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

by Sebastian Mallaby

  Griffin assembled his lieutenants to consider the firm’s options. If he cut leverage by selling convertible holdings, rivals would see he was desperate and would start squeezing his portfolio. If he did nothing, on the other hand, he would soon run out of cash and be unable to meet margin calls. Meanwhile, Griffin and his team were focused on an additional danger. If trading partners started to worry about Citadel’s survival, they would mark down the estimated value of its derivatives contracts, forcing Citadel to cough up cash until its coffers were empty. That was what brokers had done to Askin Capital, Long-Term Capital, and pretty much every failing institution since then.

  In the first weeks of October, Citadel fought a two-front war against these enemies. It jettisoned assets that were not part of its main strategies, thus raising capital without telegraphing its distress too obviously. It closed derivatives contracts with other firms, replacing them in some cases with contracts on an exchange—unlike brokerages and banks, the exchange was not going to squeeze them.33 Where it was not possible to close out derivatives contracts, Citadel took comfort in what was arguably one of its greatest strengths: a state-of-the-art back office. Unlike many hedge funds, Citadel maintained the computer infrastructure, data feeds, and financial models to track the daily value of every derivative contract purchased from a bank; the better it understood what these things were worth, the harder it would be for counterparts to push the daily marks against it. This sort of plumbing was Citadel’s pride and joy. Recalling Long-Term Capital’s promise to do without a back office—to create “Salomon without the bullshit”—a Citadel staffer joked that Long-Term had things upside down. Salomon’s back office had constituted the firm’s true edge. The LTCM partners were the bullshit.

  Citadel’s computer infrastructure increased Griffin’s chances of saving his company. But his key advantage lay in the terms of his funding. Unlike investment banks, which were willing to do the lion’s share of their borrowing on extremely short terms, Citadel’s treasury department had been more careful. It had analyzed the mix of assets in its portfolio, calculating how long it would take to sell each kind; then it had lined up a blend of loans with the same mix of maturities. The idea was that Citadel should only rely on overnight funding to the extent that it had assets that could be sold overnight; harder-to-sell investments were backed by harder-to-yank borrowing. Citadel’s five-year bond issuance, unusual for a hedge fund, was part of this focus on borrowing longer term, and Griffin’s team had also negotiated bank loans that were locked in for as long as a year. Even a crisis was not going to push Citadel into a death spiral of fire sales—or at least that was the theory.

  In practice, of course, it was hard to feel so confident. Citadel had planned for a crisis, but not a crisis on this scale, and nothing could insulate it from what was going on around it. Other hedge funds, which had done less to lock in their financing securely, faced margin calls that forced them to dump convertible bonds and other positions; the weight of their selling caused Citadel to suffer yet more losses. Rumors that Citadel might be about to go under seemed to surface at dizzying speed. Citadel had been hit with margin calls! The Fed was calling Citadel’s trading partners, asking the size of their exposures! The truth was that the Fed was indeed calling around Wall Street, telling banks not to pull loans; but whether this saved Citadel or served to fuel the rumor mill could be debated. On some days in October, CNBC parked a truck outside the Citadel Center. A new deathwatch was beginning.

  On the morning of Friday, October 24, a young Griffin lieutenant named Dan Dufresne set off to catch a train to the office. Soon after he left home, he took a call on his cell phone from the New York office of a European bank. As head of Citadel’s treasury department, Dufresne stayed in touch with all the banks that financed Citadel’s positions.

  “Hey, Dan,” the voice said. “Just so you know, there are rumors that are picking up momentum in Europe that the Fed is in your office in Chicago, organizing a liquidation of your assets.”

  Dufresne decided he would get a cab. He was not going to discuss Citadel’s alleged demise in a crowded commuter train.

  “I’m hearing from our guys in London that this is happening,” the voice pressed. “Is it? I’m sure it’s not, but you need to know that it’s picking up speed.”

  Dufresne assured his contact that it was just another rumor. He talked to him for maybe ten minutes, but as soon as he hung up he got another phone call. It was the same rumor again. By the time Dufresne had reached his desk at the Citadel Center, there had been a third call and a fourth one. Dufresne’s colleague Gerald Beeson had been in the office early. He had been peppered with questions from European trading desks since five o’clock that morning.

