Matt Taibbi Misexplains Hedge Funds & Other Stuff to Joe Rogan
Even our heroes make mistakes.
Matt Taibbi is one of my favorite writers/podcasters, and I love the Joe Rogan Experience (JRE) for its diversity of guests and long-form discussions. Despite my many disagreements with them on various topics, Rogan and Taibbi are both national treasures in my book. But that doesn’t mean they can’t make their own mistakes along the way. My objective with Narrative Combat is to provide a sort of audience fact-checking service that does not discriminate, so even my favorite content providers are fair game.
Mr. Taibbi was recently featured on episode #1745 of JRE in which he made a number of mistaken attempts to describe the way hedge funds and markets work. The structure of this piece is comprised of direct quotes from Mr. Taibbi that are followed by my own commentary in response.
Hedge funds don’t really get checked. So if you’re running a hedge fund and…you get bunch of high net worth people [to invest]…and you start investing and it doesn’t work, and then suddenly there’s this temptation: “Well, I don’t have to tell them. I can put out a report that says we actually earned 7% or 14% this year.” And no one is gonna check because there isn’t a body that checks for that kind of investment.
Hedge fund performance is independently verified two ways: 1) Through third-party administrators that reconcile portfolio marks and formally issue monthly investor statements; and 2) Through auditors that work with fund administrators and managers to annually certify a fund’s financial reporting.
Hedge funds therefore cannot just “put out a report” that says whatever they want it to say. They do often provide performance estimates as part of standard communications with their clients, but official investor statements are issued by an independent administrator.
While there may not be an official “body” that checks hedge fund performance reporting, these practices do factor into the registrations that many hedge funds maintain with various regulatory bodies.
The overwhelming majority of hedge funds operating today conform to this convention. Those who do not are inviting suspicion and therefore unlikely to attract meaningful capital. Madoff was able to get away with it because his investors simply failed to perform even the most basic due diligence.
So Mr. Taibbi is quite wrong to suggest that hedge funds can report whatever performance they want to their investors.
Bernie Madoff’s banker was JP Morgan Chase. So the bank, which should’ve been monitoring whether or not their client had a legitimate business, didn’t…They’re part of the con. This guy banked with JP Morgan Chase, it’s part of the sales pitch. Of course he’s legitimate. He’s endorsed by the biggest commercial bank in the country.
Mr. Taibbi’s overarching point here is the correct one, which is that JP Morgan Chase appeared negligent in the Madoff fraud. However, it should be noted that banking relationships for hedge funds involve some important distinctions.
Conventional relationships between hedge fund managers and their banking partners are typically arms-length affairs. This is where a manager has what equates to a standard checking account for the management company to which fees accrue and from which bills are paid. The onboarding process here is usually straightforward and involves standard KYC and AML checks. Banks are required to monitor for unusual transactions to guard against money laundering and terrorism financing violations. I’m not sure that extends to passing more holistic judgment on the quality of a client’s business, and this type of relationship doesn’t typically serve as an endorsement per se (e.g., is your local bodega endorsed by its banking partner?).
Investors do not tend to care much about a fund management company’s banking partners. The banking relationship that is much more important is the prime broker, which is more likely to convey “legitimacy”. This is where a bank like JP Morgan helps its hedge fund clients execute their investment strategies through trading, custody, financing and lending services, among others. One of the many red flags with Madoff is that he used one of his own subsidiaries to perform his prime brokerage function.
It appears that Madoff had a single corporate bank account that took in investor subscriptions and funded redemptions. This is an odd structure as hedge fund vehicles themselves tend to have their own bank accounts to facilitate the receipt and deployment of capital (separate from the management company). It stands to reason that JP Morgan Chase should have exercised some judgment given the magnitude of balances being held in Madoff’s name. It certainly would be abnormal for any fund, no matter how successful, to be holding tens of billions of dollars in a single corporate bank account. And for those funds to have never been deployed towards something that looked like trading purposes is obviously sketch.
After the pandemic, the banks had their best year in history in 2020. Because why? Because when you have the CARES Act, which is all that money from the Fed that went to rescue everybody, to keep all these companies in business. Somebody has to underwrite all that lending. The Fed is basically buying all these bonds, there’s all this new lending to companies that’s coming from the government. Well some private entity has to do all that underwriting. So banks made like $140 or $150 billion in profits just from underwriting in 2020. So they all got rich off the bailouts for the pandemic.
