On Wednesday, March 30, the sharks continued to circle. The brokers issued ever bigger margin calls, desperate to get their hands on Askin’s cash before other creditors got to it. A Swiss investment-management firm called Unigestion, which owned one of Askin’s subfunds, ordered Askin to liquidate its positions; Askin contacted eighteen dealers, but most of the bids were so low as to be worthless. Two of Askin’s positions, consisting of those mind-boggling “forward inverse IOs,” failed to attract any bids at all. In another premonition of future troubles, the sheer complexity of these instruments made them impossible to sell. Nobody on the Street knew how to value them.30
At 3:45 P.M. on that Wednesday, Bear Stearns offered to buy a chunk of Askin’s portfolio for a paltry $5 million. As though trying to kill its victim with one swift bite, Bear demanded that Askin answer yes or no within fifteen minutes. Askin prevaricated, asked for an extra fifteen minutes, and ultimately refused: He was not going to make life easier for the predators by taking his shirt off for them. The brokers now gave up hope of a negotiated asset sale and began to take possession of whatever collateral they held, hedging their new holdings by dumping Treasuries. The bond market reeled again as the remains of Askin’s fund were dismembered.
The panic in the bond market, which had swept from the United States to foreign markets and from Treasuries to mortgage bonds, now reached the top echelons of government. On the morning of March 31, 1994, as Askin’s brokers were selling the life out of the Treasury market, Bill Clinton interrupted his California vacation. The president had been schooled by his advisers to view the bond market with a special awe; the previous year he had raised taxes on the theory that a smaller federal budget deficit would reduce the government’s demand for capital, which would in turn send bond rates lower. Clinton didn’t love this argument—his first reaction had been to denounce the undue power of “a bunch of fucking bond traders.”31 But his advisers had pressed hard; and as the Clinton tax hike was followed by a fall in market interest rates amid the bond bubble of 1993, the advisers appeared to have been vindicated. The collapse of the bond market in early 1994 came as a rude shock. Interest rates were shooting up again, and Clintonomics didn’t look so brilliant.
Clinton phoned Robert Rubin, the ex–Goldman Sachs chief who served as the top economic adviser in the White House. Rubin more than anyone had persuaded Clinton to believe that his tax hike would be rewarded by the bond market. Now the president demanded to know what was going on.
For about half an hour, Rubin labored to explain why long-term interest rates were soaring. Trends in growth or inflation could not provide the answer, he confessed. The bond market was behaving in new ways; Wall Street had been changing faster than anyone had noticed. The Fed had raised interest rates just twice—by twenty-five basis points in early February and then by the same amount in March—and yet bonds were falling off a cliff; it was the steepest decline in more than a decade. Nobody seemed to understand exactly what was going on: not the Federal Reserve chairman, not hedge-fund gurus such as Michael Steinhardt, and not even Rubin.
The president finished his telephone conversation and walked out to face the gaggle of reporters that was always shadowing him. “No one believes that there’s a serious problem with the underlying American economy,” he pleaded. “Some of these corrective things will happen from time to time, but there’s no reason for people to overreact.”32
SEEN WITH THE BENEFIT OF HINDSIGHT, THE PRESIDENT’S plea encapsulated the response to financial panics that has been standard for a generation. The bond market had confounded Clinton’s gurus, as well it might have done: Events as disparate as Japanese trade negotiations and Mexican assassinations had been linked in terrifying ways by the tentacles of leverage. But the best the president could do in the face of this extraordinary chain reaction was to plead for calm, and to do so in a way that misconceived the challenge posed by hedge funds. “There’s no reason for people to overreact,” the president said; but the truth was that, in the new leveraged world, overreaction was inevitable. The whole point of leverage, the very definition of the term, is that investors feel ripples from the economy in a magnified way. They are forced to keep their fingers on a hair trigger. Overreaction becomes mandatory.
