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

by Sebastian Mallaby

  In the popular imagination, the Soros team’s ruthlessness is unbounded. But the truth was that it had only a limited appetite for speculating aggressively in emerging markets. Soros himself was of two minds about speculation—he liked to say that markets, instead of swinging like a pendulum, could swing like a wrecking ball, laying waste to economies.18 Druckenmiller was clearer in his purpose, but he was not focused on Thailand: He was taking advice from Fraga and his team, so lacked the intense conviction that he felt when a trade was his entirely. Further down the hierarchy at the Soros funds, there were complex emotions. Rodney Jones, the Hong Kong–based economist, had challenged Fraga and Kowitz about the morality of speculation in developing countries: If currencies crashed, millions of innocents would be forced into desperate poverty.19 Back in 1992, Soros had famously urged Druckenmiller to “go for the jugular.” But when it came to Thailand in 1997, some members of the Soros team felt squeamish.

  In the aftermath of the discussions in Thailand, Jones settled on his own way of living with what he was doing; and in a book published after the Thai crash, Soros offered an identical defense of his funds’ actions.20 The defense boiled down to a simple idea: Speculation could benefit poor societies if it served as a signal, not a sledgehammer. The function of the virtuous speculator was to alert governments to the need for change—in Thailand’s case, that the baht had to devalue. This signaling could avoid hardship for ordinary people, since the more a government procrastinated about devaluation, the more brutal the eventual currency collapse would be. Reserves would dwindle to zero, so that when the crisis came there would be nothing left to cushion the shock as capital flooded out of the country. This case for speculation was potentially correct, but it could only justify speculation of a mild sort. An all-out attack on the Thai baht would have precipitated a crisis rather than prodded the government to avoid one.

  In the weeks following Druckenmiller’s first baht sale, Thailand’s behavior revealed a flaw in the Jones-Soros rationalization. Speculative signals would only be helpful if governments were wise enough to respond to them. But rather than prompting the Thais to devalue sensibly and early, Druckenmiller’s short position provoked disastrous defiance: The government threw away its foreign-currency reserves, buying baht from Druckenmiller at a rate that was sure to leave it with a loss once devaluation happened. Meanwhile, the Thai economy continued to weaken. When Rodney Jones next visited in the last days of April, the country was visibly grinding to a halt: Jones counted a hundred cranes on the Bangkok skyline, but almost none were working. Overextended real-estate companies had stopped servicing their loans; eighty-seven out of ninety finance companies in Thailand were said to be insolvent. Thailand had experienced a financial crisis at the end of the 1970s, but Jones could see, to his horror, that the next one would be worse. Back then, the total stock of loans was worth 40 percent of GDP; now, thanks to the globalization of capital flows, the ratio was 140 percent, rendering the consequences of a banking bust more serious for the real economy. The only silver lining, Jones concluded, was that the authorities still had a little time. They could come to their senses and devalue before a panic forced them into it.

  As it turned out, Jones’s presence in Thailand helped to precipitate the crisis that he dreaded. The Thai press got wind of his visit, and the news that a foreign hedge fund was circling spooked jittery local investors. Thai financiers and companies began to dump baht and buy dollars, forcing another round of central-bank intervention to defend the currency’s level. On the evening of Sunday, May 11, Prime Minister Chavalit Yongchaiyudh reinforced the sense of crisis by appearing on television and vowing to support the baht, then adding the self-defeating message that he could not promise to succeed in doing so. Just as in the case of Britain, which continued to defend sterling even as it knew the game was up, so the Thai leadership lacked the courage to accept the logic of their untenable position. And just as in the British case, the reaction from the Soros team was predictable.

  Three days after Chavalit’s televised statement, Druckenmiller increased his bet against the baht from $2 billion to $3.5 billion. The new position still represented only a third of the Soros funds’ capital, a fraction of what Druckenmiller could have sold if he had leveraged up aggressively. But now Druckenmiller was no longer the only player in the game; Thai investors were leading the charge out of the baht, and other hedge funds were following. Paul Tudor Jones, who spoke with Druckenmiller several times each day, was quick to put on a trade, as did several of the other macro funds from the tight-knit group around him. The biggest player after Druckenmiller was probably Julian Robertson’s Tiger, which built a short position in the baht that eventually came to $2 billion.21

  The day that Druckenmiller increased his position, the Bank of Thailand was forced to use at least $6 billion of its reserves to maintain the baht’s level; and over the next week, the onslaught continued.22 But Thailand’s government still refused to embrace devaluation; and a visit from the IMF’s Stan Fischer, the man who had set Fraga on his path, failed to persuade it to accept the inevitable. Rather than bow to the markets, the Thai government counterattacked.