There is nuance here that needs to be disentangled.
Like most government spending these days, money for the CARES Act (Act) was generated through increased bond issuance by the U.S. Treasury. This type of deficit spending is a hotly debated topic in economic circles and is a key component of modern monetary theory. The U.S. Federal Reserve Bank (Fed) has been increasingly buying those bonds from the open market in an effort to increase the money supply and keep a lid on interest rates. This is known as quantitative easing and has resulted in significant expansion of the Fed’s balance sheet since the onset of the pandemic.
The Paycheck Protection Program (PPP) was a part of the Act that sought to provide loans to small businesses to help them stay afloat during the pandemic. The PPP was overseen by the Small Business Administration (SBA), which partnered with local commercial banks to disburse those loans.
In order to provide commercial banks with the funds required to make those PPP loans, the Fed established a liquidity facility that enabled regional Federal Reserve banks to issue non-recourse loans to participating banks. Those loans were effectively guaranteed by the SBA (and, in turn, the U.S. Treasury).
Sahil Bloom has a good primer on the dynamics at play here.
Since these loans were forgiveable by the SBA, participating banks were not assuming any credit risk and therefore were not underwriting them. They were instead administering and processing them, for which they charged fees ranging from 1-5% (depending upon loan size). Consequently, loans associated with the CARES Act had no direct relation to the Fed buying “all these bonds” that needed to be underwritten.
On the topic of profits, large investment banks are indeed historically profitable right now. Per Bloomberg, “a total profit of more than $170 billion from a dozen of the biggest firms in the past four quarters shows how far the industry has come from the frazzled early stages of the pandemic.”
We should note that those estimated profits include other large global banks like UBS, Deutsche Bank, HSBC, and Barclays, most of which had little to do with PPP. But even for the American banks, their earnings were only slightly impacted by the CARES Act. In fact, it is estimated that Chase - the commercial banking unit of JP Morgan - earned approximately $1-2 billion in PPP fees. I’ve no idea what the profit margin may have been on those fees, but it would certainly pale in comparison to a total profit during the reference period of $47.8 billion.
Furthermore, the total amount of bank fees generated by PPP loan processing stands closer to $25 billion, well short of the $140-$150 billion in profits that Mr. Taibbi suggested.
The reality is that investment banks are wildly profitable today because of their bread-and-butter businesses: namely, advising and structuring large corporate transactions like mergers, acquisitions, IPOs, and (more recently) SPACs; and good old-fashioned trading. Global M&A activity is smashing records this year. Private equity buyouts will total nearly $1 trillion in 2021 and the IPO market has been red hot. And volatile, upward-trending markets tend to be good for trading and wealth management businesses.
Mr. Taibbi may be making a noteworthy broader point, which is that all the accommodation provided by the Fed and Treasury has created conditions supportive of financial services companies. Buoyant markets are obviously good for risk assets, which has undoubtedly fueled a lot of the transaction activity that made banks so profitable. This is what is known as the Cantillon Effect, which is the idea that those closest to the money spigot stand to benefit the most from monetary expansion.
But his attempt to tie bank profitability to the CARES Act was a stretch.
Once again people are struggling, they’re being ruined. But the 1% is kind of being artificially sustained because of this run of public support. It’s gonna make them all rich, which is gonna drive that resentment even further.
The logic being applied here sounds reasonable but falters with scrutiny.
Let’s assume Mr. Taibbi’s notion of “public support” takes two forms: bailouts and fiscal/monetary accommodation.
The CARES Act was basically a bunch of bailouts wrapped into one: some of which went to big companies (e.g., the airlines), some to small businesses (e.g., PPP), and some to homeowners who couldn’t meet their mortgage payments. It’s probably safe to assume that the top 1% benefitted from the economy being supported this way, but it’s hard to decipher whether these any of these programs directly made them richer.
I therefore assume Mr. Taibbi is referencing the Cantillon issue mentioned earlier, where accommodative policies tend to favor investors over workers. Policies encouraging growth in risk assets are naturally welcome for investors. The top 1% hold a significant amount of wealth and therefore disproportionately benefit on the way up just as they suffer on the way down (recall the 500 wealthiest people lost $239 billion in a single day during the COVID-induced market selloff last March).
