation of course ignored the risks of my mattress being burgled. But it also ignored the risk of someone embezzling the fund.
Keeping the money in the bank was a far better deal.
Why does anyone invest in these funds?
Tracy W.,
You should revisit your calculations. Many funds have fees well under 1%, and index funds can be in the neighborhood of .25% or less.
Tracy W – those were the cheapest funds you could find?
Your last point is a good one – nobody should ever invest in those funds. But my question to you is, have you ever looked at Vanguard?
If hedge fund activity does not, in the aggregate, produce anything of social value — as you claim — it would
have to at some point revert to below-normal returns. In fact, this is exactly what I believe, and the
only way to check it would be to look up average H/F returns. These statistics do not exist, but the
closest approximations (which you posted about a few months ago) say they do underperform, at least once
fees are taken into account.
So, H/Fs seem to be just a giant vehicle for giving away money to other people.
One more thing: Yet a risk that pays off, say with a new product, does not in general return the entire social value of that product to the entrepreneur.
Nor would we want that! That would mean innovation is no longer a social good!
Tracy W, you need some help. I strongly second the Vanguard recommendation.
On risk: Tyler’s clearly on the right track in terms of looking at various incentives. There seems to be considerable widespread carnage from the US mortgage boom of the past few years, and this carnage extends to a variety of surprising areas. Why, for example, are banks in the UK at serious risk from their investments in US mortgages?
Some questions that might be asked:
1. Do financial managers really have good models of risk? Or do they just think we do? (insert obligatory “Black Swan” reference here)
2. Is there some fundamentally bad assumption that was made here? For example, if the probability of failure of loan A is 5%, and loan B is 10%, the joint failure is .5% — IF they are independent. But CDO’s made up of mortgages aren’t independent (surely I don’t have to explain why here). Did they underestimate the covariance? That’s what I mean by a fundamentally bad assumption.
3. Are these financial packages really offloading risk / spreading risk around / diversifying, or are they creating a large Rube Goldberg structure in which we aren’t lowering risk by diversifying it, but creating so many connections that a “margin call” creates an overall risk of crashing.
4. Citi seems to be in trouble in commercial paper for lending out long term but borrowing short term. Isn’t that a pretty basic error? Isn’t that fundamentally what happened to many S&L’s only a couple of decades ago?
5. Why do we allow companies to keep so much “off-book” that clearly creates obligations (Enron, Citi)? Is a large part of the problem one of transparency?
6. Do the rating agencies (Moody’s, etc) really understand risk? Are there good statistics about how good they are?
I’m at risk of getting to the “foaming at the mouth” stage and don’t want to hijack the discussion. I’ve provided a blog link above which is available to anyone who wants to flame me directly
Hedge funds have always had asymetric risk reward profiles. The greater the leverage, the greater the return almost assured to the managers while risk increases exponentially to the investors.
Used to be there was a hurdle rate – say the risk free rate at worst, or some market index – that had to be met before the 20% of profit incentive kicked in. Fund managers found it was too hard to make enough profit so these have largely vanished. We are left with high water marks. But typically when a fund loses a lot of money it has to close. The “talent” is paid largely on the 20% and if it going to take 2-3 years to get back over the high water mark, they just depart for other firms. Solution is to close up and start again with a new fund. Survivorship bias in the stats of the hedge fund world is rampant.
Running a HF can be incredibly profitable, and a down 20% year does significant damage to the value of that franchise. Brian Hunter may have come out ahead for his nat-gas shenanigans, but his boss who was running a $10B hedge fund that went away surely did not.
Something that many people (and worried regulators) seem to overlook, or not realize, is that derivatives don’t add any risk overall, and they don’t decrease risk overall, they merely repackage it and disperse it from agents who presumably have too much risk towards agents who presumably have too little risk. In this model derivatives are unequivocally a good thing because they enable new wealth creation devices (e.g. new firms, or new “greenfield” investments by existing firms, or the ability of individuals to take on a higher paying job that is riskier thanks to insurance) by previously “underrisked” agents.
As a basic example of spreading around existing risk, imagine Andy, Bob, and Charlie. Andy is a recent GMU grad who also just inherited $1 million from a recently deceased grandparent. Bob is 50 and owns and runs his own business, Bob’s Bakery, which is worth $1 million. Charlie is 65 and owns and runs his own business, Charlie’s Cheese Shop, which is worth $1 million.
