The Exchanges

Q How did you go from where you started, which sounded like a relatively pure arbitrage, to evolving into strategies and then what became, you know, your first firm?

A It was really Kessler and Dan Asher's idea, who were friends, acquaintances of mine in, in Chicago. Then they traded in a somewhat similar way. Late eighties, early nineties, a couple of the stocks that they were the, um, designated primary market maker for issued, um, what were called perks or decks. A perk was a single security covered right. Mathematically, it was long stock short a call. Like a lot of these things, it came into being because of the regulatory framework. There were lots of sort of institutions that could own a single security that was a covered call, but they couldn't own the stock and write, and write a call. So it was an option product to be marketed to institutional investors, opposed to, you know, sort of the standard option, which, which had always been a very retail oriented product. And they had the idea that they saw sort of institutional option products, as it were, coming down the pike, and that, you know, we had a skill set that, that could be the basis for a more institutional, a money management business involving more than just our, our own money. And we started what became Deep Haven. Fairly quickly convertible Convertible bonds dominated the portfolio. But, you know, again, sort of in that vein, a product with some option characteristics that had institutional ownership.

AI assessment note: “they saw sort of institutional option products... And we started what became Deep Haven.”

Q And if that wasn't the sort of approximate cause, because I think that is common knowledge that that was a proximate cause. What was the driver?

A In point of fact, the major investment banks were probably insolvent. The stuff that they owned, it was actually, you know, as we talk about in panic, it was an information crisis. Um, Gary Gordon has, I think, is a, a quite good book, written, oh, seven, beginning of, of, oh, eight. He talks about Information insensitive securities, and the need, which he says money is an information insensitive security. You know, you know, your 10 dollar bill, and because of the volume of securities transactions, and so forth, all sorts of securities became circulating medium, became money, and for them to work as money, they have to be information insensitive. So the crisis was about information and sensitive securities becoming information sensitive securities, and then all these securities that supported all sorts of transactions at a zero haircut, When they began haircutting, that was the equivalent of a huge increase in reserve, you know, if you, you translate it to the regular banking system, it was the equivalent of a huge increase in reserve requirements, and therefore a huge contraction in the money supply. And then kind of a classic asset liquidation scenario. So the O eight crisis looks a lot like classic. Bank runs and, and bank crises, and in Gordon's terms, you had bank runs when people thought there was a recession coming or saw there was a recession coming. They knew in a rec…

AI assessment note: “it was an information crisis... information insensitive securities becoming information sensitive securities”

Q So you launch White Box and the name itself is sort of, it has an interesting connotations to how people think about Investing. So why don't you talk about what the name White Box means for you, and then how you approach this challenge of, hey, people are entrusting a pool of capital to you. How do you go about doing what you do?

A Most people, particularly the industry, when you say White Box, they understand that it's an antonym to Black Box. And the thing about a Black, the Black Box, I always thought the Black Box firms, you're telling people, That either our system is so complicated, so detailed, so computationally intense, or, or what have you, that there's no point in opening it up, because it just, it just wouldn't make any sense. And I don't think that's often the case. Or, on the contrary, it's so original, so elegant, so Simple but profound that to open it up would be to, to lose some incredibly valuable proprietary information, and you know, I don't, I don't think that's, that's true either. I mean, one of the things I do, um, and more now than sort of then, and this has kind of evolved over time, I think it's right To think of financial markets, not as a sort of stable mathematical phenomenon, but as a biologic evolving evolutionary phenomenon, and, and the point isn't to have the right set of equations or to using one probability distribution or another, you know, exactly how many terms you, you put into, to something. It's a fun, To find a profitable niche, you know, to find some place in the ecosystem where you can survive, and, and I think always, you know, I mean, one, one of the big things we've always sort of looked at is, you know, sort of markets that don't talk to each other that we…

AI assessment note: “they understand that it's an antonym to Black Box”

Q Right. So the capital's not there to close the gap. How do you think the financial system evolves from here over the next 10 years?

A I think the very central idea that, you know, like sort of markets are better than markets, individuals better than institutions, et cetera. You know, I do, I, I think that's dead, and I think the world really wants institutional, wants to go back to sort of institutional capital allocation, government capital allocation, you know. I don't know if it's 200% of the net money or three, you know, whatever it is, but, but all the money since oh eight. Has gone to passive investment. Active managers sort of across the board have had outflows, and passive managers have had inflows, and I think that's kind of consistent with the idea that, you know, we want quasi-government allocation of capital. To me, you know, around the world, central bank balance sheets, not just being the size that they are, But there is no sort of objection to central banks owning anything, owning, owning any asset value, you know, it's, the folk wisdom is that, uh, in 87, the Fed lent directly to Kidder Peabody to meet their margin call. I describe it as folk wisdom, you know, I don't, I don't know if it's true or not. I don't know if you can find out if it's true or not, but that was, you know, sort of, Out there, you know, um, unambiguously, you know, they aren't, they're the maiden lane securities on, on the feds balance sheet. You know, the lot of central banks own stocks. Fannie and Freddie explicitly fro…

AI assessment note: “I think the world really wants... to go back to sort of institutional capital allocation”

Q What was the math of options like in the late seventies, early eighties and Were people using Black Shoals? Were you calculating on a piece of paper? I mean, what was it?

