More Money Than God_Hedge Funds and the Making of a New Elite

by Sebastian Mallaby

  Soros’s startling payout was unknown in the immediate aftermath of the pound’s devaluation. But in October, Gianni Agnelli, the Italian industrial magnate, let slip to journalists that his investment in Quantum would earn him more that year than his takings from Fiat, his car company. The next day, Saturday, October 24, Britain’s Daily Mail newspaper ran a photo of a smiling Soros, drink in hand, and a headline proclaiming, “I Made a Billion as the Pound Crashed.” When Soros opened his front door that morning, he was met by a throng of reporters, and over the next months the press drooled over his winnings. Soros was said to have enlarged his personal fortune by $650 million in 1992, and one magazine observed that it took Soros five minutes to earn what the median American family could expect for a full year of labor.50 A few years earlier, people had reacted with horrified fascination to the $550 million earned by Michael Milken, the champion of junk bonds; but now Milken had been surpassed. Soros became known as the man who broke the Bank of England, and hedge funds began to displace the 1980s buyout kings as the objects of popular envy.

  The full profits of the Soros funds were considerably larger than outsiders imagined. Just as Paul Jones had coupled his shorting of the equity market during the crash of 1987 with a profitable bet on bonds, so Drucken miller built out from his sterling coup. As the pound came under pressure, Britain’s equity and government-bond markets were hit too; traders reasoned that the flight of capital from Britain would damage other asset prices. But Druckenmiller took a different view. Britain’s ejection from the exchange-rate mechanism would free the government to cut interest rates, which would drive government bonds up; and a weaker currency and lower interest rates would be good for equities. As he sold sterling on Tuesday and Wednesday, Druckenmiller was buying British government bonds and equities. Sure enough, Druckenmiller’s bets paid off. Over the next two months, both markets were up steeply.

  Britain was not the sole focus of Druckenmiller’s attention. In the wake of sterling’s fall, speculators mounted an attack on the French franc, but this time Druckenmiller believed that the central bank would win out against the markets. Unlike British homeowners, French families were not exposed to floating mortgage rates, and the French state had myriad ways of subsidizing its people: As a result, it would be easier for the French to fight off speculators with temporary interest-rate hikes than it had been for the British. Acting on this theory, Druckenmiller bought armfuls of French bonds, which soared in 1993, helping to explain why Quantum’s extraordinary 69 percent return in the year of the sterling bet was followed by a 63 percent return the year after. But Quantum’s greatest post-sterling coup was also the most discreet. Thanks to Robert Johnson, who had by now joined the fund full-time, Quantum shorted the Swedish krona before its devaluation in November 1992, again pocketing upward of $1 billion. Having learned a lesson from the publicity following the sterling trade, Soros and Druckenmiller made sure that nobody spoke publicly about their killing in Sweden.51

  The triumph of macro trading proved, if further proof was possibly needed, that the efficient-market hypothesis missed a large part of the story. If markets were dominated by rational investors seeking maximum profits, then efficiency might possibly prevail; but if markets were driven by players with other agendas, there was no reason to expect efficient pricing. Macro trading exploited a prime example of this insight: Governments and central banks were clearly not trying to maximize profits. At the height of the sterling crisis, John Major effectively bought sterling from Stan Druckenmiller at a price both knew to be absurd. Major did this for a reason that appears nowhere in financial texts: He wanted to force political rivals to share responsibility for devaluation.

