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

by Sebastian Mallaby

  Jones had uncovered the equivalent of that Thai suitcase full of prize money. In the fortnight prior to his visit, the South Korean won had dipped by 4 percent against the dollar, and the stock market had weakened. But nobody imagined that the central bank had already chewed through two thirds of its reserves, or that Korea was in the midst of a full-blown banking-cum-currency crisis of the sort that Fraga had anticipated in Thailand. Only a month earlier, the IMF had completed its annual assessment of South Korea’s economic health and concluded that the country was immune from the turmoil elsewhere in the region. But in a memo to Soros headquarters dated November 17, Jones was able to explain why the IMF was flat wrong. Korea was “in the late stage of the crisis,” he warned. The official and widely believed numbers on the dollar debts of South Korean companies understated their real liabilities by a whopping $60 billion; and much of this debt would mature within weeks. A catastrophic collapse was in the offing.

  Over the course of the next month, the Jones memo proved prescient. Nine days after it landed in New York, the IMF’s top Asia hand flew into Seoul on an emergency mission; ushered into a meeting at the central bank, he discovered that its reserves were falling at a rate of $1 billion per day and were now down to $9 billion.36 Just as Jones had reported, much of the dollar debt held by Korean borrowers was of short maturity, so money was flying out of the country at a rate that would exhaust the reserves imminently. On December 3, the IMF announced a hastily assembled $55 billion package of loans to South Korea—a record number for an IMF bailout—but given that the dollar obligations of the private sector were more than twice that size, the package was inadequate. By the end of December, the won had fallen 60 percent from its level at the time of Jones’s November 17 memo.

  Yet Jones’s spectacular call earned the Soros team precisely nothing. Despite the strong language in the November 17 memo, and despite a follow-up message from Jones the next day, no action was taken to sell the won short and repeat the gains in Thailand. It is not certain why this was. At the time of Jones’s memo, top IMF officials believed that South Korea would escape trouble; this may have persuaded the Soros team to focus on other challenges.37 But it is hard to escape the suspicion that Soros’s dual persona contributed to the missed opportunity as well. The boss wanted to be a statesman, not a wrecker of nations. If he was going to get involved in South Korea, it would be not as a scourge but as a savior.38

  In the first days of January 1998, Soros traveled to Korea. He went as the guest of Kim Dae-jung, the country’s president-elect, and there were camera crews waiting at the airport. The great man dined with Kim at his home and affectionately called him “DJ” he visited the top industrialists and breakfasted with Michael Jackson, who was plotting to take over a theme park from a bust South Korean underwear maker.39 Addressing the local media, Soros was not shy about laying out what Korea should do. He criticized the IMF prescriptions for the country, which involved saddling it with more debt, and called for a “radical restructuring of industry and of the financial sector,” comprising a cleanup of accounting practices and flexibility for managers in firing workers.40 If Korea did these things, he said, his Quantum Fund would be willing to invest substantial sums in the economy, and other Western investors would flood in. Investors responded to Soros’s pronouncements by rushing into South Korean stocks, and Seoul’s KOSPI index jumped by a quarter in the ten days following his visit.41

  Soros’s mission to South Korea did his own fortune few favors. Not only had he missed the chance to short the won on the way down; his funds did not take a stake in Korea’s rebound until the following October. But the South Korea trip had a different payoff. The press coverage of his visit inevitably emphasized the comparison with the atmosphere in Hong Kong: Back in September, one Asian leader had vilified Soros as a criminal and moron; now another Asian leader was giving him the red-carpet treatment. Asked about the contrast between Mahathir and Kim, Soros allowed himself a smile.

