For the next two months, Jones continued to play the historical detective. Sometimes he thought that the S&P chart resembled the recession of 2001; sometimes it looked like 1987. But no matter which analogue appealed, Jones remained negative on the market outlook, and in the end his reading of the charts mattered less than the instinct behind it. What really counted was that Jones was looking at an asymmetrical bet, and he understood this intuitively. A leveraged financial system in a credit crisis is like a high-wire artist in a storm. The wire is going to wobble, and the artist may lose his balance and tumble a long way. But he is definitely not going to levitate upward.
Over the course of his long career, Jones had been working up to this moment. He had watched leverage grow exponentially since the 1980s and had frequently expressed misgivings. During the dot-com mania of the late 1990s, he had written to Alan Greenspan, the Fed chairman, urging him to raise margin requirements on stock traders so as to slow the flood of cash that was inflating the tech bubble. A few years later, in the mid-2000s, he had received regular phone calls from a senior official at the Fed, asking him what risks he sensed in the markets. He had answered repeatedly that debt was building upon debt: Nobody could know which part of the pyramid might crack; but the higher it grew, the greater the risk of a catastrophe. Clearly Tudor itself was part of this alarming edifice. At the end of each year, Jones would stay late at the office with Tudor’s president, Mark Dalton, reviewing the compensation of Tudor employees. At some point in these sessions, Jones would look at Dalton and say, “Can you imagine if the financial system ever had to liquidate? What if this enormous contraption that we’ve been part and parcel of building had to be unwound?”
“I don’t even want to think about it,” Dalton would answer.15
ON FRIDAY, SEPTEMBER 12, 2008, AT AROUND SIX O’CLOCK in the evening, a column of sleek, dark cars approached the New York Federal Reserve building. The cars disgorged the chief executives of Wall Street’s leading banks, who were greeted by Treasury secretary Hank Paulson, New York Fed president Timothy Geithner, and SEC chairman Christopher Cox—it was the government personified. The subject of the meeting was Lehman Brothers, whose fortunes had continued to slide disastrously since David Einhorn’s speech in May; and the government delegation was intent on delivering a clear message—there would be no public money for a Lehman bailout. As the politician at the meeting, Paulson felt he had already risked taxpayers’ money enough. He had approved government support for the rescue of Bear Stearns and for the rescue of the giant mortgage lenders Fannie Mae and Freddie Mac; he had been denounced by Senator Jim Bunning, Republican of Kentucky, for “acting like the minister of finance in China.” The way Paulson saw things, Lehman presented an opportunity to draw a line: to teach bankers a salutary lesson that they must face the consequences of their own errors. Of course, the markets might react badly if Lehman went under. But the Treasury secretary and his colleagues believed that the risk was worth running. After all, Lehman had been in the emergency wing for months, and its trading partners had presumably prepared for its collapse. The government team would try to find a private buyer for Lehman; but if it could not do so, it would step aside, betting that Lehman’s failure would not cause chaos.16
If Paulson and his colleagues had seen the world as hedge funds do, they would not have made this fateful call, which led to the worst freeze-up in the financial system since the 1930s. The Paulson team was walking into a version of the trap that had snared the Bank of England in 1992: It looked at the odds of various outcomes in the way that policy makers do, but it failed to ask the trader’s question—what is the payout in each instance? From a policy maker’s perspective, Lehman’s failure might engender chaos or it might not; if you thought there was a fifty-fifty chance of calm, you might choose to take the risk, especially if you were anxious to teach banks a lesson in responsibility. But from a trader’s perspective, this calculation was naive; a fifty-fifty chance of calm meant that chaos was virtually certain in practice. Hedge funds from London to Wall Street would conduct a thought experiment: In the calm world, markets would be flat; in the chaotic world, markets would crater; if traders shorted everything in sight, they would lose nothing in the first instance but make a killing in the second one. Faced with this asymmetrical payout, every rational hedge fund would bet aggressively on a collapse. And because they were going to make those bets, collapse would be inevitable.