A I actually wrote a, you know, I'm a little bitter I didn't get a Nobel Prize. I did write a Black Shoals option pricing model while I was in college. It is kind of the first thing that sort of occurs to you. But, 60, 70% of our business was, um, doing conversions and reversals, you know, so. That's turning a put into a call or a call into a put and, and arbitraging it with the stock and that, you know, so the fundamental equation is, uh, long call short put equals long stock. You didn't need to solve any differential equations to, to do that. And, you know, that relationship and other simple kind of relationships and, and sort of low risk spreading is, is what I did, anyway, to see how, how things, um, should be priced. I left Gruntel after a, a year and a half, and, uh, joined the CBOE as a, as an individual market maker. Again, in terms of, you know, like, sort of the, the time, you know, the, the prop desk at Gruntel was, um, three people. My boss, Ron Acer, a kid six months older than I am, who you may have heard of, Steve Cohen, and me. Gruntel, at the time, had capital of eight million dollars. We used a little more than two, and really the rest of the capital was marginally, you know, they didn't really use. No, but nobody else traded for the firm, and we were probably a little more than half their profits.

AI assessment note: “You didn't need to solve any differential equations to, to do that.”

Q You've been involved in, in sort of structured credit from, you know, call it the beginning of, I don't know if it's the beginning, but the subprime, shorts, pre-crisis, and all different kinds of evolution of those markets. How did you get there, and what's happened to the opportunity set over the last decade?

A The original genesis was, um, I heard a new century presentation, and, uh, the thing that was intriguing was all their businesses was, you know, essentially all of their business was cash out refis, you know, and I thought a cash out refi is fundamentally different than a new purchase. Even if you're borrowing a hundred percent on a new purchase, You have an incentive to get the right price, you know, for it to be market. A cash out refi, first of all, all the incentives are, are the other way. Typically, it means that, um, particularly a cash out refi at a higher rate. It means you're like the worst credit in the world. You know, you're not able to pay your bills now. You know, I knew there was some, some work in the corporate world, default rates, these are the different uses of, of proceeds. They're the highest default rates on cash out deals, as it were. If a deal is done to make an acquisition or something that has, it does generically sort of better. Then deals done to pay off insiders. So it struck me that, that, you know, that was a fundamental flaw. You know, so all the sort of subprime lenders, you know, I mean, they, they talk about, you know, having a better model as it were having, you know, being able to, they can see this, this, whatever. Five 70 FICO person is really a six 60 FICO. You know, they, they all sort of say that, but As a public company, you have to g…

AI assessment note: “The original genesis was, um, I heard a new century presentation”

Q Is it harder to find those mispricings today than it used to be?

A The bigger thing and the thing I think we need to focus on more and maybe develop some additional capabilities. It's not finding the mispricings. It's transitioning. It's it's they're moving to another set of owners. And I do really see a sea change. In the financial system that, that lots of things have driven, included Reg FD, you know, which wasn't particularly controversial, you know, in the sense that you can't have people with, with an informational advantage. You know, the information has to be dispersed and so forth. Though, you know, I mean, it used to be that incremental information got released incrementally, as it were. I mean, even pre-FD The company couldn't tell an investor that we're in talks to be acquired, and we think it's going to happen in the next month or two. They wouldn't say something like that, but they could say, we're running this pilot with Walmart. I think FD did sort of shut companies up, and I think that put a lot of active managers out of business. It wasn't a huge factor in their returns, but You know, it was an incremental, uh, advantage, and, and it was part of the story. You know, they could tell people they knew more about their portfolio companies than, I think that with, with them gone, with the dealer desks sort of gone, I see there being more permanently orphaned securities, and, and, you know, I mean, really, The only people to, ah, t…

AI assessment note: “It's not finding the mispricings. It's transitioning.”

Q trading, compliance, and more. In the AI era, asset and wealth management firms moving to Ridgeline gain a decided advantage. That's why customers call it miraculous, game-changing, and an awakening. If that's not how you would describe your investment management tech, request a demo at ridgeline.ai. And now back to the show. What's an example of one of those sort of transitioning securities from one group of investors to another?

