More Money Than God_Hedge Funds and the Making of a New Elite
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Before the big institutions came along, equity trading was dominated by “specialists” on the floor of the New York Stock Exchange. When an individual wanted to sell 50 shares in Ford, his broker called the New York Stock Exchange market maker who specialized in that stock; having a feel for the deal flow, the specialist would buy the shares at a price slightly below what he could sell them for a bit later. But this simple system broke down with the rise of the pension funds and mutual funds; suddenly, these institutions wanted to trade Ford in 100,000-share blocks, and the specialists lacked the capital to swallow that much. And so an opportunity arose. A few enterprising brokers, led by Oppenheimer and Goldman Sachs, began to make markets themselves. Rather than taking block trades to the specialists, they began to handle them in-house, sometimes finding buyers among their clients and sometimes buying the stock with their own capital. In 1965 block trading of this sort accounted for less than 5 percent of the transactions on the New York Stock Exchange. By 1970 that share had tripled.29
The new block-trading game was glorious. The big savings institutions needed somebody to make a market for large blocks of stock, and they were prepared to pay for this service. Indeed, they were prepared to pay handsomely because they had little choice: If they tried to unload 100,000 shares in Ford little by little, the price would move against them as they sold; and if the news of their selling leaked midway, the value of their shares would plummet. From the point of view of the savings institutions, therefore, it was better to give Goldman Sachs or Oppenheimer the whole 100,000-share block, even if that meant accepting a substantial discount to the market. But from the point of view of the brokers, the markdown could mean rapid profits. If they could find a buyer for the discounted shares, they could collect a hefty commission for arranging the trade. Alternatively, if they used their own capital to take the discounted stock onto their own books, they stood a good chance of selling it later at a profit.
The trick for the brokers was to know buyers with the guts to play in size, and that was where Steinhardt, Fine, Berkowitz came into the picture. The firm treated the trading function in an unusual manner. At most investment houses of the time, trading was a dull, back-office task, not something that a brilliant analyst would get involved in.30 But at Steinhardt, Fine, Berkowitz, the trading desk was manned by Steinhardt himself; and when Goldman Sachs and Oppenheimer called to offer blocks of stock, Steinhardt was happy to oblige, provided that the discount was sufficiently enticing. The more Steinhardt dealt with the block traders, the more they were happy to call him. The brokers needed someone on a trading desk who could make a big decision fast. Unlike the junior traders at most money-management firms, Steinhardt had the seniority to risk millions on his own authority. Perhaps because he had inherited the gambling gene from his father, Steinhardt was positively thrilled to take these risks. “Trading went from being a mechanical, insignificant, clerklike function in the fifties and sixties to a function of great significance in the seventies and eighties,” Steinhardt said later. 31
All new markets are inefficient at first, and the inefficiency means profits for early adapters. The brokers whom Steinhardt dealt with were shooting from the hip. There were few trading guidelines to govern what sort of discount made sense for a given size of block; the bosses who would later step in with trading rules and risk controls were still fumbling in uncharted territory. In this state of nature, making money could be as easy as taking candy from a baby, to use a phrase that Steinhardt loved: Once he was offered 700,000 heavily discounted shares in Penn Central, the bankrupt railroad firm; he bought and resold them straightaway, realizing more than half a million dollars in the space of eight minutes.32 Around 1970, Salomon Brothers resolved to become the third major block-trading house, alongside Goldman and Oppenheimer. To establish itself as a big player, it was willing to absorb large lots of stock at wafer-thin discounts, allowing Steinhardt to buy deeply discounted blocks elsewhere and off-load them on Salomon for a fat profit.33
Regulatory oddities created still other opportunities. Until the Securities and Exchange Commission stepped in toward the end of the 1970s, some parts of the block-trading business were transparent while others were shrouded in shadows. If you traded with Goldman or Salomon, firms that were members of the stock exchange, the price and size of the transaction would be reported on the ticker tape that was watched by every investor; if you got a discount, everybody knew about it. But if you traded in the so-called third market with brokers that were not members of the stock exchange, no transaction was reported. Steinhardt specialized in picking up unreported bargains in the third market, then unloading them quickly before anybody realized what was happening.
