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

by Sebastian Mallaby

  32. Kowitz interview.

  33. Reflecting on the rupiah trade, Arminio Fraga recalls: “We often heard ‘These big speculators can go into these small markets and manipulate them for their profit,’ but we never saw it that way. For us it was always extremely dangerous. If you had made the wrong fundamental call and you went into something and you were caught wrong, usually you paid dearly to get out.” Arminio Fraga, interview with the author, June 6, 2008.

  34. Because Druckenmiller and Fraga had earned between $200 million and $300 million on smaller Asian currency trades during 1997, their Asian calls made money even though Thailand and Indonesia roughly canceled each other out. Among the smaller Asian trades, the most important was a short position on the Malaysian ringgit. Druckenmiller recalls that the short position was worth $1.5 billion but that he took profits early, when the ringgit started to fall, limiting the profit from the trade but also rendering false the inflated Malaysian rhetoric about the Soros funds’ hostility. Druckenmiller interview.

  35. Rodney Jones, memo to Stanley Druckenmiller, Arminio Fraga, and David Kowitz, November 17, 1997.

  36. Blustein, The Chastening, p. 4.

  37. Rodney Jones recalls, “Arminio [Fraga] called Stan Fisher [the number two at the IMF] after I had been there in Korea in November. Stan said the IMF staff had been there and they don’t think this is a problem.” Rodney Jones interview, July 21, 2008. On the other hand, Edwin Truman of the Federal Reserve recalls being in Seoul with Stan Fisher shortly after Jones’s visit. By this time, Fisher knew that South Korea was in trouble, making it less likely that his influence accounts for the Quantum team’s reluctance to short South Korea. Edwin Truman, correspondence with the author, December 22, 2009.

  38. Robert Johnson recalls, “George’s purpose for years was production, and it moved to distribution. He was intuitively a speculator, but his heart was all tied up in his philanthropy.” Likewise, Rodney Jones recalls, “Mahathir had done psychological damage. Soros no longer wanted to be the bad speculator.” Robert Johnson, interview with the author, July 29, 2008. Rodney Jones, interview with the author, July 21, 2008.

  39. Robert Johnson recalls, “George was accused of being the Trojan horse. People said his philanthropy in eastern Europe was really a Trojan horse for pecuniary gain. He was very sensitive about that. If the president invited him to Korea and then he bounced Korea, it would create a scar that might be permanent. He never went to Malaysia until well after the argument with Mahathir. Once he showed up somewhere in an official capacity, he started blanking out that part of the grid for those who were taking positions.” Robert Johnson, interview with the author, July 29, 2008.

  40. Kevin Sullivan, “Soros Buoys Korean Stocks; Market Climbs After Financier Calls Crisis Fixable,” Washington Post, January 6, 1998, p. D1.

  41. Between January 5 and January 15, the KOSPI index rose from 396 to 506.

  42. Sullivan, “Soros Buoys Korean Stocks.”

  43. Michael T. Kaufman, Soros: The Life and Times of a Messianic Billionaire. New York: (Knopf, 2002), p. 230.

  44. Commenting on the financial logic of Soros’s Svyazinvest stake, Gary Gladstein, managing director of Soros Fund Management at the time, says, “That was a terrible investment. We didn’t do much due diligence on it. George decided he wanted to take a position, because George operates from his gut and he felt good about it at the time.” Gary Gladstein, interview with the author, March 18, 2008.

  45. Looking back on the secret loan to Russia, Soros calls it “a somewhat questionable maneuver.” George Soros, interview with the author, June 10, 2008.

  46. George Soros, Soros on Soros: Staying Ahead of the Curve (New York: John Wiley & Sons, 1995), p. 143.

  47. Soros recalls, “I got involved because I was, in effect, betting the government was making the transition from robber capitalism to legitimate capitalism…. I was combining two considerations—a political one, which was to help to transform the economy into legitimate capitalism, and a financial one, which was to make a profit. Obviously, they didn’t combine well.” (George Soros, interview with New York Review of Books, January 14, 1999.) Equally, Robert Johnson comments, “He felt that if he was a beacon of investment in Russia, others would follow and the capital inflows would transform the society and integrate them into the G7. There’s a philanthropic side of George that started to interfere with the speculative one.” (Johnson interview.)

