Felix Salmon

Gone fishing

Felix Salmon
Oct 22, 2009 18:02 UTC

This is getting a bit surreal: both Clusterstock and Dealbreaker are now phoning up Charlie Gasparino asking for his reaction to my tweets. It’s clearly time for me to go on holiday. So I’m off to Spain, back November 4. If you don’t expect any blogging between now and then, you won’t be disappointed.


You know you’ve made the big time when you get a hate bon voyage comment.


Felix Salmon
Oct 22, 2009 17:57 UTC

The Fed’s pay proposals are out: a whole lot of nothing? — Federal Reserve

What happens when you pay traders too much: their performance drops off. — Reuters

The Center for Plain Language 2009 symposium is next week. Shame I can’t make it, I’d love to go. — CPL

NYC can buy Battery Park City for $1. Seems like a good idea to me. — NYT


Lot of gold mining company earnings released in the past few days, good summary at http://www.goldalert.com/gold_price_blog .php. This is one of the best performing sectors this year, although they have definitely underperformed the past few weeks. But going forward I think the gold price will remain strong and benefit these companies because of the Fed’s easy monetary policies.

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Unemployment datapoint of the day

Felix Salmon
Oct 22, 2009 17:39 UTC

The length of time the average unemployed person has been without a job has been hitting new record highs for a while; it’s now managed to pass the 6-month mark. That’s much higher than any previous peak in this data series. And I fear that the only way it’s likely to come down any time soon is as these people become so demoralized that they take themselves out of the labor force altogether.

The overwhelming majority of the working population will never be able to prepare themselves for a period of unemployment lasting more than six months. As financial-market types worry about possible inflation in a few years’ time, tens of millions of Americans are finding themselves in a very real personal financial crisis to which there is no visible solution. Given the Fed’s dual mandate, it makes sense to keep interest rates low for the foreseeable future. Inflation is possible; unemployment is catastrophically real.


Here’s what I don’t understand about the inflation anxiety. Inflation results from aggregate demand rather than money supply. Dollars sitting in bank accounts shouldn’t affect prices. So I don’t think the low interest rates and massive deficits that are normally associated with inflation are at this moment, with private borrowing so far off, a danger to cause inflation. Now when the borrowing and lending come back our large deficits will become dangerous. We’ll need to raise taxes. I’m concerned we won’t have the will-power and the dollar will suffer.

Analyzing Galleon’s returns

Felix Salmon
Oct 22, 2009 17:21 UTC

The Pragmatic Capitalist gets his hands on Galleon’s monthly returns, and finds them very suspicious:

These guys just couldn’t lose. Whether the market was up or down they cranked out 25% returns like they were printing money. It makes you wonder just how long these guys were trading on insider information?

I have run the risk adjusted returns on hundreds if not thousands of portfolios throughout my career and I have never seen numbers like these. NEVER. There is virtually ZERO downside volatility in these figures… Gauging from the returns I would be willing to bet the insider trading was going on for most of Galleon’s existence and was likely much more rampant than currently reported.

I’m not completely convinced, for two reasons. Firstly, Galleon’s returns were pretty volatile: the fund was up 14.53% in May 1997, for instance, and then down 8.54% five months later, in October of the same year. That doesn’t seem abnormally consistent to me.

More generally, if you want returns which rarely turn negative, insider trading is not your strategy. Madoff-style outright fraud works, of course: you just report fictional returns instead of real ones. But Galleon isn’t being accused of making up its returns: it has the money it says it has. It just (allegedly) used illegal means to amass it.

A sophisticated insider trader isn’t trying very hard not to lose money. Quite the opposite, in fact: he’s putting a lot of money at risk, and knows there’s a significant downside. He just also knows that he’s got an informational edge which gives him an advantage over the rest of the market. Such advantages don’t always pay out, and as a result you’d expect an insider-trading strategy to show relatively frequent negative returns. Even if, over the long term, it was very successful.



No, I can second thoughtbasket. The rumors about Galleon were persistent and loud. One of the problems with piggybacking insider info is asymmetric information. When insider info goes bad, it goes very bad and can turn a years worth of legit gains into negatives tout de suite. To be assured of making money, you would first have to certain that Galleon was putting on an “insider” trade and not a “normal” position; 2) you would need to see and trade the entire book of Galleon “insider” trades to make certain that the good “insider” trades beat the bad “insider” trades in aggregate. In practice, Galleon would be spreading the trade(s) around to mitigate piggybacks. I bet Galleon has at least 3 primes and a HUGE broker list.

