[...] we had a loss over the course of three days that was like a ten-sigma event, meaning, you know, it should never happen based on the statistical models that underlie it. Because the model doesn’t assume that everybody else is trading the same model as you are. So that’s sort of like a meta-model factor. The model doesn’t know that there are other black boxes out there.

[...] What tends to happen in financial markets is, bad things happen when you really divorce the people who take the risk from the people who understand the risk. What happened is that that distance in the subprime market just increased and increased and increased. I mean, it started out that you had mortgage companies that would keep some of the stuff on their own books. Subprime lenders, it wasn’t a big business, it was a small business, and it was specialty lenders, and they made risky loans, and they would keep a lot of it on their books.

But then these guys were like, “You know, there are hedge fund buyers for pools that we put together,” and then the hedge fund buyers say, “You know what? We need to fund, we need to leverage this, so how can we leverage this? Oh, I have an idea, let’s create a CDO and issue paper against it to fund ourselves,” and then you get buyers of that paper. The buyers of that paper, they’re more ratings-sensitive than fundamentals-sensitive, so they’re quite divorced from the details. Then it got even more extended in the sense that vehicles were set up that had a mandate to kind of robotically buy that paper and fund themselves through issuing paper in the market.

Today, where people have made bad investment decisions, where people built houses they never should have built, there’s a misallocation of resources. The loss has already happened. The loss isn’t what happens on a balance sheet; the loss is what happens when someone cuts down a tree, makes cement, builds a 6,000-square-foot house in a place it should never be built. So the loss has already happened. The question is, how do you allocate that loss? And if you don’t allocate the loss, if you pretend it isn’t there, then this has really baleful consequences for the economy. So what we’re going through now is this process of loss allocation. It can be done swiftly, fairly, and intelligently, or it can be done slowly, and messily, and inefficiently, and also it can be not done at all. If it’s happened, the best is to deal with it swiftly and fairly. And when the shareholders get hurt really badly and the banks have to recapitalize at punitive levels, or get taken over $2 a share, I think it’s fair—the banks made bad decisions, the equity holders are the prime beneficiaries of the activities the bank is undertaking. When things go poorly, they should be the primary bearers of the loss. I think that’s good.

One of the oldest, in fact I think the oldest money market fund, the progenitor of the whole industry, a fund called the Reserve Primary Fund—Primary had meaningful exposure to Lehman paper. Something like 2 percent of that fund was in Lehman paper. When Lehman went under, people who had shares of the Reserve Primary Fund, especially institutional investors who were very much on top of what Primary’s holdings were, started to ask for redemptions from that fund. So that led to a run on that money market fund.

As a result, Primary “broke the buck.” They had to mark down their Lehman exposure. The holding, the value of one share of the Primary Reserve Fund, was no longer $1—money market funds always try to maintain the value of one share at $1. And that just caused people to—I think the technical term is “lose their shit.” People just lost their shit. You thought you had money; now you don’t have money. And you don’t know how much you have in Reserve Primary Fund, really…“We think people will recover 98 cents on the dollar, we don’t know how long it will take to get people back their money,” and suddenly all these money market funds fell under suspicion. [...]

I think at AIG and at some of these investment banks, there were people who were doing these securitizations who knew that ultimately they were going to blow up, and they didn’t care. They didn’t care because the structure of compensation at a place like AIG and certainly at the investment banks leads people to take a future-discounting model, that’s what I’d call it. There’s this year’s compensation period…and then there’s the future. And the future is very heavily discounted. And many of these risks, like the risk of an economic shock grave enough to cause these brittle subprime securitizations to break, was something you wouldn’t expect to happen every year, it would take a couple of years, and because people were paid according to mark-to-market profits in a given year, they continued to do this business even though they knew that it was storing up risks for an eventual meltdown. That’s true of AIG and that’s true of the investment banks.

Financial variables are a way of accounting for what’s going on in the real world. But the real world itself starts to react to financial variables if they’re extreme enough. And it’s funny—the financial system, all the big guns that have been wheeled out by the government and the monetary authorities, have in the last couple weeks kind of stabilized what gets called the “guts” of the financial market. There is short-term credit, there is a certain degree of lending between banks, corporates are able to get their commercial paper rolled over, for the most part. So it’s functioning—in a much reduced fashion, there are surprises and shocks every day, but it hasn’t ground to a complete halt. But now you are seeing the effect on the real economy. So what’s happening? We have the largest one-month drop in payrolls in twenty-five years. You’re starting to see real job loss. You’re starting to see actual companies going out of business, or high-profile default. [...]

Some of that impact is not a direct impact of the financial markets, but it’s the hangover from the misallocation of resources, which is the same thing that’s causing problems in the financial markets. Whereas a pure impact of the financial markets is where people look at their 401(k)s and say, “Gosh, I don’t want to spend.” That’s a pure impact of financial variables causing people’s attitudes to change, changing their risk tolerance, their propensity to consume.

One thing is when the short-term credit market ground to a halt [in October], a huge percentage of the bulk cargo ship fleet just went idle. Trade just wasn’t happening. It felt apocalyptic. The system had ground to a halt. Now you’re getting the hangover of that. Companies that had to stop operating for a month—they don’t go belly-up immediately, but now you’re seeing they’re starting to have layoffs, their suppliers are having problems, and their suppliers are having layoffs. The auto companies are a great example. They’ve been in trouble for a long time, but car sales in October were down like 40 percent year to year, and that was because people were like, “Gee, I don’t know if I’m going to lose my job, I don’t know if I can get a car loan, I don’t know what’s going to happen, I’m just not buying a car.” And now you see the impact of that. The car companies went from limping along in precarious shape to being in a position where they can be out of business if they don’t get an extraordinary infusion of resources from the government by year-end.

This is not a crisis that was caused because there was a drought, or because a meteor hit London and obliterated it, or because there was a war that destroyed productive capacity. This is because there was a misallocation of resources, because people had too much of that neurotransmitter in their brain, that then caused them to have too little of it, and now all they want are risk-free assets, and that causes the machinery of finance to really shudder to a halt.

Because financial decision making is about risk. What you do when you’re trading is apportioning risk. It’s about moving consumption from today to tomorrow, or vice versa, and about the risk associated with that, about transferring the risk associated with that. If nobody wants to take the risk, then nothing happens.

You know, it’s easy to understand how living standards would go down if somebody bombed all the factories in America. What’s kind of hard to get your head around is that those factories are still there! All that good stuff we were buying, there’s still the capacity to make it. But somehow it’s not getting done, because people’s attitudes about risk have changed. And as long as I’ve been in the financial markets, that’s still crazy and awesome and hard to get your head around.

Meanwhile, the U.S. government has extended so much aid to various other sectors of the economy, and it’s expected to have to do more, that now people are worried about U.S. credit. To buy credit protection on U.S. government debt now costs you more than to buy credit protection on Campbell’s soup! But, I mean, buying credit protection on the U.S., it’s sort of a mind-bending concept. The U.S. only issues in dollars; it only issues in its own currency. More importantly, from whom are you going to buy protection on the U.S. government’s credit? I mean, if the U.S. government defaults, what bank is going to be able to make good on that contract? Who are you going to buy that contract from, the Martians? [...]

[...] This was a year where any trade you had on that other hedge funds had on, that was a popular hedge fund trade, performed poorly because there were other hedge funds that were forced to unwind that trade. [...]