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

by Sebastian Mallaby

  25. Askin told one magazine that “most managers are not as comfortable as we are with prepayment risk, nor the structural risk inherent in this market. We understand it, we can measure it, and we can hedge it.” Final Report of Harrison J. Goldin, Trustee, to the Honorable Stuart M. Bernstein, United States Bankruptcy Judge, Southern District of New York. In re Granite Partners, L.P., Granite Corporation, and Quartz Hedge Fund. Case Nos. 94 B 41683 (SMB) through 94 B 41685 (SMB) inclusive. New York, NY, April 18, 1996, 27.

  26. See Saul Hansel, “Markets in Turmoil: Investors Undone: How $600 Million Evaporated,” New York Times, April 5, 1994. The success of Askin’s marketing was not surprising given his reputation at Drexel, where he was considered one of the foremost experts on prepayment risk.

  27. The bankruptcy trustee would later find that Askin lacked the analytical models necessary to determine whether his portfolio was market neutral. See Final Report of Harrison J. Goldin, 27–28.

  28. The bankruptcy trustee found no evidence of the proprietary prepayment model on Askin’s computer, and no employee of his firm was able to verify its existence. See Final Report of Harrison J. Goldin, 28.

  29. Final Report of Harrison J. Goldin, 84–85.

  30. Even when Askin tried to accept some of these low prices, it proved impossible to do so. The instruments were held by other brokers as collateral, and the brokers had hedged the risk in the instruments with offsetting trades. Because the offsets were too complex to unwind, the brokers refused to release the collateral. See Final Report of Harrison J. Goldin, 95.

  31. Woodward, Maestro, p. 126.

  32. The Late Edition, CNN, April 3, 1994 (transcript retrieved from Nexis).

  33. Al Ehrbar, “The Great Bond Market Massacre,” Fortune, October 17, 1994.

  34. “We had a far greater impact than anticipated,” Greenspan said bluntly. Federal Open Market Committee conference call, February 28, 1994.

  35. Blinder’s protest against yellow suspenders is recalled by Vincent Reinhart, a former Fed economist. Reinhart interview.

  36. See President’s Working Group on Financial Markets, “An Assessment of Developments with Potential Implications for Market Price Dynamics and Systemic Risk,” September 27, 1994.

  37. Lynn Stevens Hume, “Gonzalez Derivatives Legislation, Hedge Fund Hearing Due in April,” Bond Buyer, March 28, 1994.

  38. The paper was by Don R. Hays of Wheat First Securities. It was circulated on April 5, 1994.

  39. Brett D. Fromson, “Hearings on ‘Hedge Funds’ Planned,” Washington Post, March 25, 1994, p. G7.

  40. Robert Johnson, interview with the author, July 29, 2008.

  41. “Hedge Funds.” Hearing of the House Banking, Finance, and Urban Affairs Committee. April 13, 1994. 103rd Congress, Second Session.

  42. Steinhardt recalls: “I was really miserable. And I was miserable, I would say, in the second quarter and into the third quarter. I couldn’t get out of it, even when I was pretty much out of the bonds, I couldn’t ever quite mount a successful offensive. Every time I started something, it just didn’t work.” Steinhardt interview.

  43. A Steinhardt employee recalls of the last year: “He would intellectually hedge himself. If you had a view on something and put a trade on, he would come in and say, ‘I was just talking to’—pick your famous guy—‘and he thinks it’s the dumbest idea he’s ever heard ever, and he has no idea why you’re doing this.’ Then he’d say, ‘But I don’t know anything about this, so do whatever you want…’ And he’d leave. So now you’re screwed because if it goes badly he can say, ‘I told you this was a bad idea.’ If it worked, he could say, ‘Why wasn’t it bigger? I told you that you could do whatever you want…” He would do this consistently.”

  44. Contemporary press accounts put the earnings for 1995 at $500 million. See Stephanie Strom, “Top Manager to Close Shop on Hedge Funds,” New York Times, October 12, 1995, p. D1. However, Steinhardt’s records show that returns were 26.8 percent (before fees) on assets of $2.7 billion, suggesting profits of just over $700 million.

  45. Some commentators have suggested that Steinhardt’s dollar losses in 1994 were so large as to outweigh the gains over the rest of his career, since the earlier gains, though impressive in percentage terms, were on a relatively small asset base. This claim is not borne out by an examination of Steinhardt’s internal records.