  “One of them must be wrong,” he answered.42

  THE STRUGGLE BETWEEN SOROS’S TWO PERSONAS WAS most acute in Russia. As far back as 1987, before the Soviet Union crumbled, Soros had set up a branch of his Open Society Institute in Moscow. In the 1990s the institute supported educational reform, the printing of textbooks free of Marxist ideology, and provided millions of dollars’ worth of grants to support scientists. István Rév, a Hungarian historian who served on Soros’s philanthropic boards, thought that Soros was drawn to Russia by the same forces that fascinated Napoleon: “Its vastness, its historical challenge, its backwardness, its perpetually unfulfilled promise.”43 Not wanting his philanthropy to be seen as a Trojan horse for his financial interests, Soros made it a principle not to get involved in Russian investments, though he allowed Druckenmiller and the team to take positions. But in the spring of 1997 he cracked. He took an astonishing financial gamble in Russia, one that mirrored his errors in Indonesia and South Korea.

  Soros was not the only Western financier to fall for Russia. At the end of 1996, when President Boris Yeltsin reenergized his economic reform program, hedge-fund managers began jetting to Moscow, going out to the Bolshoi Opera and taking walks through the famous Novodevichy Convent gardens. A flood of foreign capital poured in. Portfolio investment increased from $8.9 billion in 1996 to $45.6 billion in 1997, equivalent to 10 percent of Russia’s GDP; the Russian equity index almost tripled in the first nine months of the year, making it the hottest among a lot of hot emerging markets. There were risks in this euphoria, to be sure: Property rights and the rule of law were vague concepts in Russia. But from the point of view of portfolio investors, Russia seemed a good bet so long as the reformers had the upper hand in Yeltsin’s government. If the reformers lost out, the foreigners could dump their shares and bonds and head for the exit.

  As a creature of the markets, Soros understood the importance of an exit strategy. But in 1997, he staked $980 million on a venture that was almost totally illiquid. Going over the heads of Druckenmiller and his colleagues, he joined a consortium bidding for 25 percent of Svyazinvest, Russia’s sprawling, state-owned telephone utility. It was an investment that might pay off over the long term: With nineteen phone lines per hundred people, compared with fifty-eight per hundred in the United States, telecoms in Russia had undeniable potential. But a $1 billion-odd stake in a state company was not something you could dump easily if Russian politics turned bad, and it entailed the sort of risk that seemed crazy to most foreigners. Even amid the torrent of portfolio investment into Russia, foreign direct investment into the country never amounted to more than a trickle.

  If the Svyazinvest bet seemed reckless on its face, it was all the more crazy given what Soros knew about Russia.44 In June 1997, shortly before the Svyazinvest auction was due to close, Soros received a secret request from the Russian government for emergency financing. President Yeltsin had sworn to start making good on the backlog of unpaid state wages and pensions by July 1, and he needed a temporary loan to meet the deadline. Unbeknownst to the markets or the International Monetary Fund, which was monitoring the parlous state of Russia’s debt, Soros lent the government several hundred million dollars. Had he not done so, Yeltsin’s brittle legitimacy might have cracked and unpaid workers might have rioted.

  From the point of view of Soros the philanthropist-statesman, the secret loan raised questions. Soros was going behind the back of the International Monetary Fund even as he urged Russia to become a responsible member of the international monetary system.45 But from the point of view of Soros the investor, the secret loan looked even more bizarre. Soros was about to plunk down a hard-to-exit bet of $1 billion on the theory that Russia was turning the corner to stability; but the desperation evidenced by the secret loan screamed out that stability was tenuous. In its triumph against sterling, and again in the Thai baht trade, the Soros team had used its insights into governments’ financial and political frailties to stage profitable attacks. In Russia in 1997, Soros had a privileged window on these
frailties, yet he invested as though he had never even thought about them.