Andy has parked his new cash in 11 different FDIC insured banks until he can find something more sophisticated to do with it, and he has the brain and education to in fact do something more sophisticated. Bob is looking to either expand his business, or buy another business on top of his own. Charlie wants to retire and doesn’t want the hassle nor the risk associated with owning a business.
Andy lends Bob $1 million to buy Charlie’s Cheese Shop, which he then indeed buys and merges with Bob’s Bakery. Charlie puts his $1 million into 11 FDIC banks ($100,000 is the insured limit per individual per bank), coincidentally the same 11 banks that Andy had his money in. No new wealth has been created (yet anyway) and no new risk (overall) has been created.
Worried minds though will say “wait a minute, there is $1 million in new debt, and without any new wealth creation going with that debt, how can you say there is no new risk? This is horrible, quick, somebody pass a law!” What these worried minds are missing is that the new debt creation does not in this instance mean new risk creation. What the above 3-way transaction accomplished was to take the risk away from Charlie, and redistribute it to Andy and Bob. Bob takes the first $1 million of risk of the new combined company, and Andy takes the second $1 million of risk. Before the 3-way transaction there was $2 million worth of risk amongst the three of them (assuming for convenience sake that the FDIC deposits are risk free, noting that there is no such thing as free risk….), and after the transaction there was $2 million worth of risk.
Hence in that example the worried minds are worrying for no reason whatsoever, and if they do in fact manage to pass their idiotic law society will definitely be worse off as a result.
Now for an example of added risk. Keep Andy and Bob with the same profiles pretransaction from above, and ignore Charlie. Andy lends Bob $1 million to expand Bob’s Bakery, opening up a new location, thus leveraging (they both hope anyway) Bob’s skill and Bob’s Bakery reputation. Now there is a new $1 million of debt, but even now this $1 million of debt doesn’t represent new risk. It is the creation of the second store which is new risk. The debt represents the dispersion of this risk, with Bob again taking on the first million of risk and Andy taking on the second million of risk.
The new risk is the newly created equity (which was then dispersed), yet somehow worried regulators don’t freak out over the massive venture capital explosion that has taken place since the late 70′s when the capital gains tax was dramatically slashed. Instead worried regulators freak out over the dispersion of the new risk that transfers the already existing risk from those with “too much risk” to those with “too little risk”.
If Andy and Bob have both done their due diligence then society comes out ahead taking into account the risk/reward ratio, even if the company goes bust. This is because in the long run, spread across many such open eyed “risk taking wealth creators”, there will indeed be a net new creation of risk.
In the case of the subprime mortgage morass, one of two things happened. First, not enough people did their due diligence and we have an example of mass hysteria. In the second possibility the new loans made sense on a risk/reward ratio basis, but this was the 1 time in 36 that the dice came up snake eyes and the risk didn’t pay off.
I lean toward (heavily tilt is more accurate) the former explanation. In either case, the problem was not the derivatives (i.e. the dispersion of risk), but rather the problem was the failed investments underlying the derivatives. Derivatives are a bogeyman made up by people who aren’t (or weren’t) paying close enough attention. The real bogeymen are the long list of people who needed to go brain dead at the same time and thus turn wealth into dust in order for this to eventually become a “crisis”. The concept of lending to worthy home buyers without perfect credit is a sound one that puts putative home buyers with too little risk into their own homes. What it needs to be a net “good thing” though is for both the home buyers and the mortgage buyers to make sure that the home buyer on a risk/reward basis can pay back his mortgage.
I asked a friend who is in a position to know and she reported that some well-managed investment firms use better incentive structures than a simple 2-and-20 annual bonus.
Things like managers being partially invested in their instruments (via their bonus) and multi-year averaging of returns to vest their upside comissions. I’m sure there are plenty of other tools as well to encourage a longer view among the managers.
Perhaps we hear about the spectacular flameouts only because they occur in firms that don’t take adequate management precautions about the asymmetric nature of upside/downside risk, thus incentivizing behavior that leads to spectacular flameouts.
I don’t know what the “right” amount of risk is, but I don’t think you can ignore the fact that there seem to be persistent money-makers who live entirely in high-risk areas. I suppose the market will tell us when the aggregate performance of all high-risk funds approximates the general market/GDP growth then we are at the “right” amount of risk.
Returning to Cowens point; hedge fund managers have turned Arrow upside down. The private gains to the hedge fund managers is greater then the social value of their actions. The negative externalities of these sub-prime loans (like the decline in the value of housing, the temporary downturn in the economy, etc.) will be greater then any value that society received form their creation.