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Ethics laws can’t work

Felix Salmon
Oct 22, 2009 17:05 UTC

Richard Painter, who drafted and approved the ethics agreement signed by Hank Paulson when he became treasury secretary, has come to the conclusion that such agreements can never really work as intended:

This essay concludes that government ethics law in its current state is not up to the task and that the United States is not prepared to implement bailouts in a manner that will instill public confidence. Although these problems could be alleviated through stricter ethics rules or a more systematized approach to bailouts, most solutions would be more costly than the problems they attempt to solve. Bailouts thus impose a substantial burden on government ethics that may be impossible to remove, in addition to the economic cost bailouts impose on taxpayers. Designing a bailout free economy may be the only acceptable alternative.

Painter’s essay is excellent, and highly recommended, precisely because he offers no solutions to what is an intractable problem. Here’s a little bit:

Requiring Treasury officials coming in from Goldman Sachs or other investment banks to dump their bank stock and stock options may not have been enough when they retain close ties to their former employers. There were also probably too many senior Treasury Department officials from Goldman; perhaps there were too many from the banking industry in general.   

This is very true. The saga of the government’s response to the financial crisis is one where all the key decisions are made by bankers, be they of the commercial, investment, or central variety. In a parliamentary system like the UK’s, the finance minister is an elected representative of the people. Of course, as we’ve seen in the UK, that doesn’t necessarily make bank bailouts any more taxpayer-friendly. But at least it serves as some kind of check on the banking industry bailing itself out whenever it gets into trouble.

The impression I get from the current spate of crisis books is that the likes of Paulson and Geithner became entirely consumed with the problems in the financial sector, and viewed political considerations, and the will of the people more generally, as an obstacle to be overcome rather than as any kind of guiding light. That may or may not have been a good thing. But either way, it’s fundamentally undemocratic.


The problem is that everybody is focused on creating laws and ethics policies. Once those are in place, everybody then focuses on finding the tiny loopholes so that the behaviour that is clearly intended to be thwarted, is announced as passing the legal and policy requirements.

Paulson setting up a “social hour” with his old cronies without setting out clear ground rules that no government policy would be discussed means that he really did not udnerstand the concept of conflict of interest in the first place. With the recent Galleon and other affairs, it is clear that things that Main Street America view as way over the line are either viewed as acceptable or marginally unacceptable on Wall Street and in Washington.

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When failed genius is rewarded

Felix Salmon
Oct 22, 2009 16:27 UTC

The reaction to the news that John Meriwether is setting up a third hedge fund has been entirely predictable, especially when Sam Jones’s story deadpans that “the fund is expected use the same strategy as both LTCM and JWM to make money”. (Meriwether’s first two funds, of course, were spectacular failures.)

But really this isn’t a third hedge fund at all, it’s just a reincarnation of the second one, minus the high-water mark. Kid Dynamite explains:

JWM Partners closed last year after losing 44% amidst the market turmoil of 2008. Hedge funds typically have “high water marks” which means that investors don’t pay performance fees to the fund manager in subsequent years unless the fund surpasses its highest point. Thus, the solution for fund managers whenever they have a bad year is to liquidate, wait a bit, and form a new fund?!?! Anyone who was invested in the old fund and the new fund thus pays fees twice: you paid when JWM Partners reached its high water mark, and now you’ll pay again if/when Meriweather Cubed (not the real name) manages to make money – the same money JWM Partners effectively lost after reaching its high water mark.

This is great for John Meriwether, of course. And perhaps, in an attempt to goose his AUM, he might even give investors in JWM a break on his fees. Mostly, however, it’s just an indication of the same delusion that we’re seeing in the leveraged-loan market: the idea that the status quo ante was “normal”, and that now we’ve rebounded back to something very similar. After all, if the financial crisis was a once-in-a-century event, we won’t see another for 99 years, right?

You’ve got to give this to Meriwether, though: the guy’s clearly a spectacularly good salesman. That’s a key attribute of hedge fund managers which they tend not to talk about: after all, they love to give the impression that people are giving them billions of dollars just because of their unsurpassed investment prowess. The truth is clearly very different.


Ezra, you understated the ability of Meriwether to lose money and cause trouble for investors.

Before his JWM blowup, before his LTCM blowup, he assisted in the Salmon Brothers blowup (the Treasury securities scandal) in the early 90′s.

It’s really surprising that anyone would give him any money to manage.

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Gold-denominated hedge funds

Felix Salmon
Oct 22, 2009 15:21 UTC

For a while now, hedge funds have been creating share classes denominated in gold. By far the biggest fish in this pool is John Paulson, and as a result he’s been buying gold, literally, by the ton. (With gold at $1,050 an ounce, and 29,167 ounces per ton, Paulson’s $4.3 billion gold investment would buy him 140 tons of gold.)

I’m a little unclear on how these share classes work, but it seems similar to a portable-alpha strategy. The problem with gold is that while it fluctuates in value, it doesn’t generate any kind of returns unless and until you sell it. But with these share classes you get to have your cake and eat it: you’re essentially parking your money in gold, while at the same time investing it in obscure and wonderful trading and investment strategies across all manner of other asset classes.