  Soros behaved this way because of his messiah complex. In his role as a philanthropist, he had tried to save Russia from its sins; now he convinced himself that he could save Russia even more if he risked his fortune in the country. As he put it himself:

  I deliberately chose to expose myself. To be a selfless benefactor was just a little too good to be true. It fed my self-image as a godlike creature, above the fray, doing good and fighting evil. I have talked about my messianic fantasies; I am not ashamed of them…. I could see, particularly in Russia, that people simply could not understand what I was all about…. It seemed to me that to appear as a robber capitalist who is concerned with cultural and political values was more credible than to be a disembodied intellect arguing for the merits of an open society. I could serve as a role model for the budding robber capitalists of Russia. And by entering the fray as an investor, I descended from Mount Olympus and became a flesh and blood human being.46

  Soros’s hope was that the Svyazinvest privatization would mark a turning point for Russia.47 Until 1997, Russia’s state assets had been transferred at knocked-down prices to the country’s oligarchs, with foreign investors excluded; this time foreigners were allowed in, and the auction would be won by the highest bidder. Up to a point, Soros was right: When the bids were opened in July 1997, the consortium to which he contributed did indeed win out by offering the most money. But it was not remotely obvious that the messiah’s participation was necessary for this victory; and besides, the victory was Pyrrhic. The oligarchs who lost the auction owned newspapers and television stations, and these soon released a string of smear stories about the winning faction. For weeks the mudslinging dragged on, forcing three government officials to resign and distracting the Yeltsin administration from its reform agenda. Far from helping Russia to turn a corner to a cleaner kind of capitalism, the Svyazinvest episode plunged the government into chaos.

  Meanwhile, shock waves started to arrive from Asia. Banks that had lent to Thailand, Indonesia, and South Korea began to register losses and were forced to pull some loans from Russia. Russian financiers could see that the war over Svyazinvest meant the end of economic reform, so they joined the scramble to get money out of the country. The economic collapse in Asia drove down the price of oil, which is Russia’s primary export. Caught between collapsing export income and capital flight, Russia faced an excruciating crunch. In order to attract investors, the government was forced to offer ever higher interest rates on its bonds. By April 1998, the annualized interest rate on short-term ruble bonds hit 30 percent, even though their short maturity reduced the risks to purchasers. In May the yield on these so-called GKOs reached an astonishing 70 percent.

  The chaos following the Svyazinvest auction made Soros’s illiquid $1 billion bet look crazy. But the prospect of earning 70 percent from short-term government bonds was a different matter entirely, and soon half the hedge funds in New York were salivating. Three-month bonds with double-digit yields were surely the bargain of the decade; Russia’s finances presented some risks, but these seemed acceptable on a short horizon. The West was not going to let a nuclear power like Russia default and descend into chaos, the argument went; if worse came to worst, the United States would force the IMF to increase its support for the country. In June, Goldman Sachs underwrote a $1.25 billion issue of Russian bonds, and the issue was so popular that it sold out within an hour. Every macro investor in Manhattan, from Soros to Tiger and on down, was hungry for Russian investments.48

  But the most exotic Russia play of the moment had nothing to do with GKOs. It was about palladium.

  SINCE HIS FIRST TRIP TO SIBERIA IN 1994, DWIGHT ANDERSON had continued to build Tiger’s palladium position. He learned to navigate Russia’s palladium bazaar: Each year the parliament and the government export company would haggle over how much of the metal should be sold, then the central bank, finance ministry, and officials in Noril’sk would argue over who could sell how much of the allotment. Anderson nurtured his relationship with the key selling officials over long meals and whiskeys, buying the metal whenever he got the chance. And then in the summer of 1998 he saw an opportunity to break out of this pattern. The financial desperation of the Russian state could change the game for palladium.

  Anderson approached his Russian friends with a modest proposal. He offered to buy the entire stock of nongold precious metals held by the central bank and finance ministry. He would take the palladium, the rhodium, and the silver. All of it.

  Anderson’s audacious plan involved delicate logistics. Some of the metal would have to be brought to Moscow from Siberia by armored train; the entire consignment would then be flown to Switzerland and placed in a bank vault with Tiger’s name on it. Tiger would pay $4 billion once the metal was in its hands, an amount that would relieve the immediate pressure on the Russian budget. It would then sell the stockpile gradually into the market, sharing the profits with the Russian government. The eventual proceeds to Moscow would come in around $8 billion, or so Anderson estimated.