The more Steinhardt traded, the more money he found he could make. The third-market transactions, for example, worked only because of Steinhardt’s reputation as a big swinger. Brokers who needed to off-load shares quickly and discreetly turned to him instinctively because he was the one fund manager with the guts to buy half a million shares on the strength of a brief phone call. Equally, Steinhardt was able to resell those shares because of who he was. His partnership was a huge generator of commissions for brokers, so the traders at Oppenheimer, Salomon, and Goldman could be counted upon to help him.
“I would say [to the broker], ‘I got this block in the third a few hours ago. I bought it down one point. Do you want to work with me?’” Steinhardt recalls. “Down one point” meant that Steinhardt had received a discount on each share of $1.
“How many shares?” the broker would ask.
“Four hundred thousand.”
“What do you want for them?”
“Why don’t we do two hundred thousand, up an eighth,” Steinhardt would say.
“Up an eighth!?” The broker would do a double take. Steinhardt was suggesting that they sell the discounted shares to an unsuspecting third party for 12.5 cents more than the price on the tape.
“Yeah, well, we need to attract some buyers. Let’s put it up an eighth and it will look like a positive trade.”34
Often enough, this bluff would work. Nobody knew that a huge block had been sold earlier at a discount on the opaque third market, so investors could be persuaded to buy at a premium. Even after paying the broker’s commission, Steinhardt would clear a handsome profit.
Whatever the academic skepticism about stock pickers’ ability to beat the market, it was not at all mysterious that block traders should outperform it. Block traders had figured out a new approach: They weren’t engaged in the overcrowded business of analyzing company data and picking the stocks that would do well; instead, they aimed to make money by supplying something that other investors needed—liquidity. The new institutional custodians of savings were looking to trade large blocks of stocks quickly and discreetly, and they were willing to pay the guy who made that possible. Steinhardt’s genius was to extract good fees for providing liquidity, as when he secured a hefty discount on a block of third-market stock; and at the same time to pay little or nothing to those who provided liquidity to him, as when he managed to off-load third-market stock at 12.5 cents above the market.
Though he did not express the point this way, Steinhardt had put his finger on a weakness in efficient-market theory. The theory holds that the market price embodies all relevant information about a stock; that is why beating the market is next to impossible. In the medium to long term, that theory may be roughly true. But in the short term, information is often not the chief driver of prices. Instead, stock prices bounce around because of minute-to-minute changes in investor appetites. An insurance company needs to sell a large block of stocks to pay storm-damage claims: The selling pressure drives down prices. A pension fund needs to buy a large block to employ a fresh inflow of cash from workers: The buying pressure drives up prices. In efficient-market models, these temporary price shocks are ignored; liquidity is assumed to be perfect.35 The real world is different.
This wrinkle in efficient-market models becomes especially pronounced when the
demand for large transactions jumps and market structures have yet to adapt—as happened in the late 1960s and into the 1970s and 1980s. For some years after block trading started up, major sales could push a stock sharply away from the “efficient” price—the one that reflected analysts’ best assessment of all known earnings-related information. These short-run dislocations created opportunities for alert traders to seize bargains, and Steinhardt seized them aggressively.36 Moreover, the great beauty of Steinhardt’s method was that it was hard to copy. Once Wall Street had understood the mechanics of the A. W. Jones model, two hundred imitators had sprung up. But Steinhardt’s block-trading business was protected by “network effects,” which created barriers to entry. Steinhardt got the big calls from the block-trading brokers because he had a reputation for getting the big calls. He could trade his way out of big purchases because he had the network of broker relationships that came with being a big trader. Would-be rivals faced a frustrating catch-22 as they scrambled to catch up with him.