  46. Stephen Taub, “The Hedge Rows of Wall Street,” Financial World, September 13, 1994, p. 38.

  47. Riva Atlas and Dyan Machan. “To be or not to be: Nothing personal, mind you, but Alan Greenspan pushed Michael Steinhardt—and a lot of other hedge fund operators into a corner. Many of them will not survive. Will Steinhardt?” Forbes, September 26, 1994.

  48. In a June 1995 letter to investors, Kovner announced that he would be returning $1.3 billion of Caxton’s $1.8 billion in assets under management after closing one of his two foreign funds, the $800 million GAM fund, and his $450 million U.S. fund. According to press accounts of the announcement, Kovner stated, “The lower liquidity in currency, fixed-income, and commodity markets hurt our performance.” (See Peter Truell, “A Big Hedge Fund Returns $1.3 Billion to Its Investors,” New York Times, June 9, 1995.) Louis Bacon’s Moore Capital also suffered withdrawals around this time; his poor performance was compounded by an acrimonious split with a senior lieutenant. The same went for Quantum: “We find that our size is hindering us,” Soros wrote to his clients. (Peter Truell, “Some Big Funds, Like Soros’s, Have Difficulty Despite Trend,” New York Times, July 27, 1995.) Those who returned capital to investors almost certainly did boost their performance over the ensuing years, since later research was to find an inverse correlation between size and investment returns. For example, in 2009 the software firm PerTrac Financial Solutions reported that between 1996 and 2008 hedge funds managing less than $100 million made 13 percent a year, compared with 10 percent for those running more than $500 million. (Stephen Taub, “The Hedge Rows of Wall Street,” p. 38.) Likewise, data from Rock Creek Capital, reported in chapter sixteen, reinforce the view that size is an impediment.

  49. The survey was conducted by Republic New York Securities and based on a modest sample of 130 hedge funds.

  50. The five-year performance data come from International Advisory Group, a Nashville-based consulting firm. A few years later, a paper from the Yale School of Management found that offshore hedge funds returned a bit less than the S&P 500 index: 13.3 percent from 1989 through 1995, compared with the benchmark return of 16.5 percent. But hedge funds appeared much less risky: The annual standard deviation of their returns was 9.1 percent, versus 16.3 percent for the S&P 500. Meanwhile, swings in the S&P 500 stock index explained only 36 percent of swings at hedge funds. See Stephen J. Brown, William N. Goetzmann, and Robert G. Ibbotson, “Off-Shore Hedge Funds: Survival and Performance 1989–1995” (Yale School of Management working paper no. F-52B, January 2, 1998.) Another paper, based on different data and looking at an overlapping period (1989 to 1998), confirmed that hedge-fund volatility was low. The annualized standard deviations of monthly returns for equally weighted and value weighted portfolios of all hedge funds were, respectively, 5.75 percent and 8.94 percent, much less than the standard deviation of the S&P 500, which was 13.2 percent. See Franklin R. Edwards, “Hedge Funds and the Collapse of Long-Term Capital Management,” Journal of Economic Perspectives 13, no. 2 (Spring 1999), p. 196. See also the positive finding for hedge-fund alpha reported in the conclusion.

  CHAPTER NINE: SOROS VERSUS SOROS

  1. See Andrew Meier, “Cursed Cornucopia,” Time, December 29, 1997; Paul Klebnikov, “A Company Built on Bones,” Forbes, November 6, 1995; Michael R. Gordon, “Siberia Tests Russia’s Ability to Profit from Privatization,” New York Times, December 9, 1997; Robert G. Kaiser, “Norilsk, Stalin’s Siberian Hell, Thrives in Spite of Hideous Legacy,” Washington Post, August 29, 2001.

  2. Paul Tudor Jones recalls, “I cross myself every time I think about that helicopter ride.” Paul
Jones, interview with the author, April 23, 2009.

  3. Thorpe McKenzie, interview with the author, August 15, 2008.

  4. Dwight Anderson, interviews with the author, August 26, 2008, and October 2, 2008.

  5. Arturo Porzecanski, an economist at Kidder Peabody in 1993, remembers trying to persuade his bank’s clients of the merits of buying Peru’s debt. Only hedge funds were prepared to set aside Peru’s record of default and act on Porzecanski’s argument. Arturo Porzecanski, interview with the author, June 24, 2008.

