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

by Sebastian Mallaby

  A few weeks after that, the tide turned for Paulson. On the afternoon of February 7, 2007, New Century Financial Corp., the country’s second largest subprime lender, made a startling announcement. Its fourth quarter earnings, due out the next day, would have to be postponed because the firm was still calculating losses—a shock given that it had been expected to report a healthy profit. It turned out that New Century’s subprime loans were blowing up still faster than the skeptics feared; some of its borrowers were unable to make their first payments. That same day, the British bank HSBC, which was the third-largest subprime lender in the United States, announced that it would have to set aside $10.6 billion in loan-loss reserves because of busted mortgages.

  The following morning, as the share prices of New Century and HSBC tumbled, Paulson was sitting at his desk when his head trader informed him that the ABX index had slid five points. Because of his massive positions, a 1 percent decline in the ABX handed Paulson a profit of $250 million; in a single morning he had netted $1.25 billion, about as much as Soros had earned from his wager against sterling. At the end of that month, when Paulson reported his February results, his office received a phone call from an incredulous client.

  “Is this a misprint? It’s 6.6 percent, right, not 66 percent?”10

  The results were not a misprint. Once house prices stopped appreciating, overindebted families began turning in their keys, so that BBB-rated mortgage securities were worth practically nothing. Within months New Century had declared bankruptcy and HSBC had sacked its U.S. executives; but every blow to the mortgage industry was a bonus for Paulson. On a hot day in the summer, Paulson was in the middle of a meeting with a pair of potential clients when a colleague came in and whispered something in his ear. Paulson abruptly excused himself, leaving his guests in the stuffy conference room. When he returned after a few minutes, he could not wipe a wide smile off his face. His visitors eventually asked him if there was somewhere else he needed to be. Unable to contain himself, Paulson divulged his secret.

  “We just got our marks for the day,” he blurted out. “We made a billion dollars.”11

  PAULSON’S MEMORY OF SOROS’S INJUCTION TO GO FOR THE jugular was more fitting than he realized. The subprime bubble was a twenty-first-century version of the policy errors that earlier hedge funds had exploited. In the 1970s, incompetent central banks had stoked inflation, allowing commodities traders to ride glorious trends. In the 1990s, central banks had committed themselves to untenable exchange-rate pegs that macro traders like Soros attacked gleefully. By the 2000s, inflation and unsustainable currency pegs were gone; but the passing of these follies made way for a new one. Because inflation had been vanquished, central banks felt free to stimulate economies with low interest rates, rendering money cheap and creating the conditions for an asset bubble. Because exchange rates were now stable, Wall Street was emboldened to take other sorts of risk, leveraging itself up and further adding to the bubble. Each new era brought a fresh kind of blunder, creating a fresh opportunity for traders too. The heyday of macro hedge funds might be over, but a new heyday of credit hedge funds had arrived. John Paulson was the new George Soros.

  There was another sense in which the Soros memory was relevant. The famous macro trades had yielded extraordinary profits because there were willing suckers on the other side—in 1992, it was the British government. Equally, Paulson’s subprime mortgage trade required a sucker: He could only build vast short positions on mortgages if somebody else was buying them. Of course, the mystery was who these buyers were—and why they were so eager to throw away their money.

  When the mortgage bubble burst in 2007 and 2008, extraordinary losses cropped up all over the financial system. Daniel Sadek’s handiwork, and millions of other loans that smelled equally putrid, had been packaged and sold to investors from Japanese insurers to Norwegian pension funds. Inevitably, some hedge funds were caught holding subprime garbage too; a couple of medium-sized outfits called Peloton Partners and Sailfish Capital sank under the weight of mortgages. Peloton, in particular, was hardly a model of financial prudence: Its London-based managers became famous when their secretary stole £4.3 million from their accounts without their realizing that anything might be amiss, though they told the jury at her trial that their bank account felt “one or two million light.” Still, by any reasonable reckoning, the hedge-fund sector as a whole survived the bubble extraordinarily well: By and large, it avoided buying toxic mortgage securities and often made money by shorting them. In 2007, hedge funds specializing in asset-backed securities, a category including mortgages, were up 1 percent on average, according to Hedge Fund Research, a data provider in Chicago—in other words, they completely dodged the subprime bullet. Meanwhile, hedge funds as a whole gained 10 percent during the year—not bad for a crisis.12

