22: The Unbearable Brightness of Being a Shadow Bank

dealing with regulators. Let's put it that way. Most of it is him wheeling and dealing in stocks, shorting things, making short term directional bets, going long or short. Uh, maybe it's easier if we just play a clip. Who said this deal is going to close? Ben said? This morning, Everyone's saying, who is this a new analyst? Well, if we hired you must be a genius. Yeah, Stanford, then Wharton, Okay?

Stanford Warton Electric Sun is controlled by Casuwitz. He also owns nineteen point three of Luma Therm back Door through his stake in Southern Wind. You see that block trade last Thursday come out of Meryl. Yeah, that was Fortress cashing out their shorts before the merger, wasn't it traders A twelve fifty two when everyone was at lunch, which tells me they wanted it to be missed. You guys caught it, which is something I guess, but you're looking

at it backward. Electric Soun's offer was just deployed to temporarily prop up Luma Therm. Typical Casuits played a bail on a Loseries and animal. The block trade was casuits getting out of Southern Wind getting out of Luma therm. He wrote the story now he's out, which means you need to be out. In fact short, it'll slight to thirty two and change after word breaks. Wow, is today's episode going to be your view of Billions? No, I will spare you all my opinions of Billions. I actually

wanted to bring it up for two reasons. Um mostly because our guest today is Dan's Warren, and he's a really well known hedge fund manager, but he's never actually done the type of stuff that most people seem to think hedge funds do based on clips like the one we just heard. In fact, he made his career providing capital to thousands of companies with a few other financing options, basically going where banks fear to tread. Well, at least up until recently, banks were pretty brave about that kind

of thing. So what he does must be interesting. Yeah, and we're going to talk about how that opportunity came up. And one of the reasons it is really interesting is because we often hear regulators and lots of other people talking about non bank financial institutions or providers of credit, which sometimes go by the label shadow banks. Right, And as soon as you hear the term shadow banks, you think, oh, this is a bad thing, it's risky, there's something nefarious

about it. But actually, as we're going to hear, shadow banks can fill a gap, and some times that gap needs to be filled. I still get like a small shiver up like the small of my back, of my spine when I hear shadow banking. So I feel like I'm gonna need a little bit of convincing from Dan and from you that I that it's that it's you know, it's not a shadowy a thing as its name implies. All right, well, we'll see if we could do that. But before we do, there's one other reason I brought

up billions. And that is because Dan had his own run in with regulators just before the financial crisis, right, And I remember that because of the wonderful Bill Cohan, my friend known to known to listeners and readers as William D. Cohan is violent. He wrote a really long and detailed and beautiful story about about those travails not too long ago in Bloomberg, right, and I urge all our listeners to go read that story. But in the meantime,

I'm going to summarize very quickly. Basically, it's about how Dan's hedge fund ran into some accounting problems and then investors started pulling out money. Uh. Dan eventually closed it down. It used to have twelve billion worth of assets. Uh. Eventually, however, he was cleared of all wrongdoing by the U S securities regulator. And since then he's been busy rebuilding a different fund. And we're going to find out today what exactly he's doing. Let's get started. Dan, thank you so

much for joining us, Thanks for having me. So let's get this out of a way. First. Back in two thousand and six, two thousand seven, you were this really high flying hedge fund manager. I saw one commentator who referred to you as hedge fund perfection. Uh, and then this sec thing happened. Tell us what exactly went down? Well, Look, we had a we had a wonderful business that made seven hundred million dollars in its last year two point

seven billion dollars overall. We had six billions of equity, twelve billion of assets, three hundred good employees and another eight hundred associated employees around the world, and did business and twe five countries, financing a lot of the companies and assets and and consumers and real estate properties that otherwise couldn't have been financed. UM. So we were doing well, and I think doing good. And Uh, Unfortunately, we had

a an internal bad egg that we're uh. Some folks that I had assigned to tighten the controls of our business, UH found out. I directed the firm to turn them in. And unfortunately, UM, the process by which it was made clear that neither I nor the firm had anything to do with that person's activities too longer than otherwise should have. And so while we never had any h and an audit changed or requalified or amended or any of those things. It took so long for that to clear up that