  Dufresne and Beeson suspected that financial journalists had gotten hold of this rumor and were bouncing it off everyone they knew. They must have called every bank in London. The rumor was spreading faster than Citadel could douse it.

  A little while later, James Forese, Citigroup’s head of capital markets, placed a call to Ken Griffin. According to the rumors Forese was hearing, Griffin was visiting the Fed in Washington, looking for a bailout. Credit default swaps on Citadel’s bonds were trading at distressed levels. They were signaling more trouble even than Lehman’s had on the eve of bankruptcy.

  After dialing Citadel’s number, Forese was put on hold for a minute. Then Griffin picked up and started talking.

  “You’re calling me for one of three reasons. One, to see if I’m alive. Two, to see if we have any money…”

  Forese cut him off. “The reason I’m calling is to offer you help. If you need to liquidate portfolios and need someone to discreetly handle that, you know we would do that for you.”

  “We’re losing a lot of money,” Griffin conceded. “But we’ve got a lot of liquidity.” Because Citadel had locked up long-term funding with its counterparts, it was not facing margin calls. Because it had the back-office systems to track the precise value of everything it owned, the banks were less aggressive than they might have been in moving the marks against it. Besides, Citadel had sold plenty of assets to raise cash. It had been more proactive than Bear or Lehman in preventing its leverage from spiraling upward.

  Forese wondered whether all this would be enough. “You guys are getting killed in the rumor mill,” he ventured.

  “I know. I can’t get rid of the rumors,” Griffin conceded. The rumors were making people think that Citadel was about to dump its portfolio of convertible bonds. The threat of a fire sale was driving down prices, compounding Citadel’s difficulties. Every time a Citadel executive got a panicky phone call from a trading counterpart, he explained why the rumors were false. But no matter how many panicky callers Griffin’s team assuaged, the rumors were growing more hysterical.

  “You need a good window to get your story out,” Forese said.

  “I don’t know what the forum for that is,” Griffin answered. The last thing he wanted to do was stage a conference call that appeared to confirm the market’s worst suspicions. Bear and Lehman had done calls. A fat lot of good it had done them.

  Forese remembered that Citadel had issued some five-year bonds. Without signaling panic or anything out of the ordinary, the firm could convene a phone call for the bondholders. What’s more, doing the call in that format would give the message extra weight. Griffin could get in trouble with the regulators if he gave his bondholders anything other than the truth. That would make Griffin’s assurances believable.

  “That’s a pretty good idea,” Griffin allowed. He hung up and summoned his lieutenants.34

  Around ten-thirty in the morning, Griffin’s inner circle convened around a whiteboard. Somebody jotted down the half dozen points that Citadel needed to get across. Griffin wanted Gerald Beeson, the super-charged chief operating officer, to do most of the talking. Another note was added to the whiteboard: “Speak slowly.”

  “How many call-in lines?” somebody asked. When a big company such as Coca-Cola held its quarterly
investor call, it usually arranged about 250 lines. But Citadel had only a handful of bondholders.

  “Five hundred,” somebody ventured.

  “A thousand,” Beeson countered.

  The call was scheduled for 3:30 P.M., but there was no way it could begin on time. Well over a thousand callers attempted to dial in—traders, investors, financial reporters. This was to be the culmination of the Citadel deathwatch, the biggest financial drama since Lehman’s failure; on some Wall Street trading floors, the call was played over loudspeakers. There was a twenty-five-minute delay as more phone lines were arranged. Those who managed to get in on the call were treated to some grating techno music.

  Eventually, Beeson began to give his pitch. Yes, it was true that Citadel’s two flagship hedge funds were down 35 percent. But the firm was a long way from running out of cash. Its financing was secured. It had an untapped $8 billion credit line. There was no way it would go under. Adam Cooper, Citadel’s general counsel, held up a sign in front of Beeson to remind him not to speak too fast. “To call this a dislocation doesn’t go anywhere near the enormity of what we’ve seen,” said Beeson, emphasizing that Citadel would still survive. “We will prosper in the new era of finance,” Griffin added, mustering all the confidence that he could manage. After twelve minutes, the call was over.

