The Magazine

The Demise of a Giant Hedge Fund

The old Wall Street is dead. Long live the new Wall Street!

Oct 13, 2008, Vol. 14, No. 05 • By ANDY KESSLER
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Still, those profits weren't enough. Their customers were making great money buying Wall Street's derivatives. But why should banks and pension funds and hedge funds have all the fun? What a perfect use for all that capital on their huge balance sheets and cheap financing from low interest rates. Wall Street, en masse, started buying all these high yielding derivatives for their own account. They ate their own dog food, if you will.

It was the easy trade. Borrow at 3 percent and make 6 percent or 8 percent or 10 percent. They liked it so much, they levered up. Meaning instead of just borrowing a dollar for every two dollars of assets they owned (which by the way, thanks to the 50-percent margin requirement, is the amount of leverage that you and I are allowed to buy stocks from these same firms), they borrowed 20 to 1, 30 to 1, and even 50 to 1, if they could get away with it. And man, it was a lucrative trade. So why not?

I'll tell you why not. Because all of a sudden, Wall Street is no longer a business of traders or stock brokers or investment bankers, it's a giant hedge fund. And they have no idea what they are doing. None. I ran a hedge fund for a lot of years and learned rather quickly that if a trade was too good, if everyone was doing the same trade, then I should absolutely turn around and run for the hills. But no one on Wall Street did. The spreadsheets flashed green. Risk was a four-letter word best not said in polite company.

Wall Streeters became hedge fund cowboys and loved the spoils, until a tiny little downturn in housing sent everyone rushing to get out of the pool at the same time. Deleveraging a balance sheet leveraged at 30 to 1 is not easy or pretty when everyone is doing it along with you. And this is not the customer panic-selling and paying fees to Wall Street, it's Wall Street doing the selling, pushing prices into the irrational range and turning companies belly up overnight.

Bear Stearns gone. WaMu too, into the belly of J.P. Morgan. Wachovia into Wells Fargo. Fannie and Freddie are the new U.S. Department of Mortgages and are closing their K Street offices. Lehman is dust in the wind. AIG in the penalty box. Merrill Lynch is a subsidiary of Bank of America, which barely survived their purchase of Countrywide Mortgages and, the word is, they won't change their name to Lynch America Countrywide. They should.

And horror of horrors, Goldman Sachs and Morgan Stanley are now bank holding companies. Yeah sure, free toaster jokes are flying, but the net effect is they will now be restricted to 10: or 12:1 leverage, instead of 30.

There is plenty of finger pointing to go around. You can blame the Fed for low interest rates, rating agencies for putting AAA ratings on garbage loans, the SEC, short sellers, monoline debt insurers, lying borrowers, mark to market accounting--heck, let's blame the Chinese for lending us our own dollars.

When running money, I bought plenty of stocks only to see the company screw up and the stock drop. I could try to blame the company, but my investors would blame me. And rightly so. It was nobody's fault but mine. The buck stops at the management of these firms for chasing a bad trade and not sticking to their bread and butter businesses.

Is this the end of Wall Street? More like the start of a new one. At the end of the day, Wall Street is not about the names on the door, it's about the people inside. There were great people at Lehman and Enron, Bear Stearns and AIG. Those who have a nose for making money will join other firms, or hedge funds, or start their own shop. Still, I'm pretty sure that half of those employed on Wall Street in 2007 will be doing something else by January.

And the new Wall Street? There's only one direction. It's back to basics. Not quite back to the old white shoes-blue blood partnerships of the past but certainly that business model. With a lot less capital, sit on the edge of the stock market and provide access to capital for the next set of great companies. Take 'em public, bank 'em, and grow with 'em. It may not be as exciting as the last few years, but it beats getting dumped in the East River.

Andy Kessler is a former hedge fund manager turned author who writes on technology and markets. His most recent book is The End of Medicine.