PETER KRAUS: John came to my office I think, day four, and said, we've got to go to the Fed, because Paulson was coming up from Washington. And basically, Paulson told us that if we're going to save Lehman, it's going to have to be you.
People don't want to lose their jobs. Financial advisors don't want to lose their clients. So they don't actually select managers that are in the nadir of their performance, even though they have a good performance record. They select managers that are at the top of their performance.
So clients are always invested in crowded factors. So if you look at the big fund companies in the world-- Capital, Fidelity, Wellington-- you will see T Rowe Price. You will see they have anywhere from two to five $50 billion or bigger funds. That is 100% of their profitability. All the rest are options. So everybody is striving to get this big scalable thing, because that's what the profits are. Nothing could be less valuable to the investor. Nothing could be less valuable.
GRANT WILLIAMS: I'm the offices of Aperture Investors to talk to Peter Kraus. Peter has had a phenomenal career in finance, and this new project of his is fascinating to me. It's right in the middle of active and passive, and he's doing some extraordinarily disrupting things. So let's sit down and talk with Peter and see what he has to say.
Peter, welcome to Real Vision. Thanks for having us here.
PETER KRAUS: Well, thanks for coming.
GRANT WILLIAMS: In this beautiful office with some amazing artwork around us. But I want to start and go back to the very beginning, because as anyone watching this knows, I love to go through people's careers and find interesting places to jump out and talk about stuff. So if you wouldn't mind, take us all the way back, as far as you can go.
PETER KRAUS: Sure. Well, I started in New York City in 1974. I was working for what was then known as Peat Marwick Mitchell. It was an accounting firm. I didn't have an accounting background. I was hired into a program that they called the program for liberal arts. It was called the Place Program. They had very innovative ideas amongst the all the eight firms. They hired people without accounting degrees, and they gave them the opportunity go to NYU at night. Within 15 months, I got an MBA at NYU and my CPA. And I worked with Peat Marwick. And it was quite interesting.
And half the time I spent in the consulting part of the business, and half the time I spent in the audit part of the business. And I liked it.
GRANT WILLIAMS: So what was it-- you didn't have an accounting degree. What took you into that world in the first place?
PETER KRAUS: I liked finance. And in 1974, Wall Street was not what it was today. It was a very different place. I mean, if you were talking about the bond trading business, that meant actually cutting out the coupons on the bonds, and taking it down to the trust department to get your cash payment. It wasn't exactly the same kind of bond world that you have today. And equities were certainly traded, but at $0.05 in commissions-- commissions I think, were deregulated in 1973.
It was a very different world. Banks were interesting, but not very exciting. And so the investment banking world existed. I didn't really know it that much. And accounting was an interesting profession. You know people, don't necessarily think about accounting that way today, but in the '60s, accounting grew dramatically because the SEC actually required all public firms to actually have audits. And that meant that the business grew dramatically in that time period. So you were at sort of the tail end of a big growth spurt in accounting. And that's why it looked like an interesting profession.
GRANT WILLIAMS: Yeah. So from the accounting world, there must come a point where you figured there was something bigger and broader.
PETER KRAUS: Well, no. I loved Peat Marwick. I thought accounting was great. I was interested in tax. I was interested in auditing. I was interested in consulting. And they had all those different capabilities. I like numbers. I like clients. I like people. There were a lot of good things.
But the business began to slow down and inflation actually, began to eat away at the cost structure. And I came up with a new idea at Peat Marwick, or a business to build. And I went to my boss and I said, either I'm going to build this new business or I'm going to leave, because I don't really want to keep doing what I'm doing. And he said, well, OK, go build a new business. And you know, we tried to do that, and my first client was Goldman Sachs. And little did I know, Goldman Sachs decided to offer me a job.
GRANT WILLIAMS: Doing that, did they see the business like it? Or it was just--
PETER KRAUS: No. Goldman had announced to the world that it was going to build a mortgage business.
GRANT WILLIAMS: Oh yeah.
PETER KRAUS: This is 1985. And they were behind Credit Suisse and Salomon Brothers. And they wanted to catch up. And so their idea was they were going to start this mortgage business and they took two partners, Joel Kirschbaum was one and Gene Mercy was the other. And they co-headed this mortgage securities business, and they went and hire 100 people. And I think I was employee number two or three.
But I was a partner at Peat Marwick, and they were going to hire me as a vice president and that was a little challenging. Not so much for me, but my wife was not particularly happy about that. And I remember my father said to me, he said, wow, you're going to go down to Goldman Sachs? You're a big fish in a small pond. There you'll be a small fish in a big pond, which I didn't think was very motivational.
GRANT WILLIAMS: Yeah.
PETER KRAUS: My mother said to me something that stuck with me my entire career. She said, don't do something you would regret. And I would regret not taking up the job. So I took the job.