But it isn’t just the top 1% that have benefited from all the liquidity sloshing around. In fact, household wealth has skyrocketed over the past two years. Over 55% of Americans own stocks, which have rallied strongly thanks to being “artificially sustained”. The residential real estate market has been on fire, which is good news for many since the U.S. has a homeownership rate of 66%. Over a quarter of Americans now trade crypto, which has seen meteoric growth over the past decade and minted untold millionaires in the process. It has even been suggested that this increase in wealth among average Americans is a primary factor behind today’s labor shortages.
Wealth inequality of course remains an issue in America, and the gap only continues to widen. Many Americans are struggling amidst the COVID pandemic and some in fact are being ruined. But a lot of Americans have also been doing quite well, and it’s not just the top 1%.
After 2008, there was a thing called the implied bailout. Just the fact that the public knows that the government is never gonna let JP Morgan Chase or Goldman Sachs go out of business allows them to borrow money more cheaply than some local bank. The government might let some local bank go out of business, so when they go out in the open market to borrow money, it costs more.
There are two primary ways banks access funding outside of core deposits: through the Fed’s discount window and debt issuance.
All member banks have access to the Fed’s discount window. The rates they pay on this money are directly linked to the credit-worthiness of the borrower. There isn’t much deviation in those rates and the borrowing is typically short-term in nature, so my guess is that Mr. Taibbi probably wasn’t referencing this type of activity.
With regard to debt issuance, it is easiest to focus on bonds that companies issue to raise funds. The primary underwriting consideration for bond investors is whether a company can service the debt being issued, not necessarily whether it has any implied federal backing. More specifically, bonds are (mostly) priced on the basis of a company’s financial health, which is often reflected in credit ratings provided by the likes of Moody’s, Fitch, and S&P. A review of those ratings does not indicate preferred pricing due to any implied put.
For example, a composite ranking conducted back in March showed the highest credit ratings belonging to BNY Mellon and Northern Trust. Ranked by assets, these banks are #12 and #27 in the U.S., so not names typically associated with the “too big to fail” variety. In fact, their combined assets are less than one-fifth the size of JP Morgan Chase, whose composite credit rating ranked #5.
Looking more granularly at current ratings, the senior debt of Goldman Sachs has been assigned a rating of BBB+ by S&P, which effectively scores as good but not great. That same rating is enjoyed by regional banks like Fifth-Third Bank (#17 by assets), Comerica Bank (#41), and East-West Bank (#50), just to randomly pick a few. BMO Harris Bank (#21) has an even better rating despite its much smaller stature.
Contrary to Mr. Taibbi’s suggestion, the notion of “too big to fail” has actually diminished since the financial crisis. Despite its success, the Troubled Asset Relief Program (TARP) is now burdened by a public stigma thanks to the populist narrative that the bailouts helped Wall Street more than Main Street. This has caused markets to assign a lower probability of bailout the next time around. A recent study put a finer point on this dynamic:
For globally systemically important banks (GSIBs) with U.S. headquarters, we find significant post-Lehman reductions in market-implied probabilities of government bailout, along with 50%-to-100% higher wholesale debt financing costs for these banks after controlling for insolvency risk. The data are consistent with measurable effectiveness for the official sector’s postLehman GSIB failure-resolution intentions, laws, and rules. GSIB creditors now appear to expect to suffer much larger losses in the event that a GSIB approaches insolvency. In this sense, we estimate a major decline of “too big to fail.”
Also important to note here is that it wasn’t just the largest banks that were bailed out in 2008. In fact, hundreds of banks large and small received bailout funds. For example, included on that list was Oak Valley Community Bank, which is the 50th-largest bank in California and the 593rd-largest bank in the U.S. It received bailout funds of $13.5 million from TARP, which - as measured by bank assets - was roughly pro-rata the $25 billion that JP Morgan received.
I can appreciate the logic Mr. Taibbi applied here. It stands to reason that those banks basically guaranteed to never default would have access to cheaper financing than those lacking such assurance. But the reality is different from what he described.