  This gets to a second reason why Druckenmiller had not gone for the jugular. Financial traders must contend with market risks, but they also face political ones.23 On May 15, the day after Druckenmiller upped the ante, the Thai authorities forbade all banks from lending baht to anyone outside the country. This put short sellers in a bind: They could no longer borrow baht in order to sell them unless they secured the loans offshore at punitive interest rates. Tiger, for example, had financed some of its positions by borrowing baht on a short-term basis, figuring that it could roll over the loans as they came due; now it was forced to renew them at vastly higher interest rates: At one point in early June, the cost of holding Tiger’s position hit $10 million per day.24 The clampdown on lending to foreigners, combined with the central bank’s aggressive intervention, succeeded in reversing the baht’s fall: In the three weeks after Druckenmiller’s second strike, the Thai currency gained 10 percent against the dollar and hedge funds booked perhaps $500 million in losses. The region’s English-language newspapers were reporting gleefully that hedge funds were losing the “battle of the baht,” and the prime minister called the central bank to promise its staff a victory party. The Bank of Thailand was said to be gunning personally for Soros. According to one newspaper account, it was bent on inflicting losses on his funds of as much as $4 billion.25

  Faced with this onslaught, Druckenmiller cut his short position from $3.5 billion to $3 billion. Had he leveraged up and sold baht to the max, he might have precipitated devaluation; but that was more than the political system seemed likely to tolerate. Yet although Druckenmiller was not going to stick his neck out, he was not going to walk away; he knew that the Thais were closer to collapse than they admitted publicly. The central bank’s position was ostensibly robust: Even in late June, it reported reserves of more than $30 billion. But it had effectively sold a vast quantity of reserves by taking positions in the forward market, which did not show up on its balance sheet. This maneuver had fooled almost all outsiders, including inspectors from the International Monetary Fund and members of the Thai government itself. But by doggedly calling the banks that executed the government’s sell orders in the forward markets, Jones had pieced together the alarming rate at which real reserves were dwindling. By his reckoning, the Bank of Thailand had used up $21 billion worth of reserves in May alone, a stunning two thirds of its war chest.26

  Jones took little pleasure in this finding. His moral justification for speculation had been battered: Far from reacting to speculators by adjusting their policies quickly, Thailand’s leaders were digging in their heels and condemning their people to a calamity. The combination of high interest rates and uncertainty about the Thai currency had pushed the financial system to a breaking point. Banks were charging exorbitant rates to lend to other banks, not knowing which among them would survive, and money was ceas
ing to flow through the economy. On June 25 Jones worked out his anguish in a memo entitled “The Economics of Deflation: What Keynes Would Say to Thailand.” For a country to choose sky-high interest rates in preference to devaluation was “sheer lunacy,” Jones wrote, and he invoked Keynes’s reflections on this folly going back to Roman times. In A.D. 274, Emperor Aurelian’s zeal to protect the integrity of the coinage caused deflationary misery and provoked a rebellion. The fighting that ensued resulted in the deaths of seven thousand soldiers and doubtless many more civilians.

  Jones’s anguish could not save the Thai people. Clamping down on baht loans to foreigners turned out to be about as effective as blocking up one hole in a showerhead: It only accelerated the pace at which capital whooshed out through other openings. Harassing short sellers encouraged foreigners who had lent dollars to Thai businesses to demand repayment, and the businesses dumped baht as they scrambled to meet their obligations. Besides, the attack on short sellers made it expensive to borrow baht but by no means impossible; if you were convinced that the currency was about to collapse, it paid to borrow it at sky-high interest rates in the offshore market just for a short period. As more capital fled Thailand, the odds of a collapse increased. On Tuesday, July 1, according to at least one account, Julian Robertson’s Tiger unleashed a barrage of baht selling, adding $1 billion to its short position until the Bank of Thailand finally ran out of reserves and it became impossible to find buyers for the currency.27 Thailand had finally been pushed over the edge. Robertson had played a role analogous to Druckenmiller’s in the sterling crisis.28