  Anderson flew to Moscow in July to meet a senior official at the central bank. The climate seemed propitious for a deal: GKO yields had jumped from 70 percent in May to more than 100 percent. Anderson and his counterpart got along well; President Yeltsin apparently knew about the deal and had approved it. Returning to the Tiger offices on Park Avenue after a few days, Anderson felt that the deal of a lifetime was almost in the bag: Soros and Napoleon could salivate over Russia’s limitless romance, but Anderson was about to show that a single hedge fund in New York could buy the treasure of the country. Then a message reached Manhattan from Moscow. There would have to be a commission.

  Anderson looked at the request and responded carefully. Tiger had no problem paying commissions on its trades, he said; after all, it paid them all the time to stockbrokers. But Tiger could not agree to the details of the Russian proposal. The Russians wanted two contracts for the metal sale: an official one that made no mention of the commission and a private one that laid down how it should be paid into a bank in Cyprus. Russia’s parliament and people would only see the official version, so no questions would be asked about who kept the commission.

  Anderson said he had a problem with that. “It’s got to be one contract,” he insisted.

  For a while there was silence from Moscow. Then a response came back: Okay, understood—what about paying the commission into a bank in Gibraltar?

  Anderson had to explain himself again. It didn’t matter if the payment was to Cyprus, Gibraltar, or some other haven. But it had to be disclosed, and there had to be one contract. Tiger’s lawyers and Russia’s lawyers had to be looking at the same piece of paper, and it would have to stand up to public scrutiny, both in the West and in Russia.

  The messages bounced back and forth between New York and Moscow until eventually it became clear that agreement was impossible. For the Russians, there was no earthly reason to sell without a private com mission. For Anderson, there was no way to salvage the deal of the decade.49

  BY THE TIME THE PALLADIUM NEGOTIATIONS BROKE down in late July, Russia’s crisis was taking on a new intensity. A large IMF loan had been announced on July 13, but it had calmed the markets only briefly. The week after the IMF announcement, a second Goldman Sachs–backed bond issue, intended to raise a whopping $6.4 billion, only attracted bids for $4.4 billion. The Russian bond market tumbled, quickly followed by the stock market: Suddenly even risk-seeking hedge funds were leery of financing Russia. With their options running out, the Russians reopened secret talks with their old friend George Soros.

  Yeltsin’s economic team made Soros a proposal. The state would auction off another 25 percent of Svyazinvest; meanwhile, the winners of the first auction would provide an immediate bridge loan to the government, just as Soros had done a year earlier. But this time Soros was not ready to play ball: In the summer of 1997, he had furnished Russia with a few hundred million dollars, but now
it would take billions to tide the country through its crisis. On Friday, August 7, Soros telephoned Anatoly Chubais and Yegor Gaidar, Yeltsin’s top economic officials, and told them to get real. Foreign investors and Russian investors were tired of buying Russian debt, and it would be impossible to roll over the vast quantities of GKOs as they matured. To make it through this crunch, Russia needed billions, not millions.

  After listening to Soros, Gaidar gave his estimate of Russia’s funding need: He put it at $7 billion. Soros countered that Gaidar was still lowballing the challenge: He reckoned $10 billion was needed. The Svyazinvest consortium could kick in $500 million, Soros suggested. The rest would have to come from Western banks and governments.50

  Soros’s next call was to David Lipton, the top international man at the U.S. Treasury. Soros urged the Treasury to contribute to a bridge loan, using the same facility that it had used in its Mexico bailout three years previously. Lipton retorted that there was no support in Congress for this sort of rescue: The Russians had already been given their last chance in the form of the July IMF package. On Monday, August 10, Soros spoke briefly with Lipton again. He called Lawrence Summers, the number two at Treasury, and on Friday he spoke with Treasury secretary Robert Rubin. To galvanize the Treasury team, Soros urged Senator Mitch McConnell, an influential Republican, to call Rubin and offer his party’s support for a last-ditch attempt to save Russia. In this flurry of telephone diplomacy, Soros was going beyond the role he had played in South Korea, when he had behaved like the International Monetary Fund, laying out the economic policies that would attract private capital. Now he aspired to broker a full-blown government rescue.