Paul Tudor Jones had no trouble reaching that conclusion. There was no need to parse the details of how many institutions had readied themselves for the possibility of Lehman’s demise; as Jones put it later, “You knew Lehman Brothers would be the kickoff for a big down move. You knew that.”17 Everybody understood that Lehman was part of a bewildering daisy chain of interlocking transactions. Everybody understood that the financial system was leveraged up to its eyes. And the sheer symbolism of Lehman’s implosion would be an awe-inspiring thing. Lehman Brothers was a venerable institution that had survived the Depression and world wars; its failure would scream out that nothing was safe—“it would make everybody say, ‘Oh my God, is my son good for the loan I lent him?’” Jones exclaimed. “The optics of that would be so bad that everyone was going to shoot first and ask questions later,” he carried on. “The question mark would completely totally create financial panic and chaos.”18
The news of Lehman’s bankruptcy started to leak out around lunchtime on Sunday. Even if many hedge funds had positioned their portfolios for bad news, it soon became clear that they were not fully inoculated. American funds belatedly realized that Lehman’s London operation would declare bankruptcy under British law, which meant that hedge fund accounts that might have been “segregated,” or safe, under American rules would now instead be frozen. Hedge-fund lawyers rushed into their offices from weekend homes in the Hamptons, frantic to determine whether their assets with Lehman were subject to the British rules or the American ones. They put their outside counsels on speed dial and peppered them with questions. Investors called in a panic, demanding to know the size of their exposures. Nobody had clear answers, which only compounded the hysteria. By the evening, the size of the impending tsunami had begun to sink in. Eric Rosenfeld, the Long-Term Capital partner who had lived through the traumatic failure of his own firm, recalls hearing the news of Lehman’s bankruptcy on his car radio. “I couldn’t believe it. I was shocked. I was almost hyperventilating. How could they do this?”19
When the markets opened on Monday, Paul Tudor Jones experienced the extreme highs and lows that only he was capable of. On the one hand, he was perfectly positioned in his own trading book; he had seen the wave coming, and he rode it down, as the S&P 500 fell 4.7 percent by the close of trading that evening. On the other hand, it was the worst day of his professional life. Tudor had tried to withdraw the remainder of its assets from Lehman Brothers the previous week, but the request had arrived a day late, so the firm had $100 million frozen in Lehman’s London operation.20 Tudor wrote off the entire sum as a loss, but that turned out to be the least of its problems.
Tudor had made a mistake that was as egregious in its own way as Paulson’s miscalculation on Lehman. It had allowed the firm’s emerging-market credit team to build a giant portfolio of loans to firms in emerging markets. Banks in Kazakhstan, banks in Russia, Ukrainian dairy farms—Tudor had them all, and they accounted for a significant portion of the assets in the firm’s flagship BVI fund. Like Brian Hunter at Amaranth, Tudor had spotted a genuine opportunity at the outset: Loans to emerging markets could give the fund exposure to strong currencies; the loans paid high interest rates that more than compensated for the default risk; and as other hedge funds piled into the same trade, they drove up the currency and loan market, boosting returns and encouraging the bosses at Tudor to allocate extra capital to the strategy. But once Lehman collapsed, the true risks in emerging markets were revealed. Suddenly, storied banks in the United States could not raise money anymore, and banks in Kazakhstan or Russia seemed certain
to face trouble. The loans in the emerging-market portfolio immediately lost around two thirds of their value, costing Tudor over $1 billion.21
For a trader like Paul Jones, the worst thing was that he was trapped in these positions. When he speculated in futures, he always knew he could turn on a dime; indeed, he never created a position without putting in a “stop” that would take him out if he began to suffer losses. But the emerging-market loans were utterly illiquid: After Lehman declared bankruptcy, nobody wanted to hold any loans at any price, so there was no way to get rid of them. “I realized that our emerging-market trading book was going to get absolutely hammered and there was nothing I could do about it…. That was the worst moment of my whole life,” Jones said later.22 In his anguish and his helplessness, he thought back to what he had read about the only disaster that approached this one in scale. “I used to always think, ‘Holy cow, how’d these guys in 1929 lose it all? How could anybody be so boneheaded? You’d have to be a complete moron!’ And then that day, I thought, ‘Oh my God. I see how these guys in ’29 got hurt now. They were not just sitting there long the market. They had things that they couldn’t get out of.”23
Jones’s losses from emerging-market loans dwarfed the gains from his own trading book. Tudor had been up 6 percent or 7 percent for the year on the eve of Lehman’s failure, an impressive performance given that the stock market was down substantially. But by the end of the year, Tudor was down 4 percent, even though Jones himself had seen the storm coming.24 Tudor was forced to impose “gates” on its funds, suspending investors’ access to their capital. A chastened Paul Jones promised to narrow Tudor’s focus and stick to the liquid markets he knew best. The age of the diversified alpha factory was perhaps receding.
