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

by Sebastian Mallaby

  In the end, Fisher did not have to jump on the table. Eleven banks agreed to increase their contributions to $300 million each, while smaller amounts from Lehman and the French brought the total to $3.625 billion. The money was just about sufficient to declare a rescue. Long-Term would be bought and global markets would be saved, though Meriwether and his partners, who had kept so much of their own money in the fund, would see their personal fortunes reduced to almost nothing. “We believed in ourselves,” LTCM’s counsel, Jim Rickards, said later. “There was no hypocrisy there. I like to say we lost money the old-fashioned way: through honesty and hard work.”53

  AS SOON AS LTCM HAD BEEN SAVED, THE ARGUMENTS began about the meaning of the rescue. During congressional hearings on October 1, members of the House Financial Services Committee vented about the threat to economic stability posed by a handful of secretive traders. Representative Paul Kanjorski, a Democrat of Pennsylvania, suggested that the nation’s foreign enemies had no further need to develop weapons of mass destruction: They could harm the United States more easily by partnering with hedge funds. And yet, for all the outrage, the debate following LTCM’s failure was mostly just an echo of the one following the bond-market collapse in 1994. The nation’s top regulators were forced to recognize that hedge funds do pose risks. But they did little to reduce them.

  It is tempting to be harsh about the failure to respond vigorously. Back in 1994, regulators had argued that banks and brokerages were too savvy to allow their hedge-fund clients to take wild bets with their money. Now this argument had been destroyed: Wall Street’s finest had exposed themselves to LTCM in such an extreme way that it took the intervention of the Fed to save them. And yet, in the face of this experience, the nation’s top regulators continued to resist a crackdown on hedge funds. “Individuals who lend money to others have a very important interest in getting that money back,” Alan Greenspan reminded the House hearings, falling back on the idea that private creditors would check hedge fund excesses.54 It was not until 2009 that Greenspan conceded that risk monitoring by lenders was a flimsy defense against financial excesses. Even then, he presented the concession as though the crisis of 2007–2009 had come out of the blue—as though LTCM had never happened.55

  Yet before delivering a harsh verdict, it is important to acknowledge that there were good reasons for Greenspan’s diffidence. They began with the fact that a clampdown on hedge funds would not have ended dangerous trading, since recklessness was not restricted to the hedge-fund industry. Long-Term had been too leveraged. It had overlooked the danger that its trades could implode spectacularly if other arbitrageurs were forced to dump copycat positions suddenly; it had misjudged the precision with which financial risk can be measured. But there was no reason to suppose that Long-Term’s errors were possible only at hedge funds. Indeed, Long-Term’s collapse had rattled the authorities because it had coincided with frightening losses at investment banks such as Lehman Brothers. In the wake of LTCM’s failure, Greenspan and his fellow regulators could see that the real challenge was the leverage in the financial system writ large. Ironically, this was what Soros had tried to explain to Congress in his testimony four years earlier. Sure enough, the culprits in the crisis of 2007–2009 were leveraged off-balance-sheet vehicles owned by banks (known as conduits or structured investment vehicles, SIVs), leveraged broker-dealers, and a leveraged insurer. Hedge funds were not the villains.

  If hedge funds were only part of the challenge, why didn’t regulators clamp down on the wider universe of leveraged investors? Again, the answer echoes 1994: The regulators believed they lacked a good way of doing so. They could not simply announce a cap on leverage: The ratio of borrowing to capital was an almost meaningless number, since it failed to capture whether a portfolio was hedged and whether it was exposed to risks via derivatives positions. Regulators could not simply cap hedge funds’ value at risk, either: LTCM’s collapse had shown that this measure could be misleading. The frustrating truth was that the risks in a portfolio depended on constantly changing conditions: whether other players were mimicking its trades, how liquid markets were, whether banks and brokerages were suffering from compromised immune systems. The Fed’s Peter Fisher, who was at the center of the regulatory brainstorming following LTCM, could see the theoretical case for government controls on hedge funds and other leveraged players. But it seemed so unlikely that the government would get the details right that he never pushed for action.

