The story referenced below (hat tip Felix Salmon) may well be apocryphal. It has the feel of an urban legend, and I think I've read variations of the tale before, but without the topical Bear Stearns reference. Watch me take the bait, swallow, turn bright red.

From CDO Pool PMs - Just Chillaxing:

Asked how [a CDO pool portfolio manager] is doing, he says “nothing.” I ask, “What do you mean nothing, I hear all these stories about CDOs and losses (Bear Stearns for example)?” He shrugs and says nothing will happen until the rating agencies do something. Asked about losses, he says they are there but he doesn't have to mark to market his portfolio until someone discovers it or the rating agencies force his hand. So his plan is to lie low and collect the management fees (and bonus) and pretend as if there are no losses...

He says he has the best job in the world and says there is really no work to do every day. Just wait and hope that the rating agencies don't downgrade his CDO pool and voila, at the end of the year, he and his partners can split the $10 million spoils (minus the expenses for one Park Avenue office, and a secretary).

If this is real... Just two words. Jail time. If you take your 50bps on unimpaired values of assets that you know or should know are likely to be inflated, jail time is what you should get. And not just a little. That goes double (quadruple and 40?) for hedge fund managers taking fees on phantom value.

Do think about this while you're "chillaxing" (in DealBreaker's colorful slang). Of course, you have your defenses. You rely on standard industry practices. You can claim that writing down assets prematurely would be unnecessarily damaging not only to you, but to your investors, to CDO investors as a whole, your mom's pension fund, and the Western financial system. Of course your lawyers are confident the charters, prospecti, indentures, whatever are airtight, that valuation procedures are clearly spelled out, and everything is hunkydory if you can just hold back the tide a few more months. But it's amazing how little the lawyers can do for you once transit workers' retirements and university endowments go up in smoke and pitchforks. It's like China, with this guy just executed for making a buck looking the other way on food safety. Probably lots of similar players got away with deadly corruption. Maybe a dispassionate look at the odds of getting caught said this was a rational game to play. But somebody somewhere is gonna get unlucky, gonna get smoked. It might as well be you.

Here's another word: Shame. Aren't you at all ashamed to take money from your investors in this way? Would you take a Rolex from a jewelry store window if you could get away with it? Don't give me that crap about professional investors and big boys who know what they're getting into. Asset managers (CDO pool, hedge fund, whatever) don't have an adversarial relationship with their investors. They have a fiduciary relationship. That is, they have an ethical obligation to do what is in investors' best interest even if it conflicts with their own. I believe that's a legal obligation, by the way, even if it's not spelled out in contracts and founding documents. A judge surveying the wreckage might take that into consideration, if you get my drift. Especially when the big boys you "out-traded" were themselves fiduciaries for thousands of ordinary broken dreams.

Now before I go finger-wagging too much — shame, shame — I should emphasize that I have a dog in this fight. Here's "full disclosure" in the lingo. I belong to a maligned, belittled, battered and bruised species, the unhedged speculative short. I don't have positions directly related to CDOs or hedge funds or housing — I'm a broad macro pessimist kind of guy. (I am short financials, short semis, short the Dow, short USD, long gold, an FX basket, TIPS.) Should I be ashamed? Am I just talking my book? Trying to provoke an apocalypse for thirty silver coins? Felix claims that "courts are unlikely to have a huge amount of sympathy for short-sellers." Everybody thinks that we're the bad guys.

But I'll tell you what. Short sellers are the good guys in financial markets. We're the guys who take risks that by most people's lights are simply irrational. Markets generally do go up and inflation does inflate. Nine times out of ten, a short is just a subsidy to a long. Short sellers are the true idealists. People like me, we're not traders, we don't backstop. We hold our positions and payout dividends until our margin runs out, and then we die (metaphorically), simply because we believe that assets are overpriced. We believe that prices are not numbers you trade, but references to real-economic facts. If prices are out of whack, in order for financial markets to work, someone has to try to arbitrage them back, and it might as well be us. We do hope to make a buck. We have our evil dreams of profiting just when everyone else is taking losses, and thereby being well positioned to buy value when it finally comes around again. But objectively, that's never a good bet. At some level, being a short is a vote for how financial markets ought to behave, rather than how they do behave. In the late 1990s, most unhedged shorts were right, and were slaughtered for the privilege. I fully expect that in the late 00's, I will have the same experience. But my sense is that the consequences of the capital market mispricings we have been unable to correct this time will be much more painful than the aftermath of the 1990s. We shorts don't want to see a "financial armageddon". After all, we'd never collect our paper profits from bankrupt brokerages and clearinghouses. We become shorts because shorts are supposed to be the mechanism by which catastrophic misalignments (and the distorted real-world incentives that accompany them) are prevented. Ordinary investors are pulled by fear and greed. "Buy and hold" shorts run on greed and idealism (and, many would suggest, sheer idiocy). Fear doesn't matter. We generally start losing money the day we take our positions, and we keep losing money until we can't. We are irrational, because we believe that markets should be rational. We believe that market prices have consequences, and that exaggerated asset prices do at least as much damage to the real economy as depressed prices.

I've been at this for a couple of years. I may be wrong about the fundamentals, in which case I'll take my losses with a shrug and rebuild my wealth in a healthy economy. I don't advocate fire sales, and am glad to see loan workouts and liquidity support that allow unwindings of positions to last more than a few days. But I have no patience with those who claim that the best thing to do is not acknowledge financial asset impairments that would persist even over a month-long auction (in contrast to a day long liquidation). Asset values can always change, but at some point you've got to concede that the issue isn't liquidity but uncertainty-adjusted value. Bears who were right deserve to get paid just as much as bulls who were right, and justice delayed is justice denied for shorts. Similarly, investment banks who knowingly overpay for assets in order to prevent larger losses on derivative positions are market-manipulators, and should face consequences for that. As should central banks and sovereign wealth funds, if their trading in markets other than their own debt is driven by anything other than direct return maximization as ordinary price-takers. There is no theory that lets us give real-world meaning to market prices when price-setters are driven by second-order side effects rather than direct valuation of the assets being traded. We have no reason other than blind faith or ideology to believe that anything resembling efficient allocation of real resources would occur in an economy driven by capital markets with bizarre feedback loops. I think we are watching capital market failure happen all around us, and it will work out badly.

Failing to take write-downs and tolerating central bank subsidies will eventually drive all us bears away. But that won't mean good times as far as the eye can see any more than all the successful 5-year plans of the Soviet Union meant that socialist paradise was at hand. Sometime within the next few years, today's shorts and chicken littles will be vindicated. But we'll still be poor, along with the rest of you. And that's too bad, for all of us.

Steve Randy Waldman — Thursday July 12, 2007 at 11:21pm permalink
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