THE FAILURE OF LEHMAN BROTHERS SPELLED THE END of the modern investment-bank model. Lehman and its rivals had borrowed billions in the short-term money markets, then used the money to buy assets that were hard to sell in a hurry. When the crisis hit, short-term lending dried up instantly; everyone could see that the investment banks might face a crunch, and of course the fear was self-fulfilling. To stave off this sort of bank run, commercial banks have government insurance to reassure depositors and access to emergency lending from the Federal Reserve. But investment banks have no such safety net. Believing that they were somehow invincible, they had behaved as though they did have one.
The next domino to fall was Merrill Lynch, the investment bank famous for its “thundering herd” of nearly seventeen thousand stockbrokers. On the weekend that Lehman’s fate was decided, Merrill Lynch’s chief executive, John Thain, shuttled between the New York Fed and meetings with Ken Lewis, his counterpart at the Bank of America. Over a series of negotiations that culminated at 1:00 A.M. on Monday morning, Thain agreed to sell Merrill for a song. Almost a year earlier, Merrill had rebuffed an offer from Bank of America that was worth $90 a share. Now, with the investment-bank model in tatters, Merrill was willing to do a deal for $29 a share without hesitation. One of Wall Street’s oldest names was collapsing into the arms of a Main Street commercial bank. As one newspaper wrote, it was as if Wal-Mart were buying Tiffany’s.
Now that Bear, Lehman, and Merrill were gone, the two remaining investment banks, Morgan Stanley and Goldman Sachs, came under pressure. All of Wall Street knew that their reliance on short-term funding, coupled with extremely high leverage, made them vulnerable to a bank run; and the Morgan and Goldman stock prices began to show up permanently at the top of the CNBC screen, in what traders called the “death watch.”25 The trouble at the giant insurer AIG only made things worse. By writing credit default swaps, AIG had sold protection against the danger that all manner of bonds might go into default—it was the kind of crazy risk taking you got when you located an ambitious trading operation inside the bosom of a well-capitalized firm, imbuing the traders with a heady sense of invulnerability. Inevitably, AIG’s credit default swaps lost billions when the likelihood of default spiked up amid the crisis following Lehman. On Tuesday, September 16, the government was forced to rescue the firm, lending it an astonishing $85 billion.
The day after that, rumors that Morgan Stanley was exposed to AIG’s mess helped to drive Morgan’s stock down 42 percent by the middle of the afternoon. Hedge funds clamored to get their assets out of Morgan, desperate to avoid being caught in another Lehman-type trap. Morgan’s chief executive, John Mack, raged against short-selling conspirators who were supposedly driving him under. It was a repeat of the battles that Bear Stearns and Lehman had waged against hedge funds in their own moments of crisis.