  Druckenmiller’s coup also served to show that currency pegs were vulnerable in a world of deep and liquid markets. During the 1950s and 1960s, the system of fixed currencies worked well because regulations restricted the flow of capital across borders; but now that these controls were gone, it was time for governments to accept the limits to their power over money. They could either use interest rates to manage the value of their currency, so dampening exchange-rate swings, or they could use them to manage their economic ups and downs, so dampening recessions. Attempts to have it both ways via “flexible pegs” such as the exchange-rate mechanism were likely to backfire: The contrast between the United States and Europe illustrated the point vividly. When the Bush administration had tried and failed to lift the dollar in August, no calamity had ensued; the dollar was floating anyway, so there was no sudden break in its fortunes. But the currency pegs of Finland, Italy, Britain, and Sweden were a different matter; they presented speculators with targets that were too appealing to pass up, exposing their economies to wrenching dislocations. In committing to the exchange-rate mechanism, European governments had made a promise that they lacked the ability to keep. They had bottled up currency movements until a power greater than themselves had blown the cork into their faces.

  The implications of a world featuring Druckenmiller and other macro investors were not immediately absorbed by policy makers. As happens after every financial crisis, the first instinct was to vilify the markets rather than to learn the awkward lessons that they teach: in this case, that currency pegs were dangerous. The week after the pound’s devaluation, when the French franc came under pressure, French finance minister Michel Sapin suggested that troublemaking traders should be guillotined, as during the French revolution.52 The following summer, after the exchange rate mechanism suffered another round of disruptions, French premier Edouard Balladur argued that governments had an economic and moral responsibility to curb speculators. In Belgium, foreign affairs minister Willy Claes chimed in that Anglo-Saxon financiers were plotting to divide Europe.53

  In characteristic fashion, Soros accepted much of the attack on his profession. On the one hand, he had proved himself more ruthless than any other market player: Whereas bank trading desks had to live with regulators, and therefore were reluctant to assail governments too violently, Soros had no such inhibitions.54 On the other hand, Soros was intellectually disposed to see markets as wild things, constantly at risk of boom and bust, constantly destabilizing. Shortly after the pound’s devaluation, Soros saw Jean-Claude Trichet, the governor of the French central bank, and told him that, out of concern for the destabilizing effects of his own trading, he would not attack the franc.55 The claim to selflessness was a bit much, since Quantum had correctly calculated that the franc would hold and was about to make a killing on this prophecy. Nevertheless, Soros’s overture dramatized the mood that followed sterling’s fall. The greatest speculator of them all was unwilling to defend speculation.56

  Druckenmiller did not share Soros’s misgivings. The British press had dubbed the day of sterling’s humiliation “Black Wednesday.” But Drucken miller thought “White Wednesday” would have been more apposite. Britain had been freed from the yoke of the Bundesbank’s high interest rates—freed to pursue the recession-fighting policies it needed. The London stock market’s reaction to the devaluation made Druckenmiller’s point: The FTSE index jumped by almost a fifth in the two months that followed. To be sure, Druckenmiller’s trading had upended the economic policy of the British government, but this was not necessarily bad. The high interest rates accompanying German unification had created a situation in which sterling needed to exit the exchange-rate mechanism. Britain’s rulers had failed to recognize this truth until Druckenmiller had recognized it for them. The fact that John Major had transferred $1 billion plus of taxpayers’ money to the Soros funds was not entirely Druckenmiller’s fault. If somebody had fleeced the country blind, it was the prime minister, not the speculator.

  The Soros-Druckenmiller divide anticipated a debate within economics. In the years before the sterling trade, economists argued that currency crises were triggered by bad economic policy: The villain was not speculation but government mismanagement. But during the 1990s, the academic consensus shifted—from Druckenmiller’s view to Soros’s. The new view emph
asized that traders might attack currencies that were decently managed, and that the attacks might prove self-fulfilling. The spectacular collapse of sterling created a tipping point in this debate. Druckenmiller was correct in saying that Britain had invited the crisis by imposing untenably high interest rates. But once his own trading had demonstrated the power of speculators over governments, the risk that speculators might abuse that power became obvious. Whereas before traders might only have attacked currencies that were doomed by economic fundamentals, now they might feel empowered to have a go at stable ones. When French politicians complained that hedge funds were amassing dangerous and excessive power, their concerns were not totally baseless.