  48. On July 7, 1998, Julian Robertson wrote to his investors, “With yields at 102 percent, we are being well paid to take the risks of owning sovereign Russian debt.”

  49. Anderson interviews.

  50. Soros’s actions starting August 7 are described in his diary and reprinted in Soros, The Crisis of Global Capitalism, pp. 156–67.

  51. Soros recalls, “I called Larry Summers and said, ‘If they devalue and you give them a bridge loan, they could really put their house in order.’ And Larry said, ‘You are the only one advocating us getting in; everybody else tells us to pull the plug and get out.’ That’s when I wrote an article in the FT advocating my plan publicly. And then I was blamed for provoking the collapse.” George Soros, interview with the author, June 10, 2008.

  52. Gladstein marvels, “George went around saying that Russia was going to collapse. Meanwhile, we have this huge position in Russia that we can’t sell. We had Russian equities, bonds; we had Russian exposures all over.” Gladstein interview.

  53. The main victim of Soros’s Russia escapade was Stan Druckenmiller, who recalls: “Even though it was his trade, it became my position. You know, he always put his philanthropy and his statesmanship ahead of his money management. So 1998 was the first year when Soros Fund Management had a huge separation with Duquesne [Druckenmiller’s old hedge fund, which he still managed]. Duquesne was in the fifties and Quantum was only up twelve. That’s how devastating it was.” Druckenmiller interview.

  54. Soros, The Crisis of Global Capitalism, p. 168.

  CHAPTER TEN: THE ENEMY IS US

  1. By way of comparison, Morgan Stanley, a far larger institution, had earned just $1.0 billion in 1996. Eric Rosenfeld, presentation at Harvard Business School, April 22, 2009. Rosenfeld was a senior founding partner at LTCM.

  2. James Rickards, interview with the author, February 12, 2009; James Rickards, e-mail communication with the author, March 30, 2009. Rickards was LTCM’s chief counsel.

  3. Donald MacKenzie, An Engine, Not a Camera: How Financial Models Shape Markets (Cambridge, MA: The MIT Press, 2006) pp. 215–16.

  4. Other Wall Street houses hired quants around this time. For example, Fischer Black, the third inventor of the options-pricing formula, moved to Goldman Sachs in 1984. But Black and most other quants were kept off the trading floor. The difference at Salomon was that Meriwether brought Rosenfeld and the others into the heart of the action.

  5. Roger Lowenstein writes of Coats, “Tall, likable, handsome, bound to get along with clients. Sure, he had been a goof-off in college, but he had played forward on the basketball team, and he had trading in his heart.” (Roger Lowenstein, When Genius Failed: The Rise and Fall of Long-Term Capital Management, New York: Random House, 2000, p. 11.) For the juxtaposition of Coats and the Arbitrage Group, I am indebted to Michael Lewis, “How the Eggheads Cracked,” New York Times, January 24, 1999.

  6. Lowenstein, When Genius Failed, pp. 20, 21n.

  7. The phrase was coined by an LTCM employee. See Kevin Muehring, “John Meriwether by the numbers,” Institutional Investor, November 1, 1996.

  8. Like many hedge funds, Long-Term did not like to acknowledge that it was a hedge fund. “We had moved on from thinking of ourselves as a mere ‘hedge fund’ and had started to think of ourselves as a new kind of ‘financial technology company.’” (Rickards e-mail.) Lowenstein also reports that Merton saw Long-Term Capital not as a “hedge fund,” a term that he and the other partners sneered at, but as a state-of-the-art financial intermediary that provided capital to markets just as banks did. (Low
enstein, When Genius Failed, p. 30.)

  9. What follows on Italy is drawn partly from “Portfolio Outline,” an internal LTCM document that describes many of the firm’s positions at the time of liquidation, and partly from discussion with Eric Rosenfeld and an e-mail exchange with James Rickards, the former LTCM general counsel, and other sources.

  10. The foreign investor could get around the Italian tax obstacle by borrowing money from a local bank and using it to buy government bonds; the bank would hold on to the bonds as collateral. For the purposes of Italian tax law, the bank was deemed to be the owner of the bonds, so the tax problem was solved and the foreigner was left to collect high interest payments from the Italian government. Admittedly, the foreigner’s receipts from these bonds were set with a fixed interest rate, whereas its payments on its offsetting lira loan floated: If the floating rate rose, the trade would become a loser. But this mismatch was solved by converting the floating payment into a fixed one via the international swaps market. The final messiness was the risk that the Italian government might default, but there were opportunities to hedge that in the fledgling market for credit default swaps.