we had to move along with the firm. Tell us what your fund actually did in order to achieve the

returns that you're known for. Uh. Sure, well, we we refer to ourselves as a global chaser of illiquidity UM, and so fundamentally we wanted to liquidity being assets that might be hard to buy or sell or trade in some way correct correct And and it doesn't necessarily mean assets that don't trade on a marketplace, because at times even assets that are you know, that have an accusive number on and trade over bloomberg um, have very little

bitter offer. And so we like to say that we'll we'll run into every house on fire and and stay in some of them. And ultimately we want to be in a position where both, as we say, both borrower and lender, or both buyer and seller have the exact same view on value, but the other guy just needs our money, as opposed to having a directional view on on asset prices. You said a second ago that you guys did both well and good, and it sounds like you definitely did well while while the going was good.

Explain to us why you also feel like you were doing good? Uh, well, to be clear, unlike some other people, I'm not gonna claim to be have have done the Lord's work. However, the world is, within finances, a big have and have not world, and there are a lot of very viable consumers, properties, companies, assets that don't actually intrinsically have materially large amount of credit risk in them that for non value reasons might not be able to access credit. And you know other over time banks have

done that. And what you find is there's a reflexive characterization that sometimes people have. Let's say, well banks aren't that smart at what they do and they can't really

do this thing, etcetera, etcetera. But if you were scaling a bank in the level that banks are scaled, and you had to create a very set set of rules for thousands of employees to follow regarding who should get credit, you're necessarily going to have to make some pretty blunt instrument rules to allow yourself not to get into problems. And so that leaves all of these kind of idiosyncratic, funkier things that otherwise should get credit, and if it were done one by one would get credit out in

the cold. So, in other words, you were lending where others were were fearing to go or by policy, etcetera, couldn't go right. So you might frequently see talk to folks at banks who would say, well, jeez, we would do this. I would do this, but our institution can't do this for some sort of rule that had very little do with the credit worthiness of the underlying asset.

You know, I want to be honest with you and tell you where I sit in the newsroom is literally physically close to my very good friend Zeke Fox, who writes beautifully about the nuances and sometimes the criminality, and or at least just that the very gray area of hedge funds lending to small businesses sometimes the rates can get very very high. I remember in Cohen's piece he mentioned um that you lent to a company that least

slot machines to casinos on Indian reservations. And just speaking honestly in the same way that we're gonna we're gonna talk about in a while, how shadow banking sometimes makes me nervous just from the mere sound of it. Also, just have to be honest and say it also makes me nervous, even though, mind you, I don't know too much about it. When I hear about hedge funds lending to things like, you know, Indian casinos and slots. Is that something that you felt comfortable with? Can you? Did?

You have to deal with people who felt less comfortable with and explain why this was a good a good thing. No, you know, at the at the end of the day, Indian reservation gaming facilities are large money makers for those reservations in that case, and to the extent that there are machines that they have where they don't want to deploy capital, but there's you know, perfectly reasonable credit to be had. You know, folks like us could do it

in that particular case. Because those slot machines were on Indian reservation property. You needed to have a gaming license for that reservation, uh, in order such that if you ever had to foreclose on the assets and operate them, you have a license to do so. And so we had to partner with a very specialized guy who happened to have such a license in order to be there and provide the capital that a bank wouldn't for them.

And so to the extent that that gaming facility thrived and helped and benefited its tribe, it was a perfectly legitimate business. Uh, you know, we don't see an issue with that. It worked out in the end, it didn't. So your old fund was all about investing in liquid assets extending credit to all sorts of different businesses and companies. You have this new fund now essentially doing a very

very similar thing. Walk us through the idea here, and if there is actually a bigger gap to be filled now, well, I think there's There's two different parts of the story. The first is, you know, where is the market today?