  Whatever this danger, little was done to reduce it. Clamping down on speculators—guillotining them, as the French finance minister had urged—would have involved taming the waves of cross-border money on which the speculators surfed: It would have involved a return to Bretton Woods and the reimposition of capital controls. Most policy makers viewed this option with horror. If free trade in goods and services was beneficial, surely free flows of capital were good for the same reason; just as trade allowed car manufacturing to be concentrated in the countries that did it best, so cross-border capital flows funneled scarce savings to places that would invest them most productively. Moreover, capital controls might be impractical as well as intellectually suspect. In the week after the sterling crisis, Spain and Ireland tried to dampen speculative attacks on their currencies by restricting banks’ freedom to trade them. The controls were quickly circumvented.

  If capital controls were off the table, there was one remaining way to prevent speculative attacks on national currencies—abolish them. “Speculation can be very harmful,” Soros told an interviewer in the wake of sterling’s bust; a single European currency “would put speculators like me out of business, but I would be delighted to make that sacrifice.”57 Europe eventually unified its currencies in 1999, but not everybody learned. Emerging economies in Asia and Latin America stuck with the policy of pegging, creating immense opportunities for hedge funds later in the decade.

  8

  HURRICANE GREENSPAN

  In December 1993, Michael Steinhardt escaped to his vacation home in Anguilla. His staff called in with regular updates, and one afternoon the news was particularly pleasing. Steinhardt’s funds were up more than $100 million in a single day. “I can’t believe I’m making this much money and I’m sitting on the beach,” Steinhardt marveled. It was an extraordinary moment, but his lieutenants counseled him to take it in stride: “Michael, this is how things are meant to be,” one of them assured him. After all, Steinhardt Partners was running about $4.5 billion in capital; it had built up a staff of more than a hundred employees; in 1991 and 1992, it had returned 47 percent and 48 percent after subtracting fees, and in 1993 it was heading for a similar performance.1 Magazines were reporting on Steinhardt’s purchase of a Picasso drawing for almost $1 million, and the portly figure of the investor, with glistening head and bristling mustache, was surrounded at New York parties by supplicants desperate to entrust their money to him. Perhaps this was indeed the way that things were meant to be. Steinhardt could scarcely imagine that he was about to face humiliation.

  Steinhardt had returned from his sabbatical in 1979, set up his own firm, and resumed his combination of stock picking and block trading. But he also began to make money in bonds, and by the early 1990s he was pioneering an early version of what later came to be known as the shadow banking system.2 Like Druckenmiller’s currency trading, the strategy involved taking advantage of the policies of a central bank—though this time it was the U.S. Federal Reserve that proved obliging. In 1990 and 1991, the U.S. economy was in recession following the savings and loans crisis, and the Fed was trying to stimulate it by keeping short-term interest rates low. This created a situation in which Steinhardt could borrow short-term money exceedingly cheaply, then load up on longer-term bonds that yielded considerably more, pocketing the difference. The risk in this trade was that if longer-term interest rates spiked up, the value of Steinhardt’s bonds would crater. But the sluggish economy kept the demand for capital low, meaning that the price of capital—the interest rate—was unlikely to head upward. Sure enough, longer-term interest rates fell at the start of the 1990s, handing Steinhardt a capital gain on his bonds on top of the profits from the gap between short-and long-term interest rates.

  Just as John Major had enriched Stan Druckenmiller because he wanted to neutralize political rivals, so the Fed rewarded Steinhardt because it was trying to assist the battered banking system. By increasing the gap between short-and long-term rates, the Fed was making it more lucrative for banks to engage in their normal business, which is to borrow short and lend long; it was sharpening banks’ incentive to push money into the economy.