Rubin was correct when he said that Wall Street had changed radically. As leverage multiplied investors’ buying power, the sheer size of the bond market had been transformed. In 1981, according to Securities Data Company, new public issues of bonds and notes (excluding Treasury securities) totaled $96 billion. By 1993 those offerings had multiplied thirteenfold to $1.27 trillion.33 The market was growing steadily more complex as well as larger: Askin had exaggerated his analytic powers, but other Wall Street firms were hiring physicists and equipping them with supercomputers as they designed ever more fanciful securities. Small wonder that government’s power to influence and even understand the markets was waning. Just as the deepening of currency markets had destroyed the ability of central banks to intervene successfully, as Britain had discovered in 1992, so the deepening of bond markets had weakened governments’ ability to anticipate shifts in long-term interest rates, let alone control them.
The policy makers’ response to this new world could have proceeded along two tracks, and the first concerned monetary policy. The Fed chairman conceded that the bond market’s reaction to the supposedly gentle rate hike had been a shock: Some three weeks into the mayhem, on February 28, the Fed’s interest-rate committee had convened by conference call, and Greenspan had said as much.34 Alan Blinder, the Princeton professor who became the Fed’s deputy chairman in June, lamented the bond market’s capricious behavior, denouncing the exaggerated power of “twenty-seven-year-olds in yellow suspenders.”35 The Fed’s leaders recognized that they were up against a new phenomenon. What conclusions should they have drawn from this?
The Fed could have chosen to redefine its inflation-fighting mandate. It had traditionally set interest rates with a view to keeping consumer prices stable. But the question raised by the bond market collapse of 1994 concerned the stability of asset prices. If the bond market heads into record territory, as it had in 1993, shouldn’t this be taken as a signal that credit is too cheap—and that it is time to raise interest rates in order to deflate a bubble? Because the Fed had been targeting inflation rather than the bond market, it had allowed the bubble to expand. But then Steinhardt had blown up; Askin had blown up; more than $600 billion had been knocked off the value of U.S. securities, and another $900 billion or so of wealth had been destroyed in foreign bond markets—surely an earlier hike in interest rates could have reduced this carnage? Over the course of the next decade, Greenspan wrestled with this question, ultimately deciding that using monetary policy to deflate bubbles was a bad idea. Bubbles were hard to identify until after they popped, the Fed chairman maintained, and it was easier to clean up after them than to prick them preemptively. Besides, the central bank would have to hike interest rates truly aggressively to dampen asset prices, and the cost in terms of growth forgone would exceed the benefits of calmer markets. For several years, this judgment seemed right. But in the wake of the huge credit bubble in the mid-2000s, the clean-up-afterward approach proved disastrously costly. The case for considering asset bubbles when setting monetary policy, and for requiring financiers to restrain leverage when markets appeared frothy, was belatedly vindicated.
The second response-that-might-have-been concerned regulatory policy. The deleveraging of 1994 had shown the risks that hedge funds and leverage more generally posed to the financial system. Storied investment banks were entrusting billions of dollars to cowboys, some housed within hedge funds and some seated at the banks’ own proprietary trading desks: What happened if the cowboys blew up and brought the banks down with them? Askin’s implosion had shown how an obscure and relatively small hedge fund could leave its three main brokers—Kidder Peabody, Bear Stearns, and Donaldson, Lufkin & Jenrette—with a $500 million loss among them. If a small hedge fund could infli
ct that sort of damage, what might a big one do? Surely Askin was a warning.
