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

by Sebastian Mallaby

  When Druckenmiller eventually accepted, Robert Soros’s derisive welcome on the lawn seemed at first to be well founded. Quantum’s incumbent analysts, who included some earlier “permanent successors,” clashed with the new pretender to the throne, never mind the fact that he was built like the pro footballers he loved to watch on Sundays. To make matters worse, Soros seemed to regard Druckenmiller as an S&P 500 specialist, even though he had traded bonds and currencies as well as equities. One evening in August 1989, Druckenmiller flew to Pittsburgh, where he still maintained Duquesne, and discovered that his bond position at Quantum had been sold out behind his back. He called up Soros and exploded down the phone. There was no way he could succeed with a boss who second-guessed him.5

  “I feel cramped by your presence,” Druckenmiller was yelling at Soros. “I’m intimidated and I feel dissatisfied because I don’t think I’m doing as well as I could.

  “I want to leave,” he said finally.

  That outburst might have ended Druckenmiller’s tenure at Quantum. But instead it provoked one of the best Soros gambles ever.

  “Don’t leave,” Soros responded. “I’ll leave.”

  Showing a coolness that was all the more remarkable given that he owned much of the money in Quantum, Soros moved his family to London. “I’m going to Europe,” he told Druckenmiller as he went. “Now we’ll find out whether I’ve just been in your hair too much or whether you really are inept.”6

  The next few months gave Soros ample reason to feel pleased with his gamble. The Berlin wall came down, and the move to London gave him the freedom that he craved to focus on philanthropy in eastern Europe. Meanwhile, the collapse of the wall created the sort of market turbulence that Druckenmiller relished, and his returns entered an astonishing period. He was up 31.5 percent in 1989, followed by 29.6 percent, 53.4 percent, 68.8 percent, and 63.2 percent in the next four years; he was like Bob Dylan in the midsixties, producing one hit album after the next, as a colleague put it.7 Assets in Quantum leaped from $1.8 billion to $5 billion, and Soros Fund Management opened new funds alongside its flagship, so that by the end of 1993 its total assets under management had soared to $8.3 billion.8

  Soros had the sense to recognize his good fortune. He learned a lesson from Druckenmiller’s early outburst and took care not to undermine him; he had wanted a permanent successor, and he had been lucky to find a talent like this one. Throughout the 1990s, Soros behaved as the younger man’s coach; he prodded his protégé with questions and advice, but he left him to pull the trigger. To satisfy the craving to make his own bets, Soros retained a pot of capital that he traded on the side, but Druckenmiller was firmly in control of the much larger Quantum fund.9 If journalists continued to attribute Quantum’s success to Soros, that was partly because Soros did little to discourage their error—and partly because Druckenmiller detested the limelight as intensely as Soros enjoyed it.10

  From the moment Soros moved to London, Druckenmiller’s approach was an extension of the coach’s. He had absorbed the teachings in Alchemy and had spoken to Soros continually for two years; he had learned everything there was to learn about his methods. Following Soros’s practice, Druckenmiller invested Quantum’s capital in a long/short equity portfolio, then used borrowed capital to trade S&P 500 futures, as well as bonds and currencies. Following Soros’s practice too, Druckenmiller stayed in touch with company executives, reckoning that on-the-ground stories from firms could provide early warning of trends in the economy. And following Soros’s practice, Druckenmiller seized opportunities with both hands. If there was one thing that the disciple had learned from the master, it was to pile on with all you’ve got when the right moment presents itself.11

  Soon after Soros decamped with his family to London, the collapse of the Berlin wall created such a moment. Joyful East Germans flooded into the freer and richer West, expecting jobs and social benefits; the associated costs seemed certain to force the German government to run large budget deficits. Other things equal, budget deficits fuel inflation, eroding a currency’s value; based on this logic, traders dumped deutsche marks after the wall came down, and the currency dipped against the dollar. But Druckenmiller took a different view. He recalled the passage in Alchemy on Reagan’s early budget deficits: Rather than weakening the dollar, those deficits had indirectly strengthened it.12 The reason was that Reagan’s loose budgets were offset by tight policy from the Fed; high interest rates encouraged investors to hold money in dollars, strengthening the currency. Druckenmiller saw that Germany would follow the same pattern. Loose budgets would drive Germany’s hawkish central bankers to raise interest rates, and the deutsche mark would rally. And so, after the wall fell, Druckenmiller went headlong into the German currency, buying a $2 billion position in the space of a few days. Over the course of the next year, the mark rose by a quarter against the dollar.13