  Steinhardt was effectively crashing this party. The Fed wanted to help banks, so Steinhardt turned himself into a shadowbank: He borrowed short and lent long, just like any bank would do. The difference was that Steinhardt bypassed the tedious business of hiring armies of tellers to collect customer deposits and flotillas of credit officers to lend the deposits on to companies. Instead, he borrowed from brokerages such as Goldman Sachs and Salomon Brothers, then lent by buying bonds. And because he had none of the infrastructure of the banks, he could charge in and out of their business as the Fed’s policies shifted.

  Steinhardt’s shadowbank enjoyed a further advantage. Real banks faced regulatory controls on how much they could lend: For every $100 worth of customer deposits that they turned into loans, they had to set aside about $10 in capital to ensure that, even if their loans went sour, they could still repay depositors. But Steinhardt had no depositors and hence no “capital adequacy” rule: He could borrow whatever his brokers were prepared to lend to him.3 And the brokers were prepared to lend an astronomical amount. For every $100 that Steinhardt borrowed to buy U.S. government bonds, he could often get away with setting aside as little as $1 in capital.4

  In 1993 Steinhardt and his fellow speculators took the bond strategy to Europe. With the crises of the exchange-rate mechanism over, Europe was headed for monetary union, and the process was forcing interest rates across the continent to converge on one another. Countries such as Spain and Italy, which had a weak record on inflation and therefore had to compensate investors with high interest rates, were now subjected to strict inflation-fighting rules; their interest rates began to fall toward those of Germany. Steinhardt and other traders bought truckloads of Spanish and Italian bonds, realizing a capital gain as interest rates came down. Again, they were jumping on an opportunity that governments had practically invited them to take. European statesmen had made no secret of their plans for monetary union, nor about the resulting convergence in interest rates.

  Because they were set up to seize such opportunities in a way that most rivals were not, hedge funds profited hugely in the early 1990s. Senior investment bankers quit Goldman Sachs and Salomon Brothers to get in on the new game, and one Wall Street law firm claimed to be midwifing new hedge-fund partnerships at a rate of two per month.5 The Helmsley Building at the foot of Park Avenue, known previously for its ornate Art Deco lobby and worked-brass elevators, became notorious as a hedge-fund hotel: In unmarked suites on the upper floors, small bands of traders opened shop, investing money every which way on behalf of rich clients. The number of hedge funds leaped from a bit over one thousand in 1992 to perhaps three thousand the next year, and their fees expanded almost as quickly.6 At the dawn of the industry, A. W. Jones had charged no management fee, asking only for a 20 percent share of the investment profits. The second generation of hedge funds, such as Michael Steinhardt’s, had demanded a 1 percent management fee plus the 20 percent profit share. Now, in the intoxicating boom of the early 1990s, hot new funds demanded “2 and 20.” “Perhaps never before in history have so few made so much money so fast,” an article in Forbes marveled.7

  The fast money was not without controve
rsy. Steinhardt’s energetic shadowbanking, which was mirrored by most of the other major funds, caused him to buy up vast amounts of newly issued government bonds, at one point resulting in an effective takeover of the market. In the April 1991 Treasury bond auction, Steinhardt and Bruce Kovner between them bid for $6.5 billion of the $12 billion worth of paper that was due to be issued; then they lent these bonds to short sellers and bought them back again, ending up with $16 billion of bonds—considerably more, in other words, than 100 percent of the market.8 As the bonds shot up in value, the short sellers tried to get out; but they couldn’t buy back the paper because Steinhardt and Kovner had cornered the market, and they were not selling. The victims of this short squeeze included Goldman Sachs, Salomon Brothers, and Bear Stearns; it was hardly a case of the sharks eating the innocents. But, inevitably, someone sued. After three years of fighting in the courts, Steinhardt and Kovner settled without admitting guilt. Steinhardt agreed to pay $40 million in compensation to the short sellers, and Kovner paid $36 million.9 As if one brush with the law were not enough, the duo was also sued over irregularities in the May Treasury auction. Again they agreed to settlements that involved payments to the plaintiffs.10