There was one less beautiful feature of the Steinhardt edge. It pushed the bounds of what was legal.
BEFORE WE GET TO THE SHADY STUFF, THINK BACK TO the question of liquidity. When a large block of stock comes on the market, would-be buyers can’t tell whether the seller knows something special. Maybe the seller has been tipped off that the company is about to revise its earnings down. Maybe he knows that another big institution is about to dump shares in the same company. Because buyers don’t know what they don’t know, they hesitate before bidding for 400,000 shares. Fearing that they may be at an informational disadvantage, they demand a discount in exchange for the provision of liquidity.
How could Steinhardt make money in such circumstances? Again, Steinhardt’s scale was important: He did so much block trading, and generated so many commissions for brokers, that he could expect special information from them.37 Theoretically, brokers were not supposed to identify their clients; if a seller came to the market with 400,000 shares, the seller’s identity was secret. The brokers were not meant to let on, for example, that the seller was a plodding insurance fund and therefore that it was probably selling for liquidity reasons—in which case its block discount would represent a bargain. But, as the brokers’ prized customer, Steinhardt could expect some creative bending of the rules.38 If the seller was a smart hedge fund rather than an insurer, the broker might avoid inviting Steinhardt to be the buyer, since the hedge fund might be selling on the basis of bearish information. Or if the sale represented the first sell order in a big series, the broker might issue a discreet warning.39 “The idea was not to try to hurt anybody. You wanted to do business with them,” said John Lattanzio, a Goldman Sachs block trader, recalling the clubby atmosphere of the 1970s.40 “You’d say, ‘Don’t buy the first hundred, there’s four hundred behind it,’” added Will Weinstein, the head trader at Oppenheimer, explaining that the big block traders were looking to do “things that were not collusive but were just honest attempts to protect each other.”41 How Weinstein could view this as anything other than collusion is a mystery.
Sometimes the collusion was more elaborate. A broker might call to say that a big institution was about to unload 500,000 shares of such and such, so perhaps Steinhardt should get short ahead of time, before the selling hit the market. Then, when the big order came through and the shares started to move down, Steinhardt would cover his short by buying the tail end of the order at the newly depressed price, pocketing some easy money. From the broker’s point of view, the tip-off to Steinhardt positioned his hedge fund to act as a buyer for the last tranche of the big sale: This helped the sale to go through without the price’s falling as much as it might have, making the broker look like a genius in the eyes of the seller.42 But the catch was that Steinhardt’s shorting had moved the market down before the transaction had begun: The block sale went through at something near the market price because the market had been lowered in preparation. This rigging was a clear violation of the rules. The seller had hired the broker to get the best price for his shares, but the broker had sold him out to Steinhardt.
From the safe distance of three decades, Steinhardt is remarkably frank about this. “I was being told things that other accounts were not being told,” Steinhardt says, describing the mechanics of his collusion with brokers. “I got information I shouldn’t have. It created a lot of opportunities for us. Were they risky? Yes. Was I willing to do it? Yes. Were they talked about much? Not particularly.”43
IT’S IMPOSSIBLE TO QUANTIFY THE CONTRIBUTION OF block trading to Steinhardt, Fine, Berkowitz. Steinhardt himself says that it “represented a meaningful portion of the noise, but not the profits,” though the more you listen to his descriptions of trading, the more you suspect he may be lowballing its significance.44 Certainly, the focus on trading represented the partnership’s most distinctive edge; and it is surely no coincidence that, of the three extremely gifted founding partners, it was Steinhardt who went on to become a legend. During twenty-eight years in the markets, Steinhardt suffered losses in just four. The probability of that happening is one in eleven thousand.45 At some point the coin-tossing niggles become irrelevant.