Hillel Aron has a friend who was just at breakfast with John Paulson, being sold on investing in his funds:

His conclusion – not a shocker here – there will be a rush into Gold. Paulson personally has all his own assets in Gold and his funds own 5 different Gold Mining Stocks. By the way, Paulson notes, of the 200 Trillion dollars of investible assets in the world, only 800 Billion of that is Gold.

This means, I think, that Paulson’s own investments in his funds are all in the gold-denominated share classes. And I can see how a multi-billionaire would do something like that: when you have that much money, the only things which can wipe you out are hyperinflation or outright confiscation. Gold is a good way of protecting yourself from both eventualities.

For people with less dynastic amounts of money, however, I’m less keen on the gold-denominated share classes. For one thing, there are substantial hedge-management costs involved. But more to the point, if the price of gold falls, then you can end up in the very painful position where your investment loses money in dollar terms and you still have to pay a large 20% performance fee, since it could still have done well in gold terms. Ouch.


Precious metal investors have been on a wild ride so far in 2011. After falling to start the year, gold took off from its level just above $1,300/oz., skyrocketing higher on inflation concerns and an increasingly weak dollar. Many of the world’s largest (and most successful) managers have put huge chunks of their assets into precious metals ETFs over the last year, and investors seeking to replicate their strategies have utilized the exact same instruments to express similar views. George Soros has reportedly sold nearly $800 million worth of shares in gold exchange traded funds, while fellow hedge fund manager John Paulson kept his big stake in gold ETFs unchanged in the first quarter, according to regulatory filings. With so much uncertainty in the market, what is going to happen to the price of our jewelry?


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The mortgage-servicing writedowns

Felix Salmon
Oct 22, 2009 14:20 UTC

Bloomberg’s Michael Moore has lots of detail today on the treatment of mortgage servicing rights in banks’ earnings reports. No, wait, it’s actually interesting! Especially when you look at the numbers involved.

Wells Fargo is the poster child here: it wrote down its mortgage servicing rights by a whopping $2.1 billion last quarter, but it actually made a profit of $1.5 billion on them, since the value of its hedges on those rights soared by $3.6 billion. At the end of the quarter, it valued its rights at $14.5 billion.

Moore tries to explain what’s going on here, but something smells fishy:

The value of the rights depends largely on the expected life of the mortgage, which ends when a borrower pays off the loan, refinances or defaults. When rates drop and more borrowers refinance, MSR values decline. Banks typically hedge the movements using interest-rate swaps and other derivatives…

Because there’s no active trading in the contracts, there are no reliable prices to gauge whether banks are valuing the rights accurately, analysts said.

Here’s the first thing which puzzles me: in the third quarter, mortgage rates fell by 0.26 percentage points. How could such a relatively modest decline in rates result in a plunge of $2.1 billion — more than 12.5% — in the value of a $16.6 billion portfolio? And what kind of hedges result in a $3.6 billion profit when rates decline by 26bp?

Over at JP Morgan, the numbers are a little more modest, although Jamie Dimon’s shop, too, contrived to make a profit on its hedges: the portfolio declined in value by $1.1 billion, or 7.5%, while the bank’s hedges went up in value by $1.5 billion.

I’m especially puzzled by the big writedowns because anecdotally there doesn’t seem to be a huge amount of mortgage refinancing going on, and I don’t think that expected default rates rose in the third quarter either. (If anything, judging by the prices of mortgage bonds, they fell.)

There also seems to be a strong correlation between the size of the writedown that a bank took, on the one hand, and the degree to which its hedges made money, on the other. Is there any good reason why this should be the case? Or are banks just taking writedowns as and when they manage to pay for them out of hedging profits?


26 bps over a 30 year or even a 20 year period is a lot!
I have not looked into any of the details, but just as a general comment, duration is the key word here.

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Felix Salmon
Oct 21, 2009 22:51 UTC

Stop looking at charts! — Abnormal Returns

Why you should never buy a commodity fund — Reuters

How to feed the world’s hungry: food bonds; forwards; call options; tax credits. Yes, that’s the Milken Institute — MI

Should states subsidize university tuition for out-of-state students? Makes some sense, if they’re bright and will stay in the state after they graduate. — Economist

Does Altucher think that insider trading should be legalized? — HuffPo

Does this mean that the newspaper is The Wall Street Journal Amateur Edition? — WSJ

Venture funding for art! — True Ventures

I discuss Sorkin’s tome — TBM

Good for Tapper. We need more feist in our press corps. — Atlantic Wire

Too Big To Fail, the art show — Sanford


“Good for Tapper?” What a silly reaction. If this is “feist,” it’s a waste of feist, defending a plainly biased news organization. Where is all of Tapper’s “feist” on the subjects that matter?

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