  11. Lowenstein, When Genius Failed, p. 77.

  12. The Italian government issued floating-rate bonds with a seven-year maturity, called Certificati di Credito del Tesoro (CCTs). These CCTs were off-limits to retail investors, who instead bought short-term Italian treasury bills called Buoni Ordinari del Tesoro (BOT). LTCM bought CCTs and shorted BOTs, betting on their convergence. See LTCM, “Portfolio Outline.”

  13. Ibid.

  14. Andre Perold, “Long-Term Capital Management, L.P. (A)” (Harvard Business School case study 9-200-007, November 5, 1999).

  15. Lowenstein, When Genius Failed, p. 90.

  16. Ibid., p. 84.

  17. What follows on risk management is drawn partly from Eric Rosenfeld’s draft article for the Encyclopedia of Quantitative Finance, ed. Rama Cont (Hoboken, NJ: John Wiley & Sons, 2010).

  18. To work out the worst loss on ninety-nine out of a hundred days, LTCM would take the standard deviation of a position, meaning the amount of variation from the mean that occurred in 68 percent of cases, and multiply by 2.58 to get the variation from the mean that occurred in 99 percent of cases. Thus, a position with a standard deviation of six basis points would not fall by more than about fifteen basis points in 99 percent of cases, or on ninety-nine days out of a hundred.

  19. Rosenfeld, Harvard Business School presentation. See also Perold, “Long-Term Capital Management.”

  20. For example, at the time of the Bank of China party, LTCM’s leverage was about nineteen to one—extraordinarily high relative to most other hedge funds. But, according to the firm’s calculations, LTCM’s value at risk was $720 million, and its $6.7 billion in capital was more than enough to absorb that. See Perold, “Long-Term Capital Management.”

  21. Many hedge funds borrowed cheaply by financing positions in the repo market with overnight money. Long-Term was willing to pay more in order to lock the money up for six to twelve months. It also arranged a three-year loan and a standby credit. Rosenfeld presentation; Perold, “Long-Term Capital Management.”

  22. Having done its best to lock up capital in these ways, LTCM calculated the residual liquidity risk, gaming out scenarios in which its brokers changed the terms of their lending. For example, rather than lending LTCM 100 percent of the money it needed to buy Italian government bonds, the brokers might demand that Long-Term put up “margin,” or capital, equivalent to 5 percent of the value of its positions. To withstand that sort of shock, LTCM made sure to hold emergency reserves of capital. Thus, in September 1997 the firm was using less than $1.7 billion in working capital to meet margin requirements imposed by its brokers, while its total working capital came to $7.6 billion.

  23. Rosenfeld observed, “Everyone else started catching up to us. We’d go to put on a trade, but when we started to nibble, the opportunity would vanish.” Lewis, “How the Eggheads Cracked.”

  24. It is not in fact clear that LTCM’s Royal Dutch/Shell trade really was a case of overreach. It is true that arbitrage in stocks was different from arbitrage in fixed income. Whereas convergence in bond prices must happen by the time the bonds mature, there is no such forcing event in stocks: The gap between Royal Dutch Petroleum and Shell Transport had existed for years and might exist forever. It is also true that LTCM staked a huge $2.3 billion on its position, a size that even aggressive trading desks viewed as outlandish. For example, the Goldman Sachs proprietary trading desk bet one tenth as much as LTCM on the Royal Dutch/Shell convergence. But LTCM felt able to make such a large bet because it could finance it more cheaply than its rivals. This allowed it to hold the trade with a view to capturing the “carry” resulting from the gap in dividend yield, rather than holding it in the hope that the two stocks would converge. Its rationale for putting on the trade was different from that of other trading desks, which is why it did it on a larger scale. Even with the benefit of hindsight, and even while acknowledging errors in LTCM’s risk management, Eric Rosenfeld views the Royal Dutch/Shell trade as sound. (Eric Rosenfeld, interview with the author, April 16, 2009.) For a critical view of LTCM’s position, see Lowenstein, When Genius Failed, p. 100.