  6. Between the late 1990s and the mid-2000s, the benefits of these cross-border capital flows were underestimated by economists, whose empirical tests found little relationship between the openness of a country’s capital market and its growth rate. But in an article published in 2007, Peter Henry of Stanford punched a hole in this pessimistic consensus. By searching the data for a relationship between capital-account openness and the growth rate, economists had been setting the wrong test, Henry argued. The act of letting in foreign capital should be expected to create a one-off lowering of the cost of borrowing, and hence a few years in which dozens of new ventures could be financed; but once an economy had milked this advantage, it was likely to return to its original growth rate. Opening up to foreign capital, in other words, should be expected to create a permanent increase in the level of family incomes, since even if the economy returned to its original growth rate it would be growing from a higher base; but it should not be expected to lead to permanent acceleration in growth. Sure enough, when Henry looked for temporary growth effects, he found that they were powerful: In the three years after the stock market in a typical emerging economy opened up to foreign capital, the average annual growth of real wages in the manufacturing sector increased by a factor of seven. Henry checked his results against a control group of economies that had not opened up their stock markets. These experienced no such wage acceleration. See the introduction to Peter Blair Henry, “Capital Account Liberalization: Theory, Evidence and Speculation,” Journal of Economic Literature 45 (December 2007), pp. 887–935. For the sevenfold increase in manufacturing wages, see Peter Blair Henry and Diego Sasson, “Capital Account Liberalization, Real Wages and Productivity” (working paper, March 2008). Also relevant is Ross Levine, Norman Loayza, and Thorsten Beck, “Financial Intermediation and Growth: Causality and Causes,” Journal of Monetary Economics 46, no. 1 (2000). This paper finds that a doubling in the size of private credit in an average developing country is associated with a 2 percentage point rise in annual economic growth, meaning that after thirty-five years the economy would be twice as large as it would have been without ample opportunities to borrow.

  7. I am grateful to Gary Gladstein, the former chief administrative officer and managing director of Soros Fund Management, for these data.

  8. Arminio Fraga, interview with the author, June 6, 2008.

  9. Ibid.

  10. Ibid.

  11. The paper was by Graciela Kaminsky of the Federal Reserve and Carmen Reinhart of the International Monetary Fund. It was later published in the American Economic Review.

  12. Fraga interview.

  13. A participant at the meeting recalls, “It was really kind of a bombshell statement to make. Talk about being pathetically ignorant when you say that to the three guys from Soros.”

  14. Rodney Jones, interview with the author, June 18, 2008. Sources differ as to whether the Soros team established the initial position in late January or early February, but Jones, who kept real-time notes of the crisis and was focused exclusively on the region, is confident that the sales occurred in the last ten days of January.

  15. According to data subsequently released by the Bank of Thailand, the full measure of reserves, which includes forward-market operations, registered a fall of $4.4 billion in February. No forward data are reported for the change in January, but the $2 billion sale by Soros Fund Management appears to have driven a substantial proportion of the decline in Thai reserves in this period.

  16. Druckenmiller recalls, “When I shorted it, it cost nothing. Like the British pound the first time, like half a percent.” Stan Druckenmiller, interview with the author, June 4, 2008.

  17. On February 12, Rodney Jones, the Hong Kong–based Soros economist, wrote a memo to Druckenmiller and Soros, laying out Thailand’s acute vulnerability. The Thai central bank held only $36 billion in reserves. Moreover, the private sector owed $85 billion to foreigners who would want their money out in a panic. This implied that a determined attack on the baht by Druckenmiller would have quickly forced devaluation.

  18. It is also the case that Soros was not paying sufficient attention to Thailand to repeat the trick of 1992, when he had urged Druckenmiller to “go for the jugular.” Robert Johnson, the economist who had advised Soros and Druckenmiller on the sterling trade, ran into Soros at Davos at the end of January 1997. Soros appeared unsure whether the Thai trade was worth bothering with. Robert Johnson, interview with the author, July 29, 2008.

  19. Rodney Jones interview, June 18, 2008.

  20. “By selling the Thai baht short in January 1997, the Quantum Funds managed by my investment company sent a signal that it may be overvalued. Had the authorities responded, the adjustment would have occurred sooner and it would have been less painful. As it is, the authorities resisted and when the break came it was catastrophic.” George Soros, The Crisis of Global Capitalism (New York: Public Affairs, 1998), pp. 142–43.