  On the other side of the world, at around 4:30 A.M. Bangkok time, Bank of Thailand officials conceded that they had no more ammunition with which to defend the currency. After months of resistance, the baht peg had snapped: Over the next three months, it fell by 32 percent against the dollar. The Soros funds gained about $750 million from the devaluation, and Julian Robertson gained perhaps $300 million;29 meanwhile, Thailand’s output collapsed by 17 percent from its peak, destroying businesses and jobs and plunging millions into poverty. By an uncanny coincidence, July 1, 1997, was the day when Britain ceded control over Hong Kong. It also was the day when a new kind of imperialism put its stamp on Southeast Asia.

  In the wake of the devaluation, hedge funds were inevitably vilified. There was some fairness to these complaints, since the Soros team had indeed led the selling in January, forcing the government to raise interest rates and throttle its weak economy. There was an additional element of fairness, given Tiger’s role on the last day—though at the time almost nobody knew about this. But in a larger sense, the complaints missed the point. The roots of the crisis stretched back to 1995 and 1996, when the Thais had refused to devalue their exchange rate gradually in the face of China’s rise; speculators had merely forced an adjustment that was ultimately inevitable. Besides, although Soros and Tiger were part of the trigger for the crisis, they were not quite the villains that critics imagined. In particular, Druckenmiller had refused to leverage to the max, rightly fearing a political backlash. As the endgame played out in June, he had actually reduced his position.

  As it turned out, Druckenmiller’s caution contained a prophecy. As Thailand’s crisis spread across East Asia and beyond, the image of the hedge fund as superpredator proved less and less accurate.

  IN LATE SEPTEMBER 1997, GEORGE SOROS FLEW TO HONG Kong. He went for the annual meetings of the World Bank and International Monetary Fund, and the reception he received mirrored his dual persona. Soros the speculator was predictably reviled: Having earlier called him a “criminal” and a “moron,” Prime Minister Mahathir Mohamad of Malaysia called for a ban on “unnecessary, unproductive and immoral” currency trading. But Soros the statesman-philanthropist was the toast of the meetings. He addressed a packed auditorium on how to stabilize the world economy and was lionized by the press, not least because he could rail against speculation as fiercely as the best of them. “The main enemy of the open society, I believe, is no longer the communist but the capitalist threat,” he declared, despite his own capitalist fortune. “The laissez-faire idea that markets should be left to their own devices remains very influential,” he went on. “I consider it a dangerous idea.”

  By the late 1990s, Soros had no doubt as to which side of his persona should dominate. He wanted to be a thinker, a statesman, a great public figure; he did not want to be a neoimperialist and smasher of small currencies.30 Inevitably, there was a risk that this preference might color his investment views: In a discussion with David Kowitz and Rodney Jones during the Hong Kong meetings, Soros declared confidently that the time for shorting Asian currencies had passed, even though Mahathir’s outburst against markets had triggered a new sell-off in the region. The lieutenants had doubts about the boss’s rosy prognosis, but Soros was not in the mood to listen. Although he would not micromanage the funds’ decisions—he would leave these to Druckenmiller and the team—his optimistic bias was evident.

  The bias played out first in Indonesia. In the run-up to the Hong Kong meetings, the Soros team bought about $300 million worth of Indonesian rupiah, believing that the turmoil in Thailand had spilled over to neighbors without justification.31 Rather than repeat the Thai error of defending an unsustainable exchange-rate peg, the Indonesians had let their currency fall 11 percent in August; now a rebound might be in the offing. Following a visit to Indonesia by Arminio Fraga and Rodney Jones in October, the Soros funds increased the rupiah bet to about $1 billion.

  Not all hedge funds thought this was sensible. Julian Robertson’s Tiger, which had bet on the rupiah too, dumped its holdings at the end of October. But the Soros team followed the technocratic consensus, which held that the decline in the rupiah would prove temporary. The IMF seemed confident that Indonesia would pull through, and on November 2 it announced a $33 billion credit line for the country, designed to give the central bank the foreign reserves it needed to bolster confidence in its money. The next day the rupiah rallied healthily, and Soros’s position was showing a small profit.