After 2008, when they took the failing companies like Washington Mutual, rather than break them up into smaller parts so they could become independent smaller enterprises, what they did was fold them up into the bigger companies. They got companies like Chase and Bank of America to buy up these smaller entities. They took an already concentrated marketplace and made it more concentrated. That’s happening again…
Washington Mutual (WaMu) was seized by the Federal Deposit Insurance Corporation (FDIC) at the height of the 2008 financial crisis. With over $300 billion in assets at the time, it was the largest bank failure in history. WaMu had a large mortgage portfolio that was growing increasingly impaired, and nervous depositors had started to withdraw their funds from the bank. The official narrative is that the FDIC feared a WaMu bank run could spark an even bigger panic, hence the need to step in and find a buyer as fast as possible in order to restore stability and therefore protect depositors as well as insurance funds.
There is some debate about whether WaMu even needed to be sold and whether there was chicanery involved in its purchase by JP Morgan. But the idea that WaMu should’ve been broken up into smaller parts makes no practical sense. Attempting to do so would have only increased uncertainty for depositors. Troubleshooting becomes one big confidence game when the entire financial system is on the verge of collapse, so there is wisdom in allowing the big to get bigger when stability is the goal.
Breaking up WaMu would’ve been a long, expensive process at a time when speed and loss mitigation were paramount. It’s important to note that the company had nearly $180 billion in mortgage assets and someone needed to take responsibility for managing them. The housing market was imploding at the time, so the expectation that there were a bunch of “independent, smaller enterprises” willing to take on that servicing burden - when their own businesses were being crushed - is simply unrealistic.
There is also the notion that increased financial fragmentation is not necessarily a good thing as economies of scale can allow larger banks to offer more attractive rates and innovative solutions.
I appreciate the populist distrust of oligopolies in general - and bank ones in particular - but any implication that WaMu should’ve been auctioned off in a bunch of small lots rather than sold whole is misplaced in my view.
I’m also unsure what he means about marketplaces growing more concentrated “happening again”. I suppose it might be in reference to small businesses struggling in the pandemic, but we haven’t seen the type of acquisitive consolidation that was prevalent during the 2008 financial crisis.
[GameStop] is another story that was massively misreported. I talked to a lot of the people who invested in GameStop and a lot of them were people who got ruined after the 2008 crash, whose families got ruined, and this was their way of kind of getting revenge on the system, as a form of protest. For some people it was just another way to make money.
I find it interesting how folks like to romanticize the GameStop (GME) short squeeze affair from earlier this year. I suppose it’s a fun narrative after all, where a ragtag group of keyboard warriors conspire to wage war against hotshot hedge funds. But for those of us familiar with message boards like r/WallStreetBets (WSB), the GME trade was less a revolt and more a reflection of the meme-fueled nature of risk-taking we see so much of today (e.g., crypto).
The reality is that WSB is comprised of professional traders as well as amateurs, so it’s not necessarily a disenfranchised group looking for revenge. For example, Keith Gill, the man who became the face of the GME trade, is a CFA charterholder who until recently worked at MassMutual. His interest in GME initially derived from real and proper analysis, which he freely shared with his fellow Redditors and in YouTube videos.
Part of Mr. Gill’s GME analysis included the amount of short interest in the company. It is common for traders to target stocks with high short interest since they can be susceptible to squeezes, which occur when shorts need to be covered as they rally in price. The more violent the squeeze, the more urgent a short-seller’s need to cover its position, which only adds fuel to the buying frenzy. This self-fulfilling rally can sometimes get crazy when there are a lot of shorts to be covered.
This is a common tactic among professional and retail traders alike. And the objective here is always the same: to make as much money as possible. Once it became known that hedge funds like Melvin Capital were on the losing end of the GameStop squeeze, plenty of Redditors had fun with the idea and a David-versus-Goliath narrative began to manufacture. This was to be expected since the media love to foment class conflict and bash hedge funds. Such framing may have attracted some to the trade as a form of personal protest; apparently, Mr. Taibbi was able to speak with a few of them. And there were certainly plenty of Redditors cheering Melvin’s demise in real time. But that was more of a side story than an organizing force for those of us paying closer attention.
I would therefore reverse Mr. Taibbi’s framing by saying a lot of GameStop punters were there to make money while some of them may have been tourists looking to protest. It is my view that the reality aligns more closely with an observation of the essayist Abraham Polonsky, who suggested that “Money has no moral opinions.”