Worse yet, hedge fund managers get a tax break to create the chaos. I trust the market to correct for the errors in judgement. I hope the Congress increase taxes, or do away with the tax breaks, that encourages activity with, in this case, negative benefits for society.
Brian Slesinsky,
You take the majority point of view, that the problem with derivatives is that they are misunderstood yet used anyway. As a practical matter this is basically almost all an increase in agent risk, not societal risk.
The point I was trying to make is that the real societal risk involves the real asset underlying the securities (e.g. the home that was mortgaged, not the mortgage; the business that was expanded, not the loan or equity that was issued that financed that expansion).
If “everyone” is systemically mispricing a set of securities, the losses accrue to those who have overpriced the issues, but there are symmetrical gains (on a dollar weighted basis, but not likely on a person to person basis) for those on the underpriced side of the trade.
The societal risk to any form of security is not the security (e.g. “junk” debt or “derivative”, insert your own bogeyman here ____) itself. The reason the subprime crisis is damaging is not that some institutions stand to lose a lot of money (and already have), nor is it that some mortgage lenders go out of business with their resulting job losses, nor is it that some people will have to move from houses they putatively owned and bakc into apartments like ~30% of the US population already does. The real problem is the massive misallocation of real assets (icluding both capital and labor, not to mention time) that resulted in net wealth destruction.
People gain and lose money in the stock market all the time but economists generally don’t sweat it when a multitrillion dollar stock market loses a trillion dollars here or there. So why are people so bent out of shape by the subprime morass? It is because in the stock market the losses and gains represent a repricing of what “we” think those assets are worth, and not necessarily an actual destruction (overall) of assets underlying the stock market. But the subprime morass is troubling because the plummeting prices of securites there has been a result real wealth destruction, with the real wealth destruction being the actual societal problem.
So the question comes down to this: Is the problem that collateralized debt was too hard to understand that caused the problem, or is the problem that not enough people chose to do their due diligence (i.e. their critically necessary homework) on valueing the assets and liabilities underlying the securities in question, namely the home prices and the ability of the borrowers to repay. This as opposed to their being unable to understand which the relative upside and downside of any given tranche of the underlying pool of mortgages.
I come out strongly in favor of the underlying asset/liabiity problem of course, not how it was packaged. If anyone involved (borrowers, mortgage brokers, investment bank packagers of collateralizations, mortgage insurers, and the end buyers of these products such as hedge fund managers and pension plan managers) had done their homework properly as to the value of the underlying assets and liabilities, then it really doesn’t matter one bit to society if they systemically misprice the complex final security products themselves. Such mispricing of sound underlying assets would simply mean that those on one side of the trade would make more money, while those on the other side of the trade would make less money, with zero change in actual societal wealth as a result of that mispricing.
In short, it is not the CDO’s and CMO’s that werre mispriced that is the problem. The problem is that people who had no business buying homes got mortgages, and the latter resulted in net wealth destruction.
Think of it this way. If I buy a lemon of a used car from a used car dealership, I lose a bunch of money but the dealership gains a lot of money. Sucks for me but not for society at large which shows no net gain or loss (excepting marginal efficiency). My problem was that I didn’t check out the car carefully enough, not that I bought a used car. There is nothing wrong with buying a used car, and similarly there is nothing wrong with buying CDO’s. Indeed, the marketplace for used cars is itself a healthy thing that enables a more efficient distribution of cars, pairing up appropriate car with appropriate car buyer to the net gain of society as a result.
ZBicyclist,
I made two long posts in this thread so far, so I’ll try to keep this one shorter.
In my list of people who had gone brain dead (I’ll add unethical as an alternative to brain dead), namely borrowers, mortgage brokers, investment bank packagers of collateralizations, mortgage insurers, and the end buyers of these products such as hedge fund managers and pension plan managers, I definitely should have added ratings agencies, and perhaps home appraisers as well.
Lots of people blamed “junk” bonds for all kinds of crap that they had nothing to do with in the 80′s, and while the secondary market for them got obliterated by stupid legislation in the late 80′s, it came back when the bulk of these issues came out whole and paid off their creditors in full without defaults.