And the answer to that is that, in fact, post the crisis, there is, you know, a much larger addressable market for the kind of things than we that we do then there perhaps ever has been, and arguably the people who are addressing that market um are as few as they ever have been when we had our prior business. The largest competitor we had competitors we had were the internal proprietary groups of the investment banks, which are all

gone now. Which are all gone now. And that's not to say all of those people and assets are gone, because they a large number of them have migrated to a very small number of very large alternative investment firms, large in a way that we never dreamed possible at that point. Um, there was a time when ten billion dollars of assets was a big deal. Uh. And many of these folks with whom I competed with with whom I competed are now you know, thirty and twenty billion dollars.

And so what's interesting is that in some ways the same gaps are available because they can only write checks that are you know, seventy million at a shot. And so in the absence of them, the investment banks and commercial banks, the number of the very large number of smaller opportunities out there to be financed is as big as it's ever been. So if you're looking for sort of smaller opportunities, how do you actually source your loans? Because you and I have spoken about this before, and

it is an interesting on the ground sort of process. Well. Uh, to the extent that things are intermediated by brokers of various sorts, they almost by definition tend to be less appealing. And so no, it's not that it's just that they show with the lots of people because they're looking for the fastest path to that fee. Um. And so we have found that in the type of things that we do, UM, there are frequently people who have very specialized knowledge, whether

that's sourcing, uh, analysis capability, or even servicing of assets. UH. They may not have all three of those, um, and they may specialized in very idiosocratic things, but they have a special skill. And we like to find those kind of folks UH and use that to supplement our our team on our our own teams UM where we can partner with them in a very highly financially aligned way where they're putting up significant amounts of their own money UH to go after this unique these unique assets that

leverage their unique capabilities. I think you're going to find over the next few minutes, and our listeners will to that Tracy is gonna be the one asking the assistigated question because she's really good. You can do it. I'm gonna be asking. I have a basic question when when in the olden days, when the Wall Street banks were allowed to be doing some of the stuff that you're good at, do you think just looking at the system and worrying about its safety was it a good thing?

When Golden Sacks, for example, I've written a little bit about their special Situations group, which had some brilliant people un familiar with them. Yeah, I assume they in those good old days are probably your rivals, rivals and partners. Was it a good thing that they had so much capital to play with? I think one could take the view that them having capital and deploying it and itself

was not particularly problematic. UM. Where I think some people might have had issues were situations where it was not necessarily clear where they were acting as an intermediary and where they were acting as a principle. And in everything I've ever done, you know, there's no question we have only one thing to do, which is deployed capital and

make a disproportionate return for unit of UM. So I would say, as an example, UM, there was a situation with a European bank in the early two thousands that had some assets that were a problem, and we went and met with them, and they were represented by their trusted advisors of golden Sacks, and those guys were in the room when we got to meet with the bank, and it quickly became clear that three of the four people in the room were in fact our competitors, not

their investment bankers. UM. And so, needless to say, we didn't get a chance to do much with that bank, and so I think there was perhaps it was overblown, but there was a perception that there was a mix of principle and agent there that was not always clear. And in so far as that perception it was out there,

it might have caused some issues. But you are talking about an incredibly well run business and firm, one that made it through the crisis much better than virtually everyone else, that had a huge number of really smart people, and I think, unlike virtually any other competitor that they had um created a culture where there was information flow, information sharing that was really unique. Whatever you may say about their goals, they were incredibly effective at pursuing them, all right.

But we did have this confusion about principle versus agent, so whether they're doing this as a sort of financial intermediary versus trading for their own accounts profiting it from it for themselves. That really came to the forefront during the financial crisis and afterwards we saw regulators pile in all these new rules basically restricting and or making it more expensive for banks to undertake some of this activity.

