فصل 6 بخش 9

CHAPTER 6.9

KYLE BASS: THE MASTER OF RISK

Founder, Hayman Capital Management

As a competitive diver, Kyle Bass understands the basic law of physics. He knows well that what goes up must come down. That’s why in 2005 he began to ask questions about the booming US housing market—questions no one else thought to ask, like, “What happens if housing prices don’t keep going up [forever]?” Those questions led him to make one of the biggest bets in the world on the impending housing crash of 2008 and the economic meltdown that followed. That trade would earn him his first billion. Bass would go on to make a 600% return on his money in just 18 months and secure his place as one of the brightest, most thoughtful hedge fund managers of his time.

Kyle does very few interviews, but it turned out my work had inspired him while he was still in college, so I had the privilege of flying out to Texas to sit down with him in his skyscraper building overlooking the great city of Dallas. Bass is one of the few financial powerhouses who views his distance from New York City as a competitive advantage. “We don’t get bogged down by the noise,” he says.

Bass is humble and approachable. When I asked him about the questioning that led him to bet against the housing market, he replied, “Tony, this isn’t rocket science, this is just some idiot from Dallas asking questions.” Bass lives with his wife and family and serves on the board of trustees of the University of Texas Investment Management Co., helping to oversee one of the largest public endowments in the country, with over $26 billion in assets. You’ve already learned about Bass and his nickels: he’s the guy who taught his children the lesson of asymmetric risk/reward by buying up $2 million worth of nickels and earning a 25% return on Day One of his investment. In fact, Bass says he’d put his entire net worth in nickels if he could find that many coins on the market to buy!

Nickels aside, Bass’s relentless focus on asymmetric risk/reward has led to two of the biggest return bets of the century: in both the housing market and the European debt crisis that began in 2008. And he’s got a third bet under way that he says is even bigger. What follows is an excerpt of our two-and-a-half-hour conversation in his downtown office.

TR:

Tell me a little about yourself.

KB:

I was a springboard and platform diver, which people think is intensely physical. But it’s 90% mental. It’s basically you versus yourself. For me, it was very rewarding. It taught me how to be disciplined and how to learn from my failures. It’s really how you deal with failure that defines you as a person. I have a loving mother and a loving father, but they never saved any money. I swore I would never be like that. My parents both smoked; I swore I would never smoke. For me, I’ve always been driven harder by the negative things in my life versus the positive—there are many congruencies in my life and your teachings.

TR:

Absolutely. When I look at the one common denominator that makes somebody succeed, beyond education or talent, it’s hunger.

KB:

Hunger and pain.

TR:

The hunger comes from the pain. You don’t get really hungry when it’s been easy.

KB:

That’s right.

TR:

So your hunger drove you to start your own fund. It was 2006, right?

KB:

Correct.

TR:

The thing that’s so amazing to me is the speed at which you started producing returns.

KB:

That was lucky.

TR:

You had 20% the first year and, like, 216% the next year, right?

KB:

That’s right. It was just fortuitous that early on I saw what was going on in the mortgage market. I believe in the saying “Luck is where preparation meets opportunity.” I think I might have read that in one of your books when I was in college. Well, I was prepared. I like to think that I was lucky and in the right place at the right time because I had all my resources dedicated to that in the moment.

TR:

A lot of people knew about [the housing] problem and didn’t act on it. What was different about you? What really made you succeed in that area?

KB:

If you remember back then, money was basically “free.” In 2005 and 2006, you could get a LIBOR-plus-250 term loan [meaning, a very cheap loan], and you and I could go buy any company we wanted with a little bit of equity and a ton of debt. I was on the phone with my friend and colleague Alan Fournier at the time, and we were trying to figure out how not to lose betting against housing. And the pundits kept saying, “Housing is a product of job growth and income growth,” so as long as you had income growth and job growth, home prices would keep going up. That, of course, was flawed thinking.

TR:

Yes, as we all found out.

KB:

I had a meeting at the Federal Reserve in September of 2006, and they said, “Look, Kyle, you’re new to this. You have to realize that income growth drives housing.” And I said, “But wait, housing has moved in perfect tandem with median income for fifty years. But in the last four years, housing has gone up 8% a year, and incomes have moved only 1.5%, so we’re five or six standard deviations24 from the mean.” To bring those relationships back in line again, incomes would have to go up almost 35%, or housing had to drop 30%. So I called around all the desks on Wall Street, and I said, “I want to see your model. Show me what happens if home prices go up only four percent a year, two percent a year, or zero percent.” There wasn’t one Wall Street firm, not one, in June of 2006 that had a model that contemplated housing being flat.

TR:

Are you serious?

KB:

Not one.

TR:

These guys just drank their own Kool-Aid.