  If hedge funds mostly recognized subprime assets for the garbage that they were, who did lead the buying? The answer, to a large extent, was banks and investment banks—firms such as Citibank, UBS, and Merrill Lynch. On first inspection, this seems strange. These firms were proud of the trading desks that managed their proprietary capital. And yet, unlike hedge funds, the banks and investment banks bought subprime mortgages by the bucketful. Citibank’s losses were so astronomical that the U.S. government was forced to rescue it, buying more than a third of its shares. UBS ended up needing a lifeline from the Swiss government. Merrill sold itself to Bank of America to avoid going down. And whereas the failure of hedge funds such as Peloton and Sailfish—like the earlier failure of Amaranth—cost taxpayers nothing, the failure of Citi and its peers imposed enormous burdens on government budgets and the world economy.

  Why this stark contrast with hedge funds? There are four principal reasons, and they begin with regulation. Banks that take deposits, such as Citi and UBS, are required by regulators to hold a minimum amount of capital in order to shore up their solvency. This should have made the banks more resilient than hedge funds when the mortgage bubble imploded. But capital requirements, while necessary, can become a crutch: Rather than running their books in a way that rigorous analysis suggests will be safe, banks sometimes run their books in a way that the capital requirements deem to be safe, even when it isn’t. Subprime mortgages presented a classic example of this problem. Bonds backed by toxic mortgages were given the top (AAA) rating, partly because the rating agencies were paid by the bond issuers, which dulled the incentive to be critical. Once the AAA seal of approval was affixed to subprime assets, banks were happy to hold them because capital requirements allowed them to do so without putting aside much capital. Regulation and ratings agencies thus became a substitute for analysis of the real risks in mortgage bonds.13 Because hedge funds are in the habit of making their own risk decisions, undistracted by regulation and ratings, they frequently fared better.

  If capital standards turned out to be a mixed blessing, the second problem hinged on incentives. Hedge-fund incentives are not perfect. The managers keep a fifth of the profit in a good year but don’t give back a fifth of their losses in a bad year; therefore they may be tempted to gamble recklessly. But hedge funds have a powerful advantage. Their managers generally have their own wealth in their funds, which gives them a strong reason to control risks effectively. By contrast, bank proprietary traders do not risk their personal savings in the pools of money that they manage. Instead, bank traders often own company stock. But the value of that stock is driven by a variety of different profit centers within the bank. If the prop desk loses money, its errors will be diluted by the other business lines. The stock may react marginally or not at all. The effect is too weak to change prop traders’ incentives.

  This contrast points to a third reason why the banks fared poorly in the credit bubble: Those multiple profit centers distracted executives. The banks’ proprietary trading desks coexisted alongside departments that advised on mergers, underwrote securities, and managed clients’ funds; sometimes the scramble for fees from these advisory businesses blurred the banks’ i
nvestment choices. Again, the subprime story illustrated this problem. Merrill Lynch is said to have sold $70 billion worth of subprime collateralized debt obligations, or CDOs, earning a fee of 1.25 percent each time, or $875 million. Merrill’s bosses obsessed about their standing in the mortgage league tables: The chief executive, Stan O’Neal, was prepared to finance home lenders at no profit in order to be first in line to buy their mortgages.14 To feed their CDO production lines, Merrill and its rivals kept plenty of mortgage bonds on hand; so when demand for CDOs collapsed in early 2007, the banks were stuck with billions of unsold inventory that they had to take onto their balance sheets. The banks therefore became major investors in mortgages as an unintended by-product of their mortgage-packaging business. When the scramble for commissions distorts investment choices in this way, it is hardly surprising that the investment choices are horrendous.