  In the next few years, moreover, a parallel experiment in regulation proved Fisher’s hesitation well founded. Starting in 1998, a committee of global regulators set out to design a modern set of risk controls, eventually promulgating the so-called Basel II capital requirements. Even though this exercise excluded insurers, broker-dealers, and hedge funds, concentrating exclusively on banks, it still chewed up six years and ended in abject failure. In an attempt to write rules that would capture the subtle risks in banks’ portfolios, the Basel II framework deferred to banks’ own models of how much risk they were taking: In other words, the regulators’ bottom line was that banks should self-regulate. When the crisis hit in 2007, European banks that had adopted Basel II proved hopelessly fragile. If regulators had tried to control the leverage of hedge funds and other shadowbanks, they might have done no better than the Basel standards.

  Just as in 1994, regulators’ unwillingness to impose direct controls on investment banks and hedge funds forced them back to plan B—express concern about financial risk but reassure the nation that the dangers are tolerable. Greenspan mused publicly about the dangers of financial modeling, which could get too far ahead of human judgment. He urged creditors to remember that hedge funds might perform well in the good times and then suddenly blow up when markets hit unexpected volatility. But while acknowledging the flaws in modern finance, Greenspan emphasized the cost of returning to the premodern age. If banks were required to hold capital worth 40 percent of their assets, as they had done after the Civil War, there would be far fewer episodes of market turbulence, the Fed chairman conceded. But capital would be more costly and living standards would be lower. “We do not have the choice of accepting the benefits of the current system without its costs,” he concluded.56

  In the context of 1998, this was a fair verdict. The benefits of modern finance outweighed its risks, and attempts to reduce risks via government regulation appeared uncertain to succeed—as the Basel experiment suggested. Still, with the unfair luxury of hindsight, the decision to leave risk control to the market was wrong. Banks learned one lesson from the LTCM episode—they reined in the leverage extended to hedge funds, as they should have done in the wake of Askin’s failure in 1994. But other lessons went unheeded. LTCM’s failure had shown the craziness of insuring the whole world against volatility without holding capital in reserve; but over the next decade, the giant insurer AIG repeated the same error. LTCM’s failure had exposed the fallacy that diversification could reduce risk to virtually zero; but over the next decade investors repeated this miscalculation by buying bundles of supposedly diversified mortgage securities. Most fundamental, LTCM’s failure had provided an object lesson in the dangers of leveraged finance. And yet the world’s response was not only to let leveraged trading continue. It was to tolerate a vast expansion.57

  11

  THE DOT-COM DOUBLE

  In the opening riff of The Right Stuff, Tom Wolfe describes the way that military pilots rationalize the deaths of comrades. One airman lets his speed fall before he extends his aircraft’s flaps; he crashes and is burned beyond all recognition. His friends gather after dinner and shake their heads and say it is a damned shame, but they would never make that error. A short while later, another aviator corkscrews to his death because his controls malfunction. His friends agree that he was a good man, but sadly inexperienced. Yet a third airman passes out in the cockpit because a hose is disconnected in his oxygen system, and his jet noses over and screams into the Chesapeake Bay. His comrades are incredulous: How could any
body fail to check his hose connections?1

  The week after LTCM’s crash, Julian Robertson delivered his verdict on the dramas of September. In a letter to his investors, he reported that Tiger had lost almost 10 percent in the course of that tumultuous month, but he refused to concede that Long-Term’s fate was relevant to Tiger’s prospects. Long-Term had caught ablaze because of recklessness and inexperience, whereas Robertson had a proud eighteen-year record. Long-Term’s mathematical models were designed to harvest minuscule arbitrage returns with billions in borrowed money, whereas Tiger sought out opportunities that might pay off big time without the need for dangerous leverage. Indeed, just one year earlier, Tiger’s investment commandos had been up an eye-popping 70 percent before subtracting fees, reflecting the success of its long/short equity selections and its currency trading in Asia. “Our business is no more like theirs than it is like a high volume, low margin supermarket,” Robertson sniffed. “The question might be asked as to what Tiger is going to change in light of the hue and cry over leverage,” he wrote. “The answer is nothing.”2