Around the same time, Ken Griffin of Citadel calculated the odds that his hedge fund might fail also. He had aspired to build a firm like Morgan Stanley or Goldman Sachs, and he had some of the same vulnerabilities. He had leveraged his capital by more than ten to one—a far less aggressive ratio than the thirty-to-one that was typical of investment banks but well over the single-digit multiple that was normal for hedge funds.26 And because Citadel had issued a small quantity of five-year bonds, there was a market for credit default swaps on its debt, so traders could telegraph anxieties about its liquidity.27
Griffin constructed a quick probability tree. He put Morgan Stanley’s chances of survival at 50 percent. If Morgan went down, the odds of Goldman following were 95 percent. If Goldman failed, the odds of Citadel collapsing were almost 100 percent, since the forced selling by Morgan and Goldman would destroy the value of Citadel’s holdings. If you put that sequence together, Citadel’s chances of survival clocked in at only around 55 percent. “That’s a pretty bad day—when you realize twenty years of your work now comes down to whether or not some firm that you have no influence over fails,” Griffin said later.28
Yet if Citadel shared some of the vulnerabilities of the investment banks, the way it dealt with the crisis was different. Following the path that Lehman had traveled back in the summer, Morgan and Goldman lobbied regulators to clamp down on short sales of their stock. It was an awkward demand for the two firms to make: Morgan and Goldman were short sellers themselves, since their own proprietary traders were happy to take both sides of any position; and both had built up a flourishing prime-brokerage business, financing and executing short sales by hedge funds. But in the frenzied days after Lehman, neither Morgan nor Goldman was going to stand on principle. As their stock prices cratered on Wednesday, the two firms worked the phones; and by the end of the day, both New York senators, Chuck Schumer and Hillary Clinton, were calling on the Securities and Exchange Commission to give Morgan and Goldman the short-selling ban that they demanded.
On Thursday SEC chairman Christopher Cox expressed doubts about helping the bankers, but he found himself alone. “You have to save them now or they’ll be gone while you’re still thinking about it,” insisted the Treasury secretary Hank Paulson.29 At around 1:00 P.M., the Financial Services Authority in London announced a thirty-day ban on short selling of twenty-nine financial firms, signaling that the authorities would now do whatever it might take to save flagship companies. On Goldman’s trading floor, some three dozen traders greeted the news like infantrymen who have been rescued by air power: They stood up, placed their hands over their hearts, and sang along to “The Star-Spangled Banner,” which someone was playing over the loudspeaker system.30 Later that evening, the SEC went one better than London, banning the short selling of shares in about eight hundred financial companies.
The ban brought Morgan and Goldman some brief breathing room, but it amounted to a frontal government assault on hedge funds’ viability. Stock-picking funds lost hundreds of millions of dollars as a result of the rule change: “We went from playing chess to rugby at halftime,” one Tiger cub complained; and the claim that the ban protected the financial system was a stretch, since corporations ranging from Internet incubators to retailers were included.31 But even as they tried to pull the hedge funds down with them, the investment banks were not out of the woods; and they immediately resumed their lobbying. During the good times, Mor
gan and Goldman had reveled in the fact that they were not deposit-taking banks, subject to the Fed’s regulatory oversight. But now they performed a swift U-turn: They demanded to be swept under the Fed’s purview because they wanted guaranteed access to its emergency lending. On the evening of Sunday, September 21, Morgan and Goldman got what they desired. The Fed extended its protection to them, and their vulnerability ended.
Because it was classified as a hedge fund, Citadel did not get the same access to emergency Fed lending. On the contrary, the government had kicked it in the teeth, since the ban on short selling cost it dearly. Citadel had built up a giant portfolio of convertible bonds, which it hedged by shorting stocks: The idea was that the options embedded in the bonds were underpriced relative to the underlying equity. The ban on short selling made it impossible to hedge new convertible positions, so demand for convertible bonds cratered and Citadel was left with shocking losses.32 By the end of September, its main funds were down 20 percent for the month; and the more Citadel’s equity base shriveled, the more its leverage ratio went up. Since its creation in 1990, Citadel had grown from nothing to $15 billion in assets and 1,400 employees. Now its survival was in question.
More Money Than God_Hedge Funds and the Making of a New Elite Page 42