These instruments (so-called junk bonds, aka high yield bonds, aka low grade bonds) are today common and uncontroversial. In my opinion the same will eventually hold true for CDO’s, including collateralized subprime mortgages. The key is that as always it is buyer beware, whether the security in question is stocks, plain vanilla bonds, futures, or something more exotic. They are all economically sound and useful tools designed to match buyer and seller of a risk/reward device to the benefit of both. It is completely up to both the buyer and seller to determine the soundness of both the underlying asset and the appropriateness and price of any asset they are buying.
Finally, I will concede that there is a strong dislocation effect that is going on as well as the societal wealth destruction involved in the issuance of the underlying mortgages.
This dislocation occurred because the bubble burst, and now people have overeacted in the other direction. As a result there is less matching of appropriate buyers and sellers going on (of both labor and products and services), and thus less productive economic activity. Third parties do indeed get hurt by bubbles when they inevitably burst.
I am merely trying to point out that the notion that derivatives are a bogeyman is false. The bogeyman is a lack of due diligence. The fact that some of these securities are new doesn’t excuse people from doing their homework, just the opposite in fact, one needs to put in more effort to determine if it makes sense.
Brian Slesinksy,
there was an industry-wide failure to think through what issues might arise and figure out what institutional reforms were needed due to this increase in easy credit and reduction in information-collecting, before things went south. Maybe this is because too many people are in a position where it doesn’t pay to collect and disclose more information [emphasis added]
I think you and ZB may be on to something important, namely the genesis of bubbles, or at least some of them. Not the full picture of course, if only it were that easy, but perhaps part of the DNA strand of such rare but recurrent creatures.
In any bubble one can think of there seem to be “enough” people who understand that there is a bubble. The problem seems to be that there is an asymmetrical incentive structure involved that stops those who are clueless from being informed by those in the know.
One gets rich in capitalism by being the rare supplier to a surfeit of buyers, or to be a rare (and correct) buyer from a surfeit of sellers. Giving away such information, if “they” would even listen and believe you, has no “positive internalities”, only positive externalities. Indeed considering opportunity cost, giving away your asymetrical information has a terrible opportunity cost for you.
In Chicago, in the late 60′s early 70′s, the Englewood community had a housing market collapse. The area was changing, whites were fleeing and African Americans were moving into the community. The Federal Government came in with loan programs to encourage home ownership in the minority community. Whites trying to flee were happy, they found it easier to sell their homes. Minority families were happy, they found it easier to get loan approvals. The lenders were happy because, they had the Federal Government securing the loans. Then things started to go bad.
Many of the minority families who bought homes found it increasingly difficult to pay all the expenses involved in home ownership. The lenders didn’t really care, because they frequently made money on foreclosed homes. The lenders could just declare the borrower in default, collect the balanced owed from the government and turn the empty house over to the government.
The community suffered greatly as more and more homes received FBI stickers on their front door. Families were struggled to keep up discovered that with more and more empty houses in their neighborhood, their home values were shrinking rapidly. Getting new loans, or insurance became a major problem. The are never recovered and remains a poor and high crime area.
The lesson is that if it is too easy to transfer risk to a third party, and the third party is underestimating or ignoring the risk, lenders will push the limits of sane transactions. People who took out loans have some responsibility for the troubles they caused themselves, but community based lenders traditionally had an interest in protecting the community (they depended on the community doing well). I think the growth in mortgage lending without community ties has created advantages, but it has also made the lender less interested in the impact of their business practices.
Lastly, I knew mortgage brokers who were also flipping properties on the side. They would talk as if they were brilliant and saw it almost as an ability to print money. No wonder their judgement became suspect.
Just to go back to the hedge fund risk point. The risk pointed out in the main post has been recognized for quite a while in the pool of investors who invest in hedge funds. There are some countervailing strategies:
1) Diligence – personal knowledge of the manager(s) and their prior track record.
2) Requiring the hedge fund manager to maintain a significant stake in each fund it manages. Some of the most successful fund managers keep most or all of their net worth in their funds.
3) Clawback. Not uncommon to deduct prior year losses from a subsequent year’s gain before paying out compensation in the later year.
4) Oversight. No matter what the legal documents or the stereotypes say, hedge fund managers spend a lot of time accounting to their big investors for what they’re doing.
5) Short notice redemptions. Although superstars can lock up money for a long time, newbies really can’t impose that so investors can pull out relatively fast of a failing fund.
6) Payback: The community of potential investors is a small community and it’s very difficult to raise money a second time if you inflict a big loss on them.
徵信社
徵信
徵信社
Comments on this entry are closed.