And simultaneously we saw guys like you and those asset managers you mentioned, or alternative managers you mentioned earlier start to get big as they picked business off of the banks. And then of course we heard from regulators that actually they were worried about the growth of the shadow banking sectary should we be worried well with any sorts of

idiosocratic finance. Over time, there are clearly cycles, and I would argue that one of the biggest risks in any of these activities is the moral hazard that they bring. And part of their way we structured our business with these joint ventures allowed us to have an extremely variable

cost of effective infrastructure. So there was nobody out there who said, well, I need to do things in order to get paid, right, And so we took away that moral hazard in our business and it and it importantly allowed us to find not only find good things to do, but even more importantly avoid things that were not there that we're not good to do. Can you give me an example of one of those types of things to avoid? Uh? Well,

So as an example, um um. In the last energy cycle, when Enron and Merinth and Aquila and all those firms that many of whose names we don't remember anymore, we're blowing up uh, and oil and gas prices were low this is kind of a tish uh oh. Three, We ended up buying the onshore natural gas landing business of Mirrant at about sixty cents on the dollar and pretty much and so and again we're not macro people, all right,

so we don't know about oil and gas prices. What we knew was that in the high one dollars we get our money back, in the low mid twos, we'd make a nice return, and beyond that it would be really good. And it turned out to be four bucks

and so it was really good. Um. But more importantly, at that point, nobody in town in Houston was making on on balance sheet loans the energy companies, and so based on that knowledge, we stepped in and actually worked with a couple of local folks down there to create what then became the most significant on on on shore

natural gas lender out of Houston. Once banks started to reaccustom themselves assuming that risk we couldn't really compete um or that those opportunit needs couldn't compete for our capital. Uh And so we ended up just doing less and less. And so now when prices are back where they are, we're now the fact third time around down in Houston and Dallas and other places looking at that stuff all

over again. Um. You know, when I think about shadow banking, I think about because I'm a total nerd, I think about the repo market. Before two thousand eight, we've been talking about shadow banking in the context of non banks providing credit intermediation, but the definitions can get really muddled. Are there specific types of shadow banks that you would be more concerned about, for instance, say a liquid fund buying up the kind of illiquid assets that you specialize in. Well,

I think yeah. First of all, I don't know that there's a dictionary definition of shadow banking, other than if there is, I'm sure it's a poor one. Yeah. What I would say is, if you want to think about what risks are significant now in the wake of the regular aation that happened, I think it's less about the market participants, less about Goldman Sachs participating the markets as principal, etcetera,

and much more about the provision of liquidity. And so what has happened with the new regulations is that there's tremendous disincentive for anybody to provide liquidity of any sort. And so we have not yet remotely tested what it's going to feel like when people who have for many years been used to being able to get out of things um suddenly don't have a bid. And is that

basil regulations or Dodd Frank. I think that's a combination of vasil, Dodd Frank, and importantly vulcan, because when insofar as you preclude what otherwise would be marketing making activities and over the counter products by investment banks, you preclude them from quote unquote proprietary trading um when you're trading

for their own accounts. Correct, when you're making markets and over the counter products, you can't afford to be a willing buyer or seller at a price because your own customers will take advantage of you and you will quickly get you know, busted and and and put out of business. And so you have to have some directional views as

to what's going on. And so to preclude them from quote unquote proprietary trading in the way that has been done has basically sucked the liquidity out of virtually every OTC trading market, and the effects of that have yet to be felt in a material way because since July thirteen, when kind of d dragging stepped in with his kind

of job owning about rates being low forever. Uh. In the in the periodic times when that notion has been tested, uh, and then kind of we've seen recovery driven by central bankers. Since then, we've yet to really feel how utterly devoid of liquidity the markets are. Do you think there's a chance that what Paul Walker would call, uh, casino banking.

You know that if there's anythings that by preventing the Walsh firms from trading on their own account, Yeah, casino banking, you would call that that that is nothing but a plus for for society, that that's going to protect tax barers from having to bail out banks again, and that the downside, the downside will be minimal as it has been at least so far, nothing horrible has happened because um liquidity isn't as lush as it once once. What's

do and that's optimistic? Is there any chance things will play out that way? Or are you worried that something

scary as can happen? Uh? I'm you know. Buffett says, in the long term, markets are are weighing machines, not voting machines, and so credit markets haven't been allowed to find their level yet UM, and they've been trying episodically for the last couple of years and so UM as you saw a little bit in the last little shock we had in December of January, what happened then there were a series of funds that were investing in corporate OTC product that had no liquidity in their assets, but