  Up until this point, Soros’s optimism at the Hong Kong meetings had achieved a shaky vindication. Yet by mid-November, the Soros team and its IMF allies were losing their moorings. The IMF’s $33 billion credit line had been extended in exchange for two key commitments: Indonesia would close down sixteen corrupt banks, and it would run a responsible monetary policy. But the cronies around the ailing President Suharto were determined to frustrate this plan. The corrupt banks belonged to the cronies so were impossible to close down; and the cronies were also hammering on the central bank for loans, which inflated the money supply and destroyed confidence in the rupiah. By late November, the currency was in free fall; and in early December things got worse. Suharto was rumored to be seriously ill, and the prospect of a power vacuum panicked the country. By December 15 the rupiah was down 44 percent from its high in early November, and the trade had cost Soros $400 million.

  The strange thing was that the Soros team continued to stick with the currency. In the aftermath of the Wall Street crash ten years earlier, Soros had dumped his positions as soon as they went wrong, capping out his losses. But this time the Soros team seemed paralyzed, despite the clear signs that Indonesia had turned into a disaster. On December 10 Rodney Jones got his hands on data from the Bank of Indonesia, which confirmed that the central bank had been printing money that found its way to the lenders run by Suharto’s cronies. Jones fired off a note to Soros headquarters in New York, laying out the details of the monetary binge. But the funds still stuck with the rupiah position.

  Around the same time the Indonesian finance minister, Mar’ie Muhammad, was dispatched by his government to reassure foreign investors. Muhammad had spent years building up a reputation as a respected technocrat; now his task was to defend a recovery program in which money was being printed to pay off the undeserving friends of the Suharto family. On a stop in New York, Muhammad met Soros and his lieutenants at the Plaza Hotel; but although he was g
oing through the motions of talking up Indonesia’s prospects, his heart was not in it. Soros, Fraga, and Druckenmiller posed question after question, but, placed in an impossible position, Muhammad refused to meet their gaze, mumbling his way through a series of evasive answers.

  “Oh my God,” Druckenmiller said as he strode back to the office. “I can’t believe that we are long.

  “I don’t believe anything that guy said,” he continued. “I don’t even believe he’s from Indonesia.”32

  The group made its way across midtown Manhattan, back to the Soros offices by Columbus Circle. They knew that they were trapped in an appalling trade, but there were so few willing buyers for rupiah that it was not obvious how to get out of it.33 Casting around for some kind of exit, David Kowitz suggested using the rupiah to buy a physical commodity such as iron, which could eventually be bartered.

  “That’s an interesting idea,” Soros said gravely, in his thick central European voice. But nobody followed up on Kowitz’s proposal—not even when Indonesia’s government, unable to print money fast enough, released plastic souvenir banknotes as legal currency. The Soros team followed the rupiah down to the bottom, eventually losing about $800 million. The profits from the Thai baht trade had been wiped out in their entirety.34

  The Indonesian fiasco dented the image of the Soros funds as relentless superpredators. But it was compounded at the same time by an extraordinary missed opportunity.

  IN MID-NOVEMBER 1997, RODNEY JONES VISITED SOUTH Korea. Calling on a local bank, he found its boardroom festooned with triumphant notices of financings it had done for Thai companies. Jones knew these companies, and he knew that they had since gone bust; inquiring as to how many of the bank’s Thai borrowers were behind on their payments, he learned that the total came to more than fifty. As he made the rounds of other offices, Jones realized that this was just the tip of the iceberg. Thailand’s bust had clobbered South Korea’s financial firms, leaving them short dollars that they were likely never to recover. With a bit more digging, Jones found that South Korea’s central bank was scrambling to cover up the mess by depositing dollars in Korean banks, using its reserves of foreign currency. And this discovery led to the bombshell: Like the central bank of Thailand five months previously, South Korea’s central bank was misleading the markets. Officially, its foreign-currency war chest contained $57 billion. But if you subtracted the amounts promised to wounded banks or committed on the forward markets, the real number was closer to $20 billion.35