As the bond market melted down, plenty of regulators posed this sort of question. On March 7 and March 8, hedge funds’ impact on markets was topic A at a gathering of the top central bankers in Basel. In Washington a government committee called the President’s Working Group on Financial Markets began to study the dangers of hedge funds and of leverage more generally.36 Representative Henry González, the chairman of the House Financial Services Committee, growled that “hedge funds deserve extra scrutiny.”37 All signs pointed toward a government crackdown. “Hedge funds are rogue elephants: overleveraged, undersupervised, and disruptive to the markets,” Business Week thundered, citing a recent market commentary titled “The Hedge Fund Crisis.”38
In the midst of this febrile atmosphere, González announced that his committee would hold hearings on hedge funds. The Washington Post confidently reported that these would “light a fire” under the regulators.39 But unbeknownst to the public, a counterattack was taking shape. Robert Johnson, the Soros economist who had helped to shape the sterling coup, had once worked on the Senate banking committee, and his research assistant from that time was now González’s staff director. After Johnson had heard González call for a clampdown on hedge funds, he had sensed a moment to push back: González and other lawmakers were bad-mouthing the industry without understanding what it did; it was time to call their bluff—to force them to say concretely what they would do to make hedge funds safer. So Johnson had called up his former researcher and urged him to organize the hearings. Far from lighting a fire under the regulators, Johnson was betting that the hearings would cool the temperature in Washington.40
Having made his pitch to lawmakers, Johnson set to work on Soros. Unless he made some effort to educate lawmakers about hedge funds, Johnson told his boss, a regulatory backlash was certain. Ordinary Americans were suspicious of hedge funds because they did not understand their role; they worried that “when they went to bed at night, this jack in the box could come out of the ceiling panel and eat their net worth, and his name is George Soros.” “You have to demystify that,” Johnson counseled. Given a better communication strategy, there was no reason why professional investors should be hated. After all, Warren Buffett was a folk hero.
On April 13, when the House hearings convened, a bevy of regulatory chiefs testified before the first panel. It soon became clear that the regulators had no concrete ideas on how to stop imploding hedge funds from damaging their creditors; and in the absence of an action plan, they resorted to plan B—assert that no action is needed. Eugene Ludwig, the comptroller of the currency, insisted that hedge funds barely threatened the banking system: Only eight national banks lent money to hedge funds, most of these loans were secured by collateral, and Ludwig’s office had full-time examiners on site at the eight banks in question. Fed governor John LaWare gave González’s committee the same line: The Fed’s bank supervisors were not losing sleep over the risks posed by hedge funds. When Representative Melvin Watt asked what would happen if a big hedge fund blew up, the panelists assured him that banks and brokers would be fine. They would not be so foolish as to endanger themselves by lending excessively to hedge funds.
When the second session of the hearing convened, the sole witness was George Soros. Johnson’s calculation proved exactly right: Having called the hearing, the House staff had been forced to prepare questions for Soros; and this process had taught them that they lacked any firm ground for treating him aggressively. From the moment the hearing opened, the new tone was on display. González invited Representative Tom Lantos to introduce his fellow Hungarian American and teach House members how to pronounce his name: “Shurush,” González ventured, and he sounded tickled at his own progress. Soros launched into a lecture on reflexivity, seizing the occasion to advertise his book, and then gently explained why hedge funds were not the right target for regulation. Leverage could be destabilizing for markets, Soros conceded; but restrictions on leverage should be applied not just to hedge funds but to a range of financial actors, starting with the big brokerages. Of course, if this advice had been taken, leverage across the whole financial system might have been reined in, and the financial history of the next decade might have turned out differently. But, in their fixation with the novel threat posed by hedge funds, the lawmakers failed to heed Soros’s warning. A few befuddled committee members were still struggling to understand what hedge funds actually were. “Nowadays, the term is applied so indiscriminately,” Soros lamented. “There is as little in common between my type of hedge funds and the hedge fund that was recently liquidated, as between the hedgehog and the people who cut the hedges in the summer,” he said, referring to Askin’s implosion.41
And so the search for a regulatory response fizzled. Clinton administration officials, including the future Treasury secretaries Robert Rubin and Lawrence Summers, engaged in the debates on regulatory options for hedge funds but did not push for action. The New York Fed governor, William McDonough, had manned the phones to save Bankers Trust on that hectic day in March; he did nothing thereafter to rein in the leverage that had fueled the panic. The postmortem of Askin’s failure demonstrated that, despite all those assurances to Representative Watt, the brokerage departments of the investment banks had indeed lent to Askin carelessly. But, in perhaps the clearest error that related specifically to hedge funds, little was done to prod the banks to be cautious. The upshot was that when Long-Term Capital Management failed four years later, the crisis that ensued made 1994 look trivial.