  The final explanation for the banks’ fate hinges on their culture. Hedge funds are paranoid outfits, constantly in fear that margin calls from brokers or redemptions from clients could put them out of business. They live and die by their investment returns, so they focus on them obsessively. They are generally run by a charismatic founder, not by a committee of executives: If they see a threat to their portfolio, they can flip their positions aggressively. Banks are complacent by comparison. They have multiple streams of revenue and their funding seems secure: Deposit-taking banks have sticky capital that enjoys a government guarantee, while investment banks felt (wrongly, as it turned out) that their access to funding from the equity and bond markets made them all but impregnable. The contrast between hedge-fund paranoia and bank complacency emerged most clearly in the years after Russia’s default and the Long-Term Capital crisis in 1998. For the most part, hedge funds responded to that shock by locking up investors for longer periods and negotiating guarantees from brokers to stabilize their capital. Meanwhile, banks trended in the opposite direction: Their buffers of equity capital fell by about a third between the mid-1990s and the mid-2000s. Even in 2006 and 2007, when the mortgage bubble was bursting, many banks were too sluggish to adjust. They sold John Paulson billions of dollars of mortgage insurance via the new ABX index, but they did not stop to ask themselves what Paulson’s buying might tell them.

  The contrast between banks and hedge funds was summed up by the story of Bear Stearns, even though there was a twist to it. Bear Stearns had a reputation as a vigilant manager of its trading risks; it was exactly the kind of institution that would not be expected to buy poisonous mortgage securities. But by the mid-2000s, Bear had emerged as the number one packager of mortgage-backed securities on Wall Street, up from the third slot in 2000; and to keep the sausage factory going, Bear had bought up subsidiaries that made subprime loans directly to home buyers, both in the United States and in Britain. Inevitably, this expansion shifted managers’ attention: They were less focused on what mortgages might be worth than on how to create lots of them. Meanwhile, in 2003, Bear devised an ambitious “10 in 10” strategy for its asset-management division: Revenues and profits from this unit would rise to 10 percent of Bear’s total by the year 2010, never mind the fact that Bear’s asset-management subsidiary was starting down this road from a position of insignificance. Again, this pursuit of fee income helped to seal Bear’s fate. The bank hurriedly assigned unqualified executives to build out its asset-management business by launching internal hedge funds, and some of these funds loaded up on subprime debt. That misjudgment set Bear on the path that led to its collapse the following year—and to the Federal Reserve being forced to absorb $29 billion of Bear’s toxic securities.

  The failure of Bear’s internal hedge funds could be seen as evidence of hedge funds’ riskiness. But the truth is that the Bear funds were a product of bank culture, not hedge-fund culture. Like other hedge funds launched under the umbrella of large banks, the Bear funds were managed by people who were seeded within a large firm, not by entrepreneurs who launched independent ventures. They raised capital with the help of the parent bank’s network and brand, which lowered the barriers to entry that freestanding hedge funds must reckon with. They knew that if they failed, the parent bank might bail them out, softening their vigilance. The investment thesis of the Bear funds underlined their close ties to the mother ship. Two of the funds were run by Ralph Cioffi, who had previously worked on Bear’s sales desk, peddling mortgage-backed securities to institutional clients. His plan for his hedge funds was to buy those same mortgage-backed securities and leverage them up by an astonishing thirty-five to one. This was the sort of risky bet that made sense to a deep-pocketed, fee-hungry parent. It would have been less likely to fly with a real hedge fund.

  Ralph Cioffi himself was not the sort of figure who could have launched his own hedge fund easily. As a salesman, he had virtually no experience in controlling portfolio risk—indeed, some Bear executives argued that he should not be allowed to do so. Paul Friedman, the COO of Bear’s fixed-income desk, said afterward, “There were a fair number of skeptics internally who couldn’t figure out how this guy—who was bright but had never managed money—was now going to be running money. He knew nothing about risk management, had never written a ticket in his life that wasn’t someone else’s money.”15 Likewise, Cioffi was short on managerial ability: In a brief stint as a supervisor, he had performed disappointingly. Even with Bear smoothing the way, Cioffi had trouble handling the administrative challenge of running a hedge fund. He failed to secure the approval of his fund’s independent directors before buying securities from other divisions of Bear Stearns. The paperwork was in such a disastrous state that a law firm had to be brought in to investigate. In a complaint that summed up the trouble with hedge-fund subsidiaries within banks, an investor protested that it had put money in Bear’s funds because of the parent firm’s reputation for managing its own risks and claimed that Bear treated outside clients differently.16 The truth was that Bear and other banks that jumped onto the hedge-fund bandwagon were less intent on risk management than on leveraging their brands. If you wanted a reason why John Paulson made billions from the mortgage bubble and his former employer went out of business, the non-hedge-fund character of Bear’s internal hedge funds came close to supplying it.17