had lots of liquidity on their lives ability side, right. They were mutual funds, structured funds, exchange traded funds, that sort of thing, well, specifically mutual funds that were open ended with daily liquidity that were invested in things that didn't have a bid and they had to shut down and it was very ugly. And that was only a little bit of a beginning. That was things like Third Avenue, Third Avenue. Yes, yeah, that was an example. And so

there are a lot of open ended mutual funds. There are a lot of you know, monthly or quarterly liquidity UM alternative investment funds that are investing in assets that in any type of a shock won't have a bid or won't have a material bid. And so you'll see the beginnings of that when that happens, not unlike what happened with BNP in July of oh seven, immediately preceding the crisis, where they were simply no bid, no way to mark. They had to just freeze to see where

things leveled out. Remind me, they had a bunch of was it structured finance or of some sort? I believe it was residential mortgage related to I think it was cash mortgage related securities, and then basically word got round that they were trying to offload them but couldn't. Is

that right? Well, by that point there was it was very unclear what the bid was for any of that stuff because people who were financing it suddenly had to pull back all at the same time, a lot of people who owned it had to go the same way. What happens is suddenly there are these gap downs in pricing when everybody's going the same way and something uh.

And so you don't see that frequently, and you know, it's been a several years, so there's not a lot of guys who were maybe not at the trigger, if you will, at that point, who might now be who didn't kind of feel what that felt like when it was there, And if you've been through several cycles. You know that those are very painful times, and at no point has there been as little liquidity as there has been now for the last you know, twenty plush years.

You know, on the one hand, what we're talking about here is regulators essentially overstepping their bounds and doing things that in the long run you worry aren't gonna be great for the markets. And I have to say, it's it's hard not to remember that it's also regulators that in a way essentially helps shut down DB's worn. Do

you feel like you learned anything? Do you do you feel like you came out of that whole episode more cynical, more skeptical about the role of regulators in the United States markets, Well, I think, uh, I think there's nothing wrong with good regulators and good regulation, and I think we are happy to have sufficient or more than sufficient

numbers of both. But simply making more rules and making throwing more bodies at the problem as opposed to taking the rules and buys you have and making them better is probably not the optimal way to go. And perhaps some of that occurred. You know, immediately after the crisis, we had a very specific situation um that was unfortunate, and you know it it led to uh, you know, lots of good people losing lots of great opportunity UM that shouldn't have had to do so in a in

a wonderful business having to go away. But no, I think I was skeptical and cynical to begin with, and I still am. All right. Uh Dan's weren is CEO of Arena Investors. Thank you so much for joining us today. You're welcome. Okay, Max, what do you think about that? You know, I always find it so interesting when like really smart, powerful hedge fund managers want to describe themselves

as doing well and good. Clearly he aims to um bounce back from what happened a few years ago and provide liquidity where he feels like it doesn't exist from other places. So, you know, I've been covering shadow banking for a long time. I've also been covering the liquidity question that we just discussed, and I can really see

it from both sides. I can see, on the one hand, how regulators want to de risk bank balance sheets, but I can also see how regulators in the aftermath of the financial crisis maybe rushed to do a few things and potentially unknowingly shifted risk into another sector. And now that might be a good thing, right because guy's legs were maybe know what they're doing. They have deep pockets, they can handle that sort of illiquid credit asset. But there are other types of funds, like the mutual funds

that Dan mentioned that I do worry about. It's lucky that we're just journalists and not regulators, because I don't I don't know how I would deal with this. I agree with you. I feel sympathetic to the idea that if you overregulate the banks, this activity will move into corners that um, you know, we'll be able to handle it well. And on the other hand, I feel worried about the big banks getting involved in risky things that belong in um entities that aren't backed by government guarantees.

So I'm glad we're just writers. All right, Let's go celebrate the fact that we're not regulators. I'm Tracy Alloway, executive editor at Bloomberg Markets. You can catch me on Twitter at Tracy Alloway. I'm Maxi Avilison of Bloomberg News on Twitter at Max Avilson. Thanks for listening, O