KB:

So in November of 2006, I asked UBS to put forth a model that had flat home prices. And their model said that losses to the mortgage pool would be 9%. [A mortgage pool is a group of mortgages with similar maturities and interest rates that were lumped together into a single package, or security, called a mortgage-backed security. These securities were assigned a high credit rating and then sold to investors—for an expected return. Assuming house prices continued to go up, the pool would deliver high returns.] But if home prices didn’t go up, if they just sat still, these things were going to lose 9%. I called Alan Fournier of Pennant Capital Management [he formerly worked for David Tepper’s Appaloosa Management], and I said, “This is it.” And when I formed the general partner of my subprime funds, I named it AF GP—after Alan Fournier, because of the phone call we had. Because for me, that phone call flipped the switch.

TR:

Wow. And can you tell me what the risk-reward ratio of that bet for you and Alan was?

KB:

Basically, I could bet against housing and only pay 3% a year. If I bet a dollar, and home prices went up, all I could lose was three cents!

TR:

Amazing. So the risk—the price to bet against housing—was totally out of whack.

KB:

Yep. It only cost me 3%.

TR:

Because everyone thought the market would go up forever. And the upside?

KB:

If housing stayed flat or went down, I’d make the whole dollar.

TR:

So 3% downside if you were wrong, 100% upside if you were right.

KB:

Yes. And it’s a good thing I didn’t listen to every mortgage expert I met with. They all said, “Kyle, you have no idea what you’re talking about. This isn’t your market. This can’t happen.” I said, “Okay. Well, that’s not a good enough reason for me, because I’ve done a lot of work on this, and I may not understand everything you understand.” But I could see the forest for the trees. And the people that live in that market, all they could see were the trees.

TR:

You understood the core of risk/reward.

KB:

I also heard this a lot: “Well, that can’t happen because the whole financial system would crash.” That still wasn’t good enough for me either. That bias—the positive bias that we all have is built in; it’s innate in human nature. You wouldn’t get out of bed if you weren’t positive about your life, right? It’s a bias we have as humans to be optimistic.

TR:

It works for us everywhere but in the financial world.

KB:

That’s exactly right.

TR:

What’s even more amazing is that after calling the housing bust, you were also right about Europe and Greece. How did you do that? Again, I’m trying to understand the psychology of how you think.

KB:

In mid-2008, post–Bear Stearns, right before Lehman went bankrupt, we sat in here with my team and said, “Okay, what’s going on throughout this crisis is that the risk in the world—that used to be on private balance sheets—is moving to the public balance sheets. So let’s get a white board and let’s reconstruct the public [government] balance sheets of the nations. Let’s look at Europe, let’s look at Japan, let’s look at the United States. Let’s look everywhere there’s a lot of debt, and let’s try to understand.” So I thought, “If I’m Ben Bernanke [head of the Fed at the time] or Jean-Claude Trichet, president of the European Central Bank, and I want to get my arms around this problem, what do I do? How do I do it? Well, here’s what I’d do: I’d look at my own balance-sheet debts as a country. And then I need to know how big my banking system is in relation to two things: my GDP [gross domestic product], and to my government revenue.” TR:

Makes sense.

KB:

So we basically looked at a bunch of different countries and asked, “How big is the banking system? How many loans are out there?” Then we tried to figure out how many of them were going to go bad, and then back-solved for how bad it was going to be for us as a country. So I told my team to go call some firms and find out how big those countries’ banking systems were. Guess how many firms had a handle on that mid-2008?

TR:

How many?

KB:

Zero. Not one. And we called everybody.

TR:

Wow!

KB:

So I dug into the white papers on sovereign [country] debt and read them all. They are mostly focused on emerging economies, because historically, it was emerging nations that restructured their sovereign balance sheets.

TR:

Developed nations only restructured postwar.

KB:

Right. Two countries spend a fortune to go to war; they run up debts, and to the victor go the spoils and to the loser went defeat, every time. That’s how the world works. In this case, it was the largest accumulation of debt in peacetime in world history.

TR:

Amazing.

KB:

So how big is the banking system? We went out there and gathered the data and used two denominators: GDP and central government tax revenue. And this was a huge learning process because we had never done it before.

TR:

It sounds like nobody else had.

KB:

This isn’t rocket science, Tony. This is some idiot in Dallas saying, “How do I get my arms around the problem?” And so we did the work, and I came up with charts, and I said, “Rank them worst to best.” Who is the single worst entry on that sheet?

TR:

Iceland?

KB:

Right, Iceland went first. Who was next? It wasn’t rocket science.

TR:

Greece?!

[Kyle nods yes.]

TR:

Wow.

KB:

So we did all this work, and I looked at the analysis, and I said, “This can’t be right.” I was being hyperbolic to my team. I was saying, “If this is right, you know what’s going to happen next.” TR:

Correct.