  In June 2007, Cioffi’s leveraged subprime mortgage funds blew up. They had been marketed on the strength of the Bear Stearns brand, so now Bear felt obliged to rescue them with an emergency loan—vindicating the view that deep-pocketed parents dull the incentive to be vigilant. Meanwhile, Paulson’s mortgage wager generated the biggest-ever killing in the history of hedge funds. By the end of 2007, his flagship mortgage fund was up a cumulative 700 percent, net of fees.18 His company generated an estimated $15 billion in profits, and Paulson himself pocketed between $3 billion and $4 billion—he was “the man who made too much,” according to one magazine profile. The following year, when Paulson recommended changes to Treasury secretary Hank Paulson’s bank bailout plan, his reception in Congress recalled the deference that Soros frequently enjoyed. “I was thinking we probably had the wrong Paulson” in charge, remarked Representative John Tierney of Massachusetts.

  Yet if Bear’s failure and Paulson’s triumph constituted a victory for hedge funds, it was too early to be sure that they would survive the shocks that followed.

  THE MONTH AFTER THE BEAR FUNDS FAILED, KEN GRIFFIN of Citadel headed off to France on vacation. He was a man in his prime. His formidable firm occupied a landmark tower in Chicago’s downtown business district. He had paid $80 million for a painting by Jasper Johns. He had recently married his French bride at the Hameau de la Reine in Versailles, the eighteenth-century mock village where the young Queen Marie Antoinette had once played peasant. But in the summer of 2007, Griffin found his vacation impossible to enjoy. Every day began with phone calls back to Chicago and ended the same way, and by Friday morning, Griffin had had enough. “Don’t take this the wrong way,” he told his wife. “You can come or you can stay. I’m going.”19

  That Friday, Ju
ly 27, was the day when the subprime troubles morphed into a larger credit crisis. Loans from guys who catapulted Porsches, byzantine collateralized debt obligations with eighteen layers, the whole pyramid of side bets on the ABX index—until just recently, all could be dismissed as a mania confined to one corner of the markets. But that Friday a Boston-based hedge fund named Sowood Capital Management began to catch fire. Its $3 billion portfolio was down sharply, and it was starting to receive margin calls from brokers.20

  The remarkable thing about this development was that Sowood had avoided subprime securities. Its boss, Jeffrey Larson, had made his reputation working for the Harvard endowment, which had matched Yale’s enthusiasm for absolute return by creating its own stable of in-house hedge-fund managers. By the end of his twelve-year stint with Harvard, Larson had been running $3 billion of the $20 billion endowment. Then in 2004 he had persuaded Harvard to seed an independent multistrategy fund. The new firm, Sowood, had acquired about seventy employees. It had notched up gains of 10 percent annually in its first three years, largely by focusing on credit markets.

  At the start of 2007, Larson had rightly sensed that default rates might be heading upward. In a version of the capital-structure arbitrage that John Paulson favored, he bought relatively safe “senior” bonds and shorted riskier paper, positioning himself to do well in a downturn. The subprime losses that buffeted Bear Stearns did not appear to threaten him and might even be good news. In early July, Larson injected another $5.7 million of his personal savings into Sowood.21

  Soon after that, Larson was forced to reckon with his error. Other leveraged players that had lost money in mortgages were raising capital by dumping nonmortgage positions; and in the third week of July, Sowood’s holdings of corporate bonds began to suffer serious losses. High-quality bonds that were supposed to be fine in a downturn were often the easiest to sell, so they were dumped first; when traders deleveraged indiscriminately, the logic of capital-structure arbitrage went out the window. Larson turned to his old mentors at Harvard, hoping for an emergency injection of capital; Harvard decided that would be too risky. By the morning of Friday, July 27, the news of Sowood’s troubles had spread around Wall Street, and traders began to position themselves for a contagious spiral. Margin calls might force Sowood to dump its corporate-bond portfolio in a fire sale, hitting other bond funds, triggering more sales and driving the market downward. Of course, these fears were self-fulfilling, and the bonds fell hard that afternoon. Sowood was hemorrhaging money, and even when the market closed for the weekend, the fund continued to get hit in after-hours trading.