  Within a few days, Robertson had trouble with his own oxygen hoses. Tiger’s 10 percent loss in September 1998 was followed by a shocking 17 percent drop in October, and the manner of Tiger’s humiliation bore an embarrassing resemblance to the LTCM experience. Just as Long-Term had made reasonable bets in unreasonable sizes, so Robertson’s October losses reflected an almost suicidally large wager that the yen would fall against the dollar.

  The origin of Tiger’s losses went back to the summer, when a confident Julian Robertson had written an upbeat investor letter. His fund was up 29 percent in the first half of 1998, and he had recently returned from a powwow in Europe with Tiger’s external advisers. Margaret Thatcher and Senator Bob Dole had been in attendance, with financial rainmakers from Japan and Mexico. Robertson had been particularly impressed by the discussion of the yen. Japan was deregulating its financial markets, allowing investors to shift money abroad; and with yen interest rates at just over 1 percent, it seemed obvious that Japanese savers would seize the chance to earn more on their investments. As Japanese capital flooded abroad, the yen would head down. Robertson left his investors in no doubt that he would short Japan’s currency.

  Robertson’s July letter soon proved doubly incautious. Just as Long-Term Capital Management had underestimated its exposure to a generalized “deleveraging”—a pulling in of bets by sophisticated traders that would cause the forces of arbitrage to reverse—so Robertson had underestimated the extent to which deleveraging would hit his yen trade. Precisely because yen interest rates were low, traders borrowed the Japanese currency to finance their positions around the world; if they dumped those positions and paid their yen back, the currency would be pushed upward—the opposite of what Robertson was expecting. When Russia’s default inflicted losses on leveraged traders, driving them to sell holdings, both Long-Term and Tiger got hit. Indeed, Friday, August 21 was not only the day when Long-Term lost more than half a billion dollars, causing the professors to rush back from their vacations. It was the day that Tiger’s yen bet started to go wrong. Japan’s currency rose 7 percent against the dollar over the next month, and Tiger saw over $1 billion of its capital evaporate.

  That was only the start of Tiger’s troubles, however. Just as Long-Term was hammered by rivals who knew too much about its positions, so Robertson found himself in a similar predicament. His spectacular investment record and booming personality attracted plenty of attention, and his monthly letters to partners were eagerly faxed around Wall Street. The moment that Robertson sent out his July letter, every trader knew he was short Japan’s currency; and the more the yen rose, the more they expected him to be forced to staunch his losses by buying back yen and closing his position. On October 7 the yen jumped especially sharply, and traders sensed that Robertson would crack. They drove the yen up still more, calculating that Tiger’s compelled exit from its trade would deliver yen holders a handsome profit.

  By around 10:00 A.M. on October 8, 1998, Japan’s currency had appreciated by an astonishing 12 percent since the previous morning. More than $2 billion of Tiger’s equity had gone up in smoke; in the space of just over a day, the firm had lost two hundred times more capital than the $8.8 million with which it had been founded. Years later, in April 2009, the news that Morgan Stanley had lost $578 million in the space of three months was shocking enough to make the front page of the Financial Times. But in just over twenty-four hours, Robertson had watched four times more than that vanish.

  Robertson convened a crisis council of his top lieutenants. They gathered in his splendid corner office, with its panoramic views of Manhattan; but the spectacle that mattered was flashing and blinking in the windowless core of their building, where the trading desk monitored the yen’s surge upward. The currency had been trading at 130 to the dollar the previous morning; it was now trading at 114; by the end of this meeting, who knew where it might be? By an irony that was no doubt lost on the participants, the man who dominated the crisis council was none other than Michael Bills, the son of the military aviator who had joined Tiger after Tom Wolfe called him and talked about the fighter-pilot culture. Bills argued to his colleagues that the market had gone crazy because it thought Tiger was on its knees; if Tiger could show that it still had the right stuff, it could restore Wall Street to its senses. Bills proposed that Tiger should attack rather than retreat. Rather than closing out its yen short, as the market expected, it should demonstrate its fearlessness by adding to its bet against Japan’s currency. One brave gesture would prove to predatory traders that it was not easy meat. The yen would stop speeding upward.