  Griffin got off the phone and went to answer questions from his staff in a town-hall meeting. Beeson spent the afternoon on a series of calls with reporters. He hammered home the same message. Citadel had moved aggressively to raise cash. Its credit lines were all secured. Even though the government had rescued Morgan Stanley and Goldman Sachs while leaving hedge funds in the cold, Citadel was not going under.

  The next day the CNBC truck was gone from its usual position outside the Citadel Center. For the time being at least, the fires had been doused.35

  FOR THE NEXT SEVERAL WEEKS, CITADEL’S LOSSES CONTINUED. By the end of the year its two flagship funds were down a stunning 55 percent; the $9 billion that evaporated was the equivalent of at least two Long-Term Capitals. But although nobody said so, Citadel’s humiliation was a model of how the financial sector should work. Investors who had risked their capital with Griffin, and been rewarded for years, were forced to take extraordinary losses—exactly as should happen. But the financial system was not destabilized, and taxpayers were not called upon to throw Citadel a lifeline. The episode showed that leveraged trading firms with billions under management do not necessarily need government rescues when markets go berserk; careful liquidity management can substitute for the Fed’s safety net. The old-line investment banks had built castles of leverage on foundations of short-term loans; when the crisis came, the whole edifice toppled. But because he shared the paranoid culture of hedge funds, Griffin had leveraged himself a bit more cautiously and relied less on short-term loans; when the moment of truth came, Citadel survived it. And so it turned out that an upstart Goldman imitator could be better for the financial system than the real Goldman—not to mention incomparably better than Bear Stearns or Lehman Brothers.

  Citadel’s experience dramatized the wider experience in the hedge-fund industry. Hedge funds had danced through the minefields until Lehman’s collapse in September, but they were whipsawed in the panic that followed. They based their strategies on short selling, and the government banned that. They based their portfolios on leverage, and leverage dried up as brokers hoarded capital. By the end of 2008, most funds had lost money; almost 1,500 had gone bust; many a titan found his reputation justly deflated. And yet, even in the worst period of their history, hedge funds proved their worth. The industry as a whole was down 19 percent in 2008, but the S&P 500 fell twice that much. And unlike the banks, investment banks, home lenders, and others, hedge funds imposed no costs on taxpayers or society.

  This point was largely lost amid the crisis. The bursting of the hedge-fund bubble left no room to think about the policy meaning; the titans had flown so high that the spectacle of their fall was mesmerizing. Back in the first half of 2008, Phil Falcone of Harbinger Capital had returned 43 percent and stalked the New York Times; in September he lost more than $1 billion in a week thanks to Lehman’s collapse and the SEC ban on short selling. In February 2007, an alpha factory called Fortress had gone public amid great fanfare, creating paper wealth of $10.7 billion for its helicopter-riding chiefs; by December 2008, Fortress’s assets had collapsed by almost a third, and the firm was forced to fire two dozen portfolio managers. John Meriwether and Myron Scholes, veterans of the Long-Term Capital saga, had each set up new hedge funds in 1999 that did well for several years; by the end of 2008, both were near the precipice. Chris Hohn of the Children’s Investment Fund finished 2008 down 42 percent and seemed to lose his intellectual moorings too. “Quite frankly activism is hard,” he said, as though surprised by his discovery.36

  Stunned by these reversals, investors scrambled to get their money out. Hedge funds might have fallen far less than the S&P 500, but customers expected them to be up in any sort of market, as though the magicians who ran them had abolished risk rather than merely managing it. Even the macro hedge funds, which gave up only a small sliver of their earlier gains in the months after Lehman, were not exempt from this storm: They had to contend with $31 billion of net redemptions because everybody was withdrawing cash from everybody. Hedge funds responded with the tool to which Tudor had resorted—they locked investors in by suspending quarterly redemptions and “gating” their money. Sometimes investors were lucky to be taken prisoner: The gates averted the need for disastrous fire sales of assets and were accompanied by a suspension of management fees. But other times the gates were an outrage. One prominent hedge fund was said to have charged a departing investor a fee for early redemption; then it blocked the redemption, refused to return the fee, and carried on charging a management fee on top of that.