GRANT WILLIAMS: It's funny, the first big career move I made when I went from Robert Fleming, which is a small independent investment merchant bank in the UK to UBS, and my first six, eight months there, I felt like that. I was out of my depth completely and thinking, what the hell did I do here? You just feel so small, and it ended up being probably the best decision I ever made, because it was a new business, you didn't have that--
PETER KRAUS: It was a new business, I had that opportunity. But the one thing about Goldman that I thought was really unique-- Peat Marwick was a governance structure where you sort of had to be a jack of all trades. You had to be a technician, you had to be a client person, you had to be a manager, you had to operate your business, you had to go get new clients. You know, nobody is good at all those things.
And what was really interesting about Goldman Sachs they had sort of an ability where if you were a technically strong person or you were a very good client person or you were a good trader, everybody could actually execute on their skill set and just on their skill set. And yet the compensation levels were consistent. So you didn't have people trying to be managers because you got paid more. You know, you could be a really good merger guy and get paid as well as the really good investment banking guy as well as the really good trader.
GRANT WILLIAMS: Yeah.
PETER KRAUS: That created a really interesting dynamic, I thought, to attract talent and to allow people to specialize and be much more effective in their roles. So that was the thing that actually I thought was special about the firm, and made me feel like, OK, it's worth the risk.
GRANT WILLIAMS: So where did you go-- what was your chosen skill that you decide to focus on at Goldman?
PETER KRAUS: Basically, I'm a salesman at the end of the day. I'm really good with people, and I'm willing to ask for the business, and I'm willing to put myself out there. I'd say that over my time there, I was able to build both technical skills, and trading skills, and investing skills. And today, I'm probably more multi-dimensional than I was when I first started. But that was the core skill at the time.
GRANT WILLIAMS: So walk us through building that business, because Salomon was a behemoth back then. I mean, anyone that wanted to challenge Goldman, probably the only people that could have done it with any reasonable expectation of success. What was it like to see Goliath there and coming into day, how do we knock this guy down?
PETER KRAUS: Well, I think ignorance is bliss a little bit. So you know, I'm not sure we necessarily appreciated the size, and skill, and sophistication. But it was also a great time of innovation. I think of money sort of like water. It finds the lowest level. It always moves to that level. Cash flows are similar. And so if you think of finance as just a series of cash flows, well, how do you structure the cash flows, and how do you think about the cash flows? How to optimize the cash flows?
Well, that really hadn't been done very much until the mid '80s. And collateralized mortgage obligations and interest rate swaps and things like that-- they were all new. And one of the reasons why I ended up at Goldman Sachs was the accounting profession was reacting readily or actually, quite frequently to changes in finance. So for example, in the early '80s, there were no interest rate swaps. In the early '80s, you started to actually create these collateralized mortgage obligations. How did you account for these things? What were the accounting methodologies that you used?
And so actually, it was quite innovative. And so even though we were starting something new, we were in a space where we thought innovation would actually work. And in fact, we did. We innovated a lot of things. And so did the whole Street, but Goldman was part of that. And that's really how we competed.
GRANT WILLIAMS: It's funny. When you think about mortgage bonds today, they seem like such a plain vanilla asset. But back when Lou Ranieri and these guys created that market out of thin air, essentially.
PETER KRAUS: Out of thin air. You know, you traded a Ginnie Mae security and a whole loan, meaning an actual loan, and the bid ask spread was sometimes a point or even more. We didn't have securities that we have today. Freddie Mac and Fannie Mae existed, and they were-- I don't think Fannie Mae and Freddie Mac securities until the early '80s. And that government securities market exploded over time and got enormously large.
But even the bond market, even the corporate bond market, if you wanted to actually underwrite a bond for Procter and Gamble, you literally had to file a document with the SEC, it had to go effective I mean, you don't do those things today. We buy the bonds right off the shelf and trade them immediately. And sometimes, the asset managers are actually driving the price as opposed to the Street. So the world's changed dramatically from that time period.
GRANT WILLIAMS: Well, I mean, the other thing to obviously remember when we think back about that time is the direction of interest rates. You'd come in, and you'd start this business just after they peaked. Was there any sense back then that--
PETER KRAUS: The poorest investment decision ever made in my life was not buying in 1983, 30 year government bonds at 13%.
GRANT WILLIAMS: You and everybody else.
PETER KRAUS: That was a very bad decision that I made. Now I didn't have a lot of money, but it would have still been a good investment.
GRANT WILLIAMS: No kidding. But there wasn't any sense of that? Because we look at it now, we look at that chart of 10 year of US government bonds, and we see it's just a one way ticket for 35 years. And I'm always interested in what it felt like at the time, because no one could have known, but was there a sense that this was a secular shift once we got through the early '80s period when they peaked and started heading that way?