KB:

So then I asked, “Where are the insurance contracts trading on Ireland and Greece?” and my team said, “Greece is eleven basis points.” Eleven basis points! That’s 11/100ths of 1%. And I said, “Well, we need to go buy a billion of that one.” TR:

Wow, that’s incredible.

KB:

Mind you, this is third-quarter 2008.

TR:

The writing was on the wall at that stage.

KB:

I called Professor Kenneth Rogoff at Harvard University, who didn’t know me from Adam. And I said, “I’ve spent several months constructing a world balance sheet and trying to understand this.” I said, “The results of our construct, they’re too negative for me.” I literally said, “I think I must be misinterpreting these. Could I come sit down and share with you the results of my work?” and he said, “By all means.” TR:

That’s great.

KB:

So I spent two and a half hours with him in February of 2009. And I’ll never forget: he got to the summary page, with a chart of all the data, and he sat back in his chair, put his glasses up, and said, “Kyle, I can hardly believe it’s this bad.” And I’m immediately thinking, “Oh shit! All of my fears are being confirmed by the father of sovereign balance sheet analysis.” So if he wasn’t thinking about it, do you think Bernanke and Trichet were? No one was thinking about this; there was no cohesive plan.

TR:

None?

KB:

He was dealing with curveballs as they were being thrown.

TR:

That’s just unbelievable. So I have to ask about Japan, because I know that’s what you’re focused on now.

KB:

Right now, the biggest opportunity in the world is in Japan, and it’s way better than subprime was. The timing is less certain, but the payoff is multiples of what the subprime market was. I believe the world’s stress point is Japan. And it’s [about] the cheapest it’s ever been right now—meaning, [to buy] a kind of insurance policy.

TR:

Yes, and what is it costing you?

KB:

Well, the two things to take into account for the options pricing model are (1) the risk-free rate and the (2) volatility of the underlying asset. So imagine if the turkey used this theory. If he were gauging his risk [of being killed] based upon the historical volatility of his life, it would be zero risk.

TR:

Right.

KB:

Until Thanksgiving Day.

TR:

Until it’s too late.

KB:

When you think about Japan, there’s been ten years of suppressed prices and subdued volatility. The volatility is mid-single digits. It’s as low as any asset class in the world. The risk-free rate is one-tenth of 1%. So when you ask the price on an option, the formula basically tells you it should be free.

TR:

Right.

KB:

So if the Japanese bonds move up 150 basis points to 200 basis points [1.5% to 2%], it’s over. The whole system detonates, in my opinion.

TR:

Wow.

KB:

But my theory is, I have always said to our investors, “If it moves two hundred basis points, it’s going to move fifteen hundred.” TR:

Right.

KB:

It’s either going to sit still and do nothing, or it’s going to blow apart.

TR:

This all plays into your idea of “tail risk.” Tell me what tail risk is; not many investors focus on it.

KB:

If you look at what I’m doing, I’m spending three or four basis points a year on Japan. That’s four-hundredths of 1%, okay? If I’m right about the binary nature of the potential outcome of the situation there, these bonds are going to trade at 20% yields or higher. So I’m paying four-tenths of 1% for an option that could be worth 2,000%! Tony, there has never been a more missed-price option that’s existed in the world’s history. Now, that’s my opinion. I could be wrong. So far I am, by the way.

TR:

You’re wrong on timing.

KB:

I’ll tell you what. I can be wrong for ten years, and if I’m right ten years from now, it was still 100% odds on that to be there before it happened. And people say to me, “How you can bet on that, because it’s never happened before?” And I say, “Well, how can you be a prudent fiduciary if I give you the scenario I just laid out, and not do this? Forget whether you think I’m right or wrong. When I show you the cost, how do you not do that? If your home is in an area that is prone to fire, and 200 years ago there was a big fire that wiped everything out, how do you not pay for home owner’s insurance?” TR:

Got it, that’s awesome. So let me ask you this: Do you consider yourself to be a significant risk taker?

KB:

No.

TR:

I didn’t think so; that’s why I asked. Why do you say you’re not a risk taker?

KB:

Let me rephrase that. Significant risk taker means we can lose all of our money. I never set myself up for the knockout punch.

TR:

Tell me this: If you could not pass on any of your money to your children, but you can only pass on a portfolio and a set of rules, what would that look like for your kids?

KB:

I’d give them a couple hundred million dollars’ worth of nickels because then they wouldn’t have to worry about anything.

TR:

They’re done, their investment portfolio is done. Oh my God, that’s wild. What gives you the most joy in life?

KB:

I have my kids.

TR:

That’s awesome!

KB:

A hundred percent.

TR:

Kyle, thank you. I so enjoyed this, and I learned a lot!