  The larger the hedge fund, the more peremptory and arrogant the managers tended to be—and frequently it was the bigger funds that had the worst performance. The big alpha factories were stuck in losing positions when liquidity dried up: Tom Steyer’s Farallon, which had been managing $36 billion at the start of 2008, shriveled to $20 billion in 2009. Meanwhile, nimbler boutiques—closer in spirit to the Steyer of the previous decade—frequently escaped with minor scratches. Rock Creek Capital, a savvy fund-of-funds, calculated that hedge funds with assets under $1 billion were down a relatively modest 12 percent in 2008. Meanwhile the funds that Rock Creek tracked with $1 billion to $10 billion in assets were down 16 percent, and those with more than $10 billion were down 27 percent.

  And yet, for all the losses, hedge funds’ mystique survived the crisis. They were repellent and attractive, objects of envy and yearning; they remained the wizards of modern capitalism’s favorite pastime, the unabashed pursuit of money. In November 2008, after two months of market pandemonium, five hedge-fund barons were called to testify in Congress, in what promised to be a show trial: The billionaires would be scolded for upending the economy. But some way through the proceedings, an unexpected tone emerged. Peering down from his dais, Representative Elijah Cummings, Democrat of Maryland, recounted his neighbor’s reaction to the day’s hearing. It was not a reproach, an accusation, nor even an expression of pity. It was a simple question, tinged with awe. “How does it feel to be going before five folks that have gotten more money than God?”37

  CONCLUSION: SCARIER THAN WHAT?

  Early in the first hedge-fund boom, in 1966, bankers at Merrill Lynch, Pierce, Fenner & Smith agreed to underwrite a convertible debt offering for Douglas Aircraft. As they worked with their client, they learned that Douglas was cutting its earnings forecast to $3.50 per share, about a quarter lower than projected. A little while later they heard that Douglas’s earnings might come in at under $3; and then they were informed that earnings would be, ahem, zero. This was a bombshell. The news would send Douglas’s share price into a free fall; and Merrill’s bankers, who were privy to the information by virtue of their role as insi
der advisers, were strictly forbidden to leak it to Merrill’s brokerage customers. But not for the last time at an investment bank, internal controls failed. On June 21 the facts about Douglas Aircraft’s collapsing prospects made their way to Lawrence Zicklin, a Merrill Lynch broker who handled the firm’s hedge-fund clients.1

  Zicklin had a direct wire from his desk to Banks Adams, a segment manager who ran money for A. W. Jones. The wire had been installed a year earlier, and its presence signified that Zicklin was expected to tell Adams everything he knew the moment he knew it. The Jones men were paying Merrill generous commissions, and they expected service in return; Zicklin was not about to make the stunning Douglas Aircraft news some kind of holy exception. According to an administrative proceeding filed by the Securities and Exchange Commission, Zicklin called Adams, who immediately placed orders to sell 4,000 shares of Douglas short. Then Zicklin also phoned Richard Radcliffe, the ex-Jones man who had set up a new hedge fund with Barton Biggs, and Radcliffe shorted 900 Douglas. John Hartwell, a mutual-fund star who was running a model portfolio for Jones, got the call too. He dumped 1,600 Douglas shares instantly.

  The next morning the Wall Street Journal ran a bullish story on the aircraft industry. As far as the average investor was concerned, nothing was amiss with Douglas, and its stock actually advanced a dollar. But that day some of the best-connected money managers attended one of the regular lunches hosted by Bob Brimberg, a legendary broker. Brimberg combined a formidable intellect with a formidable physique: He was as wide as a truck, and the scale that his partners had installed by his desk failed to stop him from becoming wider. At a typical lunch at Brimberg’s, the host would ply his guests with meatballs and corned-beef sandwiches and cocktails. Then he would demand to know what they were buying and selling; and no money manager would risk an outright lie, because he would not be invited back again.2 On June 22, Brimberg pumped his guests as usual. Somebody said something about Merrill Lynch and Douglas, and that afternoon the guests were jumping on the phones, calling the Merrill desk to demand confirmation. By the end of the next day, thirteen Merrill clients had dumped 175,800 shares in Douglas. Six of the thirteen were hedge funds, an impressive tally for an industry that was still little known outside Wall Street. The sales became the subject of a drawn-out inquiry by the Securities and Exchange Commission, which forced several of the funds into expensive settlements.