  The beauty of this trade was that it built on a version of Paul Tudor Jones’s insight: If you understand the other players in a market, you can identify trades with hugely attractive risk-to-reward ratios. Jones’s early specialty was to see how private traders were positioned; but Druckenmiller was onto a bigger and more attractive game—understanding governments. Central banks, in particular, could be a gift to a trader. Their intentions were often evident—the Bundesbank, for example, made no secret of its determination to fight inflation—and their actions could move markets. In November 1989, it was enough for Druckenmiller to see that the Bundesbank would raise interest rates. This fact alone would be sufficient to create a trend that he could ride profitably.14

  The Deutsche mark trade fueled Quantum’s 29.8 percent return in 1990; but it was merely a dress rehearsal. Two years later, Druckenmiller staged the greatest coup of his career, shattering the European monetary order and establishing hedge funds as a rising force in global finance.

  GERMAN UNIFICATION DID NOT MERELY CAUSE THE Bundesbank to act in a deliciously predictable manner. It exposed the central bank’s conflicted role as the anchor of the deutsche mark and simultaneously of Europe’s exchange-rate mechanism. This system had been set up in 1979 to dampen currency fluctuations within Europe, allowing companies to invest and trade without worrying that wild exchange-rate swings would upend their business models. For more than a decade, the mechanism worked well, stabilizing currencies without going to the extreme of unifying them. Participating currencies were allowed to move against one another within narrow bands; and if that flexibility was not enough, a country could negotiate devaluation with its European partners. These rules afforded national governments some room to use interest rates to manage their economic cycles. The system balanced the objectives of exchange-rate stability on the one hand and interest-rate flexibility on the other.

  German unification strained this compromise. It created inflationary pressure within Germany, pushing the Bundesbank to raise interest rates. But the German rate hikes came at a time when other European economies were experiencing a recession that cried out for lower interest rates. High interest rates in Germany coupled with relatively low rates elsewhere caused money to flow into deutsche marks; as a result, the weaker European currencies, notably the Italian lira and the British pound, traded near the bottom of the band permitted by the exchange-rate mechanism—and threatened to break out of it. This presented Europe’s governments with two options. Germany could cut its rates in order to attract less capital, while the Italians and British did the opposite. Or central banks could intervene in the currency markets, selling marks and buying lire and pounds. If both interest-rate adjustment and currency intervention failed, Italy and Britain would be forced into devaluation.

  In the summer of 1992, Druckenmiller began to ponder these tensions. He was particularly focused on Britain, where a young Quantum portfolio manager, Scott Bessent, had studied the volatile housing sector and shorted several of the stocks in it. Bessent pointed out to Druckenmiller that interest rates on British mortgages were generally not fixed; when the Bank of England raised
rates, families felt the pinch immediately in their home payments. Because of this transmission mechanism, high German interest rates would put Britain in an especially tight bind. If the Bank of England raised rates to protect the pound’s position within the exchange-rate mechanism, the instant hit to mortgage payers would dent consumption at a time when Britain was already in recession.

  Druckenmiller saw an opening for one of those bets that could scarcely go against him. There was a significant chance that the British authorities would balk at higher rates and allow sterling to devalue. On the other hand, there was virtually no chance that sterling would rise against the deutsche mark; with Britain’s economy in the doldrums, the Bank of England would certainly not raise rates more than it had to. Seizing on this asymmetrical bet, Druckenmiller loaded up on deutsche marks and sold pounds, investing $1.5 billion in this position by the end of August.15

  Thus far the sterling trade had employed three Druckenmiller skills. It involved, first, an appreciation for equity research as a source of insights into economic trends; like Soros, but unlike the Commodities Corporation trio, Druckenmiller focused on companies as an important harbinger of an economy’s performance. It involved, second, an understanding of currencies and interest rates; like Soros, but unlike Julian Robertson, Druckenmiller was an equity trader who was equally at home trading other instruments. And it involved, finally, an eye for the institutional factors that created bets with good risk-to-reward ratios: Just as Paul Jones had seen the asymmetrical bet created by the expectation that Japanese fund managers should clear a hurdle of 8 percent per year, so Druckenmiller grasped the significance of Britain’s floating mortgage rates. But the next stage of the sterling bet drew upon a different talent. It required Druckenmiller to understand the financial politics of Europe, starting with the pressures that swirled around the Bundesbank.

