Financial institutions' risk preferences and investment horizons

No major news in Joe Nocera’s “Hedge Fund Manager’s Farewell”, but it reminds us once again of the immense importance of an investor’s risk tolerance and investment horizon and how our banks incented employees to gamble with other people’s money:

[Hedge fund managers] had far fewer incentives than Wall Street traders to take truly insane risks. “Ninety percent of my net worth was in [my] fund,” said Mr. Barsky, and that is true of most hedge fund managers. Wall Street traders got rich by making deals that brought short-term profits, even if they “blew up” later. Hedge fund managers who blew up hurt not only their investors but themselves. “As long as the hedge fund manager has his own capital in the fund, the risk equation is different,” Mr. Barsky said.

“When I first started in 1998, we used to send out quarterly numbers. Now investors want weekly numbers. Professor Louis Lowenstein” — the iconoclastic and recently deceased Columbia University business law professor — “has a great line in one of his books: ‘You manage what you measure.’”

…Mr. Barsky had bought [Blockbuster] stock [in 2000] — and then had written to Mr. Buffett suggesting that he buy the company.

Mr. Buffett sent back a one-sentence reply: “I’ve thought about the business a lot but have never been able to come up with a conviction as to where the industry will be in 10 years.”

“Ten years!” Mr. Barsky said. “I think of myself as a long-term investor and I have a two- or three-year horizon.”

The article also notes the incredible irony that the large Wall Street banks had borrowed way too much money even as they refused to let their hedge fund clients borrow too much:

[N]obody in government is calling for a hedge fund bailout because hedge funds losses, however painful to investors, don’t create systemic risks to the nation’s financial apparatus. As it turns out, it was the big regulated entities, the banks and investment banks, that were the problem…

[M]ost hedge funds didn’t have the kind of 30-1 leverage ratios that the big banks had. Mr. Barsky’s fund, for instance, didn’t need much leverage to carry out his long-short strategy. But even if he had wanted to “lever up,” as they say, his prime broker — that is, the investment bank that did his back-office work — probably wouldn’t have let him.

In a wonderful irony, the banks and investment banks that were themselves drowning in debt were fearful of allowing their hedge fund clients to carry too much debt.

Posted by James on Saturday, May 16, 2009