But there is another question about Steinhardt’s trading. If his collusion had been known at the time, might the Securities and Exchange Commission have revived its interest in regulating hedge funds—and might the story of the industry have been substantially different? Collusion between hedge funds and big brokers was sometimes suspected, to be sure; but it was never proved. During the 1970s, the Securities and Exchange Commission came after Steinhardt once: It alleged that in January 1970 his partnership had purchased a large block of stock in Seaboard Corporation, apparently as a favor to a broker who wanted to boost its price ahead of a public offering; the SEC maintained that Steinhardt had acted on the understanding that it would be compensated for any losses. But in 1976 Steinhardt settled the case without admitting wrongdoing.46 The suspicion of collusive market behavior remained just that—a suspicion.
Even so, it is not clear that Steinhardt’s admission would have tipped the balance in favor of a regulatory clampdown, still less that it should have. To the extent that Steinhardt was acting on privileged information, regulators were already empowered to go after him—as they did in the Seaboard incident. Besides, part of Steinhardt’s success reflected regulatory oddities that were not of his own making. In 1975 and again in 1978, the regulators acknowledged their own failings and sought to put them right: They set about bringing Steinhardt’s beloved third market out of the shadows, first insisting that all stock transactions be printed on a new “consolidated tape,” then stipulating that bids and offers for stocks be similarly reported.47 The intention was to spread trading information evenly to all market players, eroding the unfair edge of Wall Street’s inner circle.
Yet the main reason to hold back the outrage is more basic: Taken as a whole, Steinhardt’s activities were good for the economy. The search for the smoking gun of “market disruption,” on which the Securities and Exchange Commission embarked in 1969, had ended in failure because no disruption could be identified. Equally, the success of Steinhardt, Fine, Berkowitz over the ensuing years did not disrupt markets. It stabilized them.
Two themes in the young troika’s success were unambiguously good for the stability of the financial system. The partnership’s contrarianism made a small contribution toward dampening disruptive swings in stock prices: The troika sold during the bubble of 1972; it went long at the end of 1974, when the postcrash market was desperately in need of buyers. Likewise, by pioneering the application of monetary analysis to stock markets, the partnership brought new sophistication to the pricing of assets. If the bubble-to-bust cycles of 1968–70 and 1972–74 reflected Wall Street’s naïveté about inflation, Tony Cilluffo’s analytical techniques made such bubbles less likely in the future.
And then there was the matter of that block trading. Steinhardt’s collusion with the big brokers sometimes damaged outsider investor
s, who might have gotten better prices for their stock if the insiders hadn’t fixed the market. The outsider investors included mutual funds and pension funds, so the ultimate losers were ordinary Americans—while the winners were the millionaires who invested with Steinhardt. But this reverse Robin Hood story is not the whole picture. The block-trading business grew up because the outsider investors needed liquidity to shift big chunks of stock; by providing the outsiders with an opportunity to trade, Steinhardt was helping them. It was not as though the institutional investors enjoyed the benefits of wonderfully efficient markets, only to have an evil hedge fund corrupt them. Rather, institutional investors faced lousy markets that were highly inefficient in the short run. Steinhardt’s contribution was to offer liquidity that they were free to use or to ignore, and the fact that they chose to use it was revealing. In all probability, the service Steinhardt provided outweighed the effects of his wrongdoing.
If that sounds too charitable, fast-forward to 1987. The stock-market crash in October of that year provided a lesson in what life might be like without Steinhardt and his trading counterparts. In the wake of Black Monday, the big block-trading desks pulled back from the business, and the result was a furious outcry. The New York Times reported in December that blocks of 25,000 shares now disrupted prices as much as 100,000-share blocks had done before the crash; the market had grown horribly unstable.48 The mere rumor that an institution might be selling a block of Ford or IBM was enough to drive the share price down; because the block traders had irresponsibly pulled back, innocent companies were being damaged. In a twist that put the debates of the 1960s and 1970s in a whole new light, the SEC promised to investigate the troubling lack of block trading. The only thing worse than fast-trading hedge funds was a sudden dearth of them.