  Ever since the hyperinflation that had fueled Hitler’s rise, the Germans had prized monetary stability. In the United States, the Federal Reserve’s statutory mandate requires it to target both low inflation and full employment; in Germany, the Bundesbank’s mission was exclusively to fight inflation. For this reason, it was clear that the Germans’ first instinct would be to refuse to cut interest rates so long as the costs of reunification were causing budget deficits; and if Germany hung tough, the pressure on sterling would grow ever greater. But there was at least a chance that, for political reasons, the Bundesbank would soften its stance. Europe’s leaders had recently signed the Maastricht Treaty, which envisaged the eventual creation of a single European currency, the euro. Germany’s government supported this project. It would have to think twice before fighting inflation with such zeal that Europe’s monetary order splintered.

  When Druckenmiller made his first bets against sterling, it was not obvious how the Bundesbank would weigh its traditional anti-inflation stance against its responsibility toward Europe. But German intentions soon became clearer. On September 4 and 5, European Community finance ministers and central-bank officials met in the pretty English town of Bath. Desperate to create space for lower British interest rates, and egged on by Italian and French counterparts who were also battling recession, the British finance minister, Norman Lamont, pressed repeatedly for an easing of German monetary policy. He banged his fist on the table and shouted at Helmut Schlesinger, the Bundesbank president: “Twelve finance ministers are all sitting here demanding that you lower your interest rates. Why don’t you do it?”

  Schlesinger was so shaken that his first instinct was to walk out. He prized the independence of the Bundesbank, to which he had devoted his career; he resented political pressure, especially from a foreigner. When Schlesinger eventually recovered his composure, he ventured that, although he didn’t plan to cut interest rates, he saw no reason to raise rates, either. Lamont seized upon this statement and presented it to the media as a concession, even though nobody expected interest rates to rise anyway.16

  In a pattern that was to repeat itself over the next few days, Lamont’s overreach infuriated Schlesinger. The Bundesbank president felt compelled to correct the impression that he had compromised his institution’s independence. On September 8, after a central bankers’ gathering in Basel, Schlesinger declared publicly that he could make no guarantees about the future course of interest rates. Far from conceding that Germany would modify its monetary policy to make life easier for its neighbors, he warned that he had little confidence in the fixed relationships among European currencies. As if to underline the point, Schlesinger alluded particularly to the unsoundness of the Italian lira.

  Seated in the audience as Schlesinger made his remarks was none other than George Soros. To make sure he had heard the Bundesbank president correctly, Soros approached him after the speech was done. To gauge the German commitment to European harmony, Soros asked Schlesinger what he thought of the ECU, the notional European currency that preceded the euro. Schlesinger replied that he liked the concept of a European currency but didn’t like “ECU” as a name. He would have preferred to call it the mark.

  Schlesinger’s answer was as clear as Soros could have wished for.17 The Bundesbank was open to the idea of monetary union, but not at any price; its first priority was to preserve the proud tradition of the inflation-proof deutsche mark, and if other economies could not stomach the austerity that this implied, well, then they should devalue. Soros suspected that Schlesinger would be perfectly content to see his hard line on inflation sabotage the plans for European monetary union, since that union would involve the creation of a European central bank, which would supplant the Bundesbank.18 All bureaucracies are motivated by self-preservation, Soros reflected; and Schlesinger, a career Bundesbank official, was surely the personification of this tendency. In a state of some excitement, Soros called Druckenmiller in New York and told him that the lira was heading for a fall. Druckenmiller quickly added a bet against the Italian currency to his existing bet against sterling.19

  When Soros returned to New York, he called Robert Johnson, a currency expert who was in the process of moving from Bankers Trust to Soros Fund Management. Soros was convinced that the lira was going down, but now he was looking beyond that. Perhaps the rules of Europe’s game were changing.

  “What do you think about sterling?” Soros asked.

  “I think I better come and see you,” Johnson answered. He did not want to keep talking on the phone because Bankers Trust recorded its traders’ conversations.

  Johnson took a cab to the run-down Soros offices at 888 Seventh Avenue. There was duct tape on the carpet and a couple of screens by Druckenmiller’s desk. Johnson, Soros, and Druckenmiller sat around a small conference table.

  Soros asked Johnson to describe the risks in betting against sterling.

  “Well, sterling is liquid, so you can always exit losing positions,” Johnson responded. “The most you could lose is half a percent