  25. Lowenstein, When Genius Failed, p. 126.

  26. Rosenfeld interview. Relatedly, Rosenfeld explains that Long-Term’s partners debated the question of whether they should reduce the size of their trades in light of the fact that profit opportunities were smaller than in 1994–96. They concluded that this was not their job: Investors expected them to incur risk of a specified and constant size, not to exercise discretion in taking risk on and off. If investors had wanted to reduce risk, they could have withdrawn funds from LTCM.

  27. Rosenfeld, Harvard Business School presentation.

  28. Rosenfeld interview.

  29. LTCM made money on swap spreads in 1997 by going long Treasuries and betting on the spread broadening. In 1998 it was short Treasuries and betting on the spread narrowing. See Perold, “Long-Term Capital Management.”

  30. Rosenfeld, Harvard Business School presentation.

  31. Rosenfeld interview. Similarly, Rickards recalls, “I was on vacation in North Carolina with my family and it was a Friday. Then I got a call from Jim McEntee, and he said, ‘Jim, there’s a partners’ meeting on Sunday. I think you ought to be here.’ So we got in the car and drove home. This was a group that liked to play golf. There was nothing normal about a Sunday meeting. And then we just worked for seven weeks almost nonstop after that.” Rickards interview.

  32. Gary Gladstein, managing director of Soros Fund Management, recalls, “Meriwether came in offering us a very attractive deal with reduced fees and certain percentage of the firm.” (Gary Gladstein, interview with the author, March 18, 2008.) Druckenmiller recalls, “We were out of our own pond, and we really didn’t know what we were doing, so we didn’t do it.” (Stanley Druckenmiller, interview with the author, June 4, 2008.)

  33. Lowenstein, When Genius Failed, p. 153.

  34. Rickards recalls, “What you realize [when you suddenly need to raise capital] is that everybody will see you. They might not have any intention of investing with you, but to them it’s information. You’re the desperate ones, so you’re like, ‘What do you want to know?’ We had had high-quality operational security for four years, and all of the sudden we’re pouring our hearts out.” Rickards interview.

  35. Gary Gladstein, managing director of Soros Fund Management, recalls of this period, “The major bank we dealt with was Kleinwort Benson. Kleinwort had been acquired by Dresdner. The CEO of Dresdner made this comment in Europe that he didn’t have any exposure to hedge funds. Then he finds out that he has major exposure to hedge funds because Kleinwort Benson is doing most of the financing for us. So immediately he said that Kleinwort had to close down the account.” Gladstein interview.

  36. Rosenfeld interview.

  37. The imitators were legion. One upstart
named Convergence Asset Management launched in January 1998 and raised $700 million in a single month from investors who had been shut out of LTCM, and by the summer of that year, LTCM-style funds were said to account for a quarter of all swaps trading in London. The hedge-fund manager (and future TV celebrity) James Cramer recalled, “I can’t believe how many times I was told to do a trade because the boys at Long-Term deemed it a winner.” MacKenzie, An Engine, Not a Camera, p. 228.

  38. The quote comes from Richard Leahy, a Long-Term partner. See Lewis, “How the Eggheads Cracked.”

  39. Rosenfeld, Harvard Business School presentation.

  40. Lowenstein, When Genius Failed, pp. 156–57.

  41. Rickards recalls, “The whole world knew. So now you could start to trade against us, whereas before if you were on the other side of a trade from LTCM, you might not like it. Now, it’s like, ‘Okay, these guys are going to die. Figure out what they have and trade against it.’” Rickards interview.

  42. MacKenzie, An Engine, Not a Camera, p. 234.

  43. Meriwether observed: “I like the way Victor [Haghani] put it: The hurricane is not more or less likely to hit because more hurricane insurance has been written. In the financial markets this is not true. The more people write financial insurance, the more likely it is that a disaster will happen, because the people who know you have sold the insurance can make it happen. So you have to monitor what other people are doing.” See Lewis, “How the Eggheads Cracked.”

  44. “When we engaged Goldman, a couple of things happened. I’m the lawyer, so I said, ‘I need you guys to sign a nondisclosure agreement.’ They’re like, ‘No way. You’re desperate; we’ll help you, but we’re not signing anything.’ Typical Goldman. So I say okay. I didn’t have a lot of leverage. So they came in and they literally, in front of our eyes, downloaded our positions and took them back to their headquarters.” Rickards interview, February 12, 2009.