A Probably the most classic is, and, and has been around for quite a while, is an investment grade bond. Strong credit goes, becomes a junk, you know, something happens and it becomes a junk bond. You know, it's always been sort of a, a mainstay of white box to deal in, in what I call stressed credit. A, a stressed credit is, is one that, as opposed to a distressed credit, the company might heal and, and it may again be investment grade or almost investment grade, or the company might need to reorganize and then that's an app to become equity. It could go either way. So, definitionally, I think of distressed bonds as bonds that are going to become, they are equity. You know, they're, they're the security that's participating a hundred percent in, uh, the change in enter, in enterprise value of the enterprise as it goes forward. Strong investment grade bonds don't participate at all, at least for quite some time, in the changing enterprise value of, of the business. That's, that's all of the equity security. In the stressed kind of niche, both The nominal debt securities and the nominal equity securities are, are moving with changes in enterprise value. One of the things, um, as a ninth grader, I was traveling with my father. He went skiing, and then he was attending a medical convention in San Francisco, and, and I went with him. He insisted that while we were there, I should go …

AI assessment note: “Probably the most classic is... an investment grade bond. Strong credit goes, becomes a junk”

Q Yeah. As you're organizing your investment efforts, how do you think about what principles guide the types of investment activities you'd like to be involved in?

A One of the classic Andy pieces is, uh, um, coupon clippers versus, um, I think I called them security resellers. I want to be a coupon clipper. If you're owning a stress credit, you have to be willing to finance the reorg. There's a lot of discussion that's gone back and forth, you know, whether we want to be a CLO manager, The strength of a CLO is, you know, CLOs have matched funding. They have their sort of bankruptcy, remote, as it were. They, you know, they have a good liability side. Downside, you know, particularly as a new manager, you know, very restricted on the asset side. You have to make it look like every other CLO, and probably get some flexibility. As you become established. To me, a huge issue is, you know, as, as, as a CLO, you know, you can't fund, you know, you, you have to sell. You get a little bit of flexibility, but generically speaking, if the loan trades below 80, you start having issues, and you probably just, just have to sell, so in that sense, you're, you're in the wrong side, so we have to, you know, kind of figure out How you structure it, that we're not leaking, uh, there. I think RISCARB may be interesting, not at this instant, but over the next 10 years. Because there you have this specific function of corporate America, closing a evaluation gap. And the kind of classic players have been sort of hollowed out. The huge deals is a profitable nich…

AI assessment note: “I want to be a coupon clipper. If you're owning a stress credit”

Q Has that gotten harder and harder over the years as more people are looking for inefficiencies or pricing discrepancies across capital structures?

A I bought a bank three years ago. I've always sort of thought about it because as a hedge fund, we borrowed at great rates, you know, rates that almost no manufacturing business in the country could touch. Everything overnight, everything secured, everything marked to the market. The very best rates, not the very best terms. On the short end of the curve, commercial banks with FDIC insurance, they have both the best rates and the best terms. What you give up, you know, obviously you're examined and there are a lot of restrictions on what you can do. On the asset side. But, you know, short term liability, the best, the best thing to be is, is a bank. On the long end, it's probably an insurance company. And I've always thought that Warren Buffett is not a great investor. He's a, he's an above average good investor. He's, he's good on the asset side. He's the world record holder. He's the absolute best borrower in the world. Uh, and had sort of a, a unique model, and that's, that's not to in any way denigrate him, because it's both sides, and he's, you know, good on one side, and phenomenal on the other side. It's just not the sides that people think, or people talk about. So one of the things that the financial crisis did, as a hedge fund, or me, for the first time in, in my career, we actually You know, we're not looking to borrow more money, but for the first time, if we wanted …

AI assessment note: “I bought a bank three years ago. I've always sort of thought about it”

Q And so did you start with a, a short of New Century, and did that lead into the securities?

A One area I know, our book's been declining in size. Pretty consistently. Like one area where we saw opportunities was, um, things that are now the top of a capital structure at the bottom, you know, the other stuff has been paid off or disappeared. Isn't par certain? You know, something trading in the seventies that maybe, maybe at the end of the day, the principal, you know, you're only going to, you know, it's only going to be 65 that you collect in principle, but maybe it's 85 or a hundred, and this was something in the seventies that, that's a six percent yielder. Yeah, if, you know, if seven, you know, so over seven years, you're kind of, you know, you're, oh, it doesn't, doesn't really matter that much whether you end up with 65 of principal or 75 of principal. Your return's gonna be okay at the bottom end versus, you know, the par security.

AI assessment note: “One area where we saw opportunities was, um, things that are now the top”