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
Before the last of Wall Street gets sold off as day-old fish on Fulton Street or washed into the East River altogether it's worth asking, what is Wall Street these days anyway?
Thanks to Dick Grasso and CNBC, most of us think of Wall Street as balding men in ugly solid-colored suits yelling at each other and throwing litter on the floor of the New York Stock Exchange. Not even close. They might as well be holograms from Disneyland's Haunted Mansion, just a hangover of years gone by. Or maybe Wall Street is stockbrokers, calling you at dinnertime, trying to put you into a few shares of some hot IPO. Or sleek bankers, guys (mostly) in gray Armani suits, blue shirts with white collars, and Hermès ties, jetting off to London to close some important deal. Not anymore.
So what is it? From 40,000 feet, Wall Street is about access to capital. The stock market trades every weekday, and sometimes slowly, sometimes violently, picks the economy's winners and losers. Actually, it's not the market, it's you and me, our mutual funds and pension plans, the collective "we," that do the picking via our buying and selling. It's nice to be needed. You may not even realize it, but magically, the value of companies with great prospects goes up, meaning they can raise capital much more cheaply to hire smart programmers or build another solar-panel factory. The flip side is that the price of companies doing all the wrong things (think General Motors and now Lehman Brothers) goes down, starving them of capital, a punishment for screwing up, until they disappear or do something to turn themselves around. The stock market, which is really you and me, does the dirty work of hiring and firing managers and green-lighting or killing projects. Pretty cool.
On the street level, of course, Wall Street is a lot nastier. After 20 years in the business, when I think of Wall Street, I think of alpha dogs generating revenue however they can: getting deals done, fighting for market share against all the other firms, and then at the end of the year, on the inside of their firms, unsheathing the political knives to carve up the ever growing bonus pool, and maybe also carve up each other. Wall Street is really just a compensation scheme. Firms generate sales, and employees get half the money. Yes, half. The rest, after expenses goes to shareholders. Sweet deal.
Back in the days of private partnerships, White Weld or Brown Brothers or even Morgan Stanley, that was fine. They traded stocks and made good money. They offered advice on mergers and acquisitions and got paid handsomely. But in August 1983, the stock market and the U.S. economy took off. So did mutual funds. And Silicon Valley. And biotech. And a massive service economy. More capital was needed to fund the growth of great companies Think of all the technology companies that didn't even exist in 1983.
Wall Street partners had to pay for memberships in Greenwich country clubs, so partnerships couldn't retain much earnings. They needed to tap those same public markets, and so went public to raise huge buckets of capital to help their clients. What a great 25-year run!
A very subtle change ruined the party. The same PC and Internet technology that was sweeping corporate America and getting rid of tellers and travel agents and secretaries and typesetters was also invading Wall Street. No one needed a broker anymore--you could do it all online. Traders at firms were being replaced by electronic trading systems that were faster, cheaper, and don't show up late for work after taking clients out to Smith & Wollensky's.
By 2002, Wall Street firms, despite being flush with huge balance sheets of capital to generate returns with, were no longer making money in their bread and butter business of stock and bond trading, investment banking, and money management. The one group making money were these weird guys with math Ph.D.s creating exotic securities, derivatives, pieces of paper backed by pools of assets, maybe airplane leases, or home mortgages. The neat thing about derivatives is that no one but the person who created them knows what they're worth, so you can sell them at huge markups. Woo-hoo. Mammoth departments were created all over Wall Street to securitize everything that moved. With the Fed forcing low interest rates in 2002-2004, the higher the yield the better.
Subprime home mortgages, because of higher risk (ooh, don't say that word), had high yields and moved to the top of the list. When not enough of these loans could be bought from banks, firms like Bear Stearns and Lehman set up entire loan-origination subsidiaries, and in true Wall Street style were aggressive and rose to the top of the market-share tables. If you want to know why Wall Street CEOs made so much, it wasn't from trading your 1,000 shares of Apple stock.
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.