FOR MICHAEL STEINHARDT’S FAMILY OF FUNDS, THE losses of 1994 were terminal. Steinhardt had flirted with the idea of retirement for years: “I don’t feel what I do is profoundly virtuous,” he had told Institutional Investor as far back as 1987. “The idea of making wealthy people wealthier is not something that strikes to the inner parts of my soul.” After the humiliation of the bond-market meltdown, Steinhardt resolved to make his exit.42
To those who worked for Steinhardt at the time, it was clear that his nerve had been shattered. He was frightened to take risks, and his temper went from bad to horrible.43 He would fire an employee at lunchtime and invite him to return the following day; he would scream at people with his intercom switched on, so that his bloodcurdling curses were relayed to every corner of the office. Steinhardt hung on through 1995, turning in a surprisingly good 27 percent return and recouping $700 million of his losses.44 His honor thus restored, he announced his long-rumored retirement.
Steinhardt’s departure was a watershed moment in the history of hedge funds: After twenty-seven years as a wizard of the trading screens, one of the Big Three was exiting the business. A dollar invested with Steinhardt in 1967 would have been worth $480 on the day he closed the firm, twenty-six times more than the $18 it would have been worth if it had been invested in the S&P 500 index. The debacle of 1994 had cost Steinhardt’s funds an astonishing $1.5 billion, but he had earned more than twice that much between 1991 and 1993, and his returns over the rest of his career had been excellent.45 “I’ve made my investors and myself more money than I ever conceived of as a kid,” Steinhardt reflected. His retirement would give him more time to dance with Martha, the elegant blue crane on his country estate that had taken to courting him with a graceful gavotte. There was life beyond Wall Street.
For those who remained behind, the question was what 1994 implied for the hedge-fund industry. Even if regulators were inclined to be soft, clients might take a different view: By September 1994, investors had pulled roughly $900 million out of hedge funds, and the withdrawals were still coming.46 Financial magazines pointed out indignantly that hedge funds were not actually hedged, and Forbes magazine proclaimed, not for the first time, “The hedge fund party is over.”47 Macro hedge funds, which had disastrously overestimated the liquidity in currencies and bonds, returned money to their clients rather than waiting to be asked to do so. Paul Tudor Jones handed back a third of his capital to investors, w
hile Bruce Kovner decided in June 1995 to give back two thirds; both cited the difficulty of maneuvering in and out of markets with too much capital. A month after Kovner’s announcement, Soros wrote a letter to Quantum’s investors, blaming recent disappointments on the same problem of size. Macro investing was now contemptuously dubbed “leveraged directional speculating.”48
In the early 1970s a similar backlash had buried hedge funds for a generation. But by the mid-1990s the industry was more resilient than before: With the exception of Steinhardt, famous funds were forced to shrink but carried on in business. An ecosystem of smaller players had evolved a rich range of investment styles, some of which performed robustly in a crisis. There were funds that bet on company mergers, funds that lent to companies in bankruptcies, funds based on computer models that arbitraged the gaps between similar financial instruments. One survey found that the average decline for a hedge fund in the first quarter of 1994 was a surprisingly modest 2.2 percent—less than the 3.3 percent decline for the average equity mutual fund.49 Another found that hedge funds had beaten the S&P 500 stock index over the past five years and had also been considerably less volatile.50 University endowments and other sophisticated investors were waking up to the fact that hedge-fund returns could diversify the risks from holding stocks and bonds. They could work wonders for a large portfolio.
And so, in the aftermath of the bond-market crisis of 1994, there were two verdicts on hedge funds. Regulators were forced to confront worrisome questions about the industry; but lacking a good theory of how to tame it, they ultimately chose to look the other way. Meanwhile, institutional investors reached a critical verdict: Notwithstanding the turmoil of 1994, hedge funds promised risk-adjusted returns that were simply irresistible. In a sense, the two verdicts were one. Because markets are not perfectly efficient, hedge funds and other creatures of the markets raise difficult issues: They are part of an unstable game that can wreak havoc on the world economy. But by the same token, the inefficiency of the markets allowed hedge funds to do well. Investors would line up to get into them.
More Money Than God_Hedge Funds and the Making of a New Elite Page 22