PETER KRAUS: Not really. I mean, there are some prescient investors, some very good investors in that time period that did buy that 30 year bond, and held it, and made enormous gains as a result of it-- at a risk free rate, I wold add. But most of the market looked at the shorter rates which were 16% or 17% and saying, well, I get paid 16% or 17% or 18 months, why wouldn't I do that. And the yield curve is significantly inverted at the time. Volcker came in and basically put in place tough fiscal or tough monetary policies in order to actually change that. He was successful. But the world didn't see that bull market in bonds until it was well established.
GRANT WILLIAMS: So that's what always fascinates me, because we look at it now, and it seems like the most obvious trade of the last 40, 50 years. So I'm interested at the time, how what did it take to convince people that this is a train we can get on. Even though we've gone from high teens to low teens, we're not fearing the bounce back to 20. This ship is going all the way to single digits.
PETER KRAUS: I think the interesting question today is, why aren't people fearing inflation?
GRANT WILLIAMS: Yeah.
PETER KRAUS: You know, why do people think that interest rates are going to stay low for the next 20 years? I mean, people are willing to buy the 10 year bond at almost 2% today. Why are they willing to do that? You just have the inverse.
GRANT WILLIAMS: Exactly. That's why I find it so fascinating. Because it is literally the opposite of where we are today. And yes, the mindset is the same. But back in the '80s, we had no experience, certainly not in recent memory, of bonds going down to these kind of levels. And now, there are people around like yourself that have experienced that. So I'm always surprised it's not an easier mindset change for people than it was going the other way. Because I agree with you-- people now should be looking at this thing and saying, why are we not fearing inflation?
PETER KRAUS: Well, I mean, it's the pain trade. So I'm going to be short the 10 year, Pay the carry, because I think the next five to seven years, that 10 year is going to go to 6%. I should do that if I believe that. But I have to make decisions today with the capital I have today. And it's hard to actually pay that carry over a long period of time, waiting for the bond to actually deteriorate in value.
So people don't do it. And only a very few do it. And when you get on the other side of that, there will be people who actually put that trade on for sure, and there will be the prescient ones. But the large scale of the money never goes in that direction. And if it did, of course, the rates would change.
GRANT WILLIAMS: Yes. At some point, they will. But for now-- I'm going to get back to your career in a second, but I want to stick with this for a moment, if we can, and just get your thoughts on the very recent activity in the bond markets. We've had head fakes in both directions in the last sort of six to 12 months. What do you make of this most recent dive in two years for example, which looked for all the world like they're headed to zero in a hurry now.
PETER KRAUS: So it's funny you raised this, because I was thinking about this morning. I actually think we have an inverted yield curve. We're used to looking at the inversion between the two year and the 10 year, because we're used to that 1983 time period. That was the significant version. And then in yield curves that have existed between '83 and now, we looked at 2 to 10 inversions, and thought they were good descriptors of recessions. Not 100% of the time, but 65%, 70% of the time, the yield curve is a pretty good predictor.
But interest rates are very low today and inflation is very benign today. Yet the real returns, the actual real rates of interest-- so if you take inflation out of the nominal rate, they're very low. And the three month rate is actually 2.13%. That three month rate is inverted relative to the 10 year. Given the fact that inflation is so low, and the 10 year bond is reacting to that low level of inflation, the inversion between the three months and the 10 year may be more of a more accurate predictor.
And it has been a very good predictor over time, as was the two to 10 inversion. Usually, they happen concurrently. Now they're not happening concurrently. But that's because people are really anticipating if the Fed is going to move. And so that anticipatory action is forcing down the two year, people are bidding down that, expecting for rates to actually move. The three month can't move because it's being regulated by the, Fed the Fed actually hasn't moved. So that is the level of inversion that I think is most predictive today, and that is saying that we're going to have an earnings slowdown, potentially a recession. And I think that's very clear. I don't think that's debatable.
GRANT WILLIAMS: Yeah. It's interesting, because we're in a profits recession now officially. This is the second quarter we've had negative profit growth in the S&P 500. And yet people just really struggle at this point-- and they've been on the other side of this trade for so long, they struggle to believe that a recession might be coming, I need to do something about that, because they've had this tailwind. And they've had the Fed helping them every possible juncture. Do you think things might change?
PETER KRAUS: No-- I think they will change, but I think that the equity market is still acting as if the Fed can bail them out. And I don't think it's dawning on equity investors if the Fed is helping them out, it is because of two things. There is no inflation-- they'll think that is good. But there are also no earnings.
GRANT WILLIAMS: Yeah.
PETER KRAUS: And they're trying to stimulate economic growth. If you're trying to stimulate economic growth, then that's because earnings are actually falling. And if earnings are actually falling, why are you holding stocks at these levels? And I just think that realization hasn't occurred yet.