  21. The extent of contact between Druckenmiller and Paul Jones is confirmed by people who worked at both funds. The size of Tiger’s position is recalled by Dan Morehead, who executed Tiger’s macro trades during this period. On the other hand, Rob Citrone, who was Tiger’s macro analyst, thinks the position was considerably larger—as big as $5 billion. Because of the way that Tiger worked, however, a trader is more likely to have known the real position than an analyst. Rob Citrone interview, September 30, 2009. Morehead interview, September 2, 2008.

  22. Rodney Jones, who tracked the reserves closely, put the leakage on May 14 at $6.5 billion. On the other hand, Paul Blustein, another careful observer, puts it at $10 billion. According to Thai central bank data, total loss of reserves in all of May came to $18.3 billion. See Paul Blustein, The Chastening: Inside the Crisis that Rocked the Global Financial System and Humbled the IMF. (New York: Public Affairs, 2001), p. 71.

  23. Rodney Jones recalls, “Soros did not go even bigger because of fear of crazy reaction. One did not know how that would play out. This was why the baht short could not be sized as aggressively as the sterling short in 1992. You were dealing with a developing country, and it was much harder to understand the reaction function.” (Rodney Jones, interview with the author, July 21, 2008.) In addition, David Kowitz recalls that he was worried in February about possible government countermeasures. “They were shooting bullets at us, making the thing strengthen, so we looked like we were losing a lot of money. It was a bit stressful, and I probably would’ve folded, but Stan Druckenmiller, he doubled down. It was a famous call.” (David Kowitz, interview with the author, August 26, 2008.)

  24. Morehead calculated this amount for a memo he wrote to his Tiger colleagues on June 3, 2007. Dan Morehead, interview with the author, September 2, 2008.

  25. Barry Porter, “BOT Out to Make Soros Pay for Attack; BOT and Soros Do Battle,” South China Morning Post, June 24, 1997, p. 1.

  26. Rodney Jones’s calculations were not far off. Data released later by the Bank of Thailand show that reserves fell by $18.3 billion in May, slightly less than the $21 billion that Jones estimated. As a share of total reserves, the fall in May was even larger than Jones thought, since total reserves at the end of the month, net of forward sales, came to only $5.3 billion.

  27. Morehead interview. Morehead was Robertson’s currency trader. His account fits with the memory of another currency trader at a different hedge fund who was deeply involved in Thailand. On the other hand, Rob Citrone, Tiger’s macro analyst, says he does not recall th
e episode; but Robertson did not always inform analysts of his actions. In any event, Tiger documents record that the fund was up an impressive 13.1 percent in July 1997, the month of the Thai devaluation. In a letter to investors at the end of the quarter, Robertson reported that the 29.3 percent gain in July to September mainly reflected two factors: profits in equities and in Asian currency trading. Julian H. Robertson, letter to the limited partners, October 7, 1997.

  28. According to data on central-bank reserves kept by Rodney Jones, the $1 billion of selling by Tiger would have accounted for two thirds of the decline in the reserves on the last day before the peg broke, implying that Tiger played a role akin to Quantum’s in sterling’s 1992 devaluation. Rodney Jones, interview with the author, February 9, 2009.

  29. The Soros team sold $500 million of its baht position in June 1997, some $2.5 billion in August and September, and another $500 million toward the end of the year. The positions had been created around January 20–24 ($2 billion) and around May 14–15 ($1.5 billion). Using average exchange rates for the six-month forward market, Paul Swartz of the Council on Foreign Relations calculates that Soros’s total earnings from the baht trade would have come to about $750 million. The estimate of Tiger’s profit comes from Dan Morehead, though again, Rob Citrone has a different memory: He believes the profits exceeded $1 billion. Morehead interview; Rob Citrone, interview with the author, September 30, 2009.

  30. David Kowitz recalls, “I don’t think he liked to be the bad guy. He wants to be remembered as a great statesman. Being blamed for the destruction of pathetic third-world countries wasn’t helpful for that.” Kowitz interview.

  31. Speaking in Hong Kong on September 21, Soros revealed that Quantum was long the rupiah, explaining that markets had overshot in the case of the Indonesian currency and that the Indonesian government’s consistent approach to reform gave him confidence. See Thomas Wagner, “Rubin Sees Promise in Southeast Asia, But Markets Fall Again,” Associated Press, September 22, 1997; AFX News, “Soros Says Mahathir ‘Menace’ to His Own Country,” September 22, 1997.