  The meeting broke up after about thirty minutes. The yen had risen from 114 to 112 during this time, vaporizing another half billion dollars. Dan Morehead, Tiger’s currency trader, hurried to his cockpit to execute the Bills plan. He would add $50 million to Tiger’s bet against the yen, gambling that this signal would break the currency’s momentum.

  Morehead called a dealer at one of the big banks. He asked for a two-way price on dollar-yen, not wanting to give away whether he was buying or selling. Normally it took a couple of seconds for the bank to quote a price. This time there was a lengthy silence. The expectation that Tiger would soon be forced to buy yen by the billion had scared potential sellers to the sidelines; who wanted to shed yen when Tiger was about to force their price up? Because of the dearth of sellers, the market had dried up; there were no trades and no prices. Morehead’s bank dealer would have to name a price in a vacuum. He was clearly terrified to do so.

  After fully half a minute, the answer came back. The bank would sell Tiger dollars using an exchange rate of 113.5 yen to the dollar; it would buy dollars back using an exchange rate of 111.5 yen to the dollar. The two-yen gap between the quotes was astronomical—maybe forty times the spread that Morehead saw in a normal market. Like LTCM before it, Tiger was discovering that liquidity can dry up when it’s most needed.

  “I buy,” Morehead said.

  In that instant, the bank that took his order knew that Tiger was not going to be squeezed out of its trade. Julian Robertson and his Tigers still had the will to fight! Only a fool would trade against them! Seconds later the dearth of sellers came to an abrupt end: The bank’s proprietary traders began dumping yen, and the dumps communicated the sea change to every currency desk on Wall Street. The yen started falling as quickly as it had risen earlier in the day. The aviator’s son had won. Tiger had been in a tailspin, but disaster had been averted.3

  In one respect at least, Robertson had been vindicated. His contention that Tiger was different from superleveraged LTCM was right; Tiger’s debt-to-equity ratio was around five to one, which gave it the muscle to hold on to its yen short rather than getting squeezed out of the position.4 But this vindication was scant comfort to Tiger’s partners. During the course of October, Robertson managed to lose $3.1 billion in currencies, primarily from his bet against the yen; and his excuses were not p
ersuasive. “The yen, which was as liquid as water, suddenly dried up like the Sahara,” he pleaded to his investors, failing to add that liquidity had evaporated not least because of Tiger’s recklessness.5 Tiger had been short an astonishing $18 billion worth of the currency—a position almost twice as large as Druckenmiller’s famous bet against sterling.6 By trading currencies even more ambitiously than his rivals at Quantum, Robertson had baked his own Sahara.7

  In the aftermath of this disaster, Robertson promised his investors that he would scale back his currency trading. But Tiger’s yen losses were just a foretaste of the troubles in store—troubles that came in the surprising guise of a technology bull market.

  THE TECHNOLOGY BUBBLE OF THE LATE 1990S SERVES AS a test for two views of hedge funds.8 On the one hand there is the optimistic view—that sophisticated traders will analyze prices and move them to their efficient level. On the other hand there is a darker view—that sophisticated traders lack the muscle to enforce price efficiency and that, knowing the limits of their power, they will prefer to ride trends rather than fight them. Among the hedge funds we have encountered, there are examples of both schools. Long/short investors, from A. W. Jones in equities to John Meriwether in bonds, aim to buy underpriced securities and sell expensive ones, pushing prices to their efficient level. Meanwhile, trend followers such as Paul Tudor Jones make no claim to understand the fundamental value of anything they trade. They buy securities as they go up and dump them as they go down. They are not interested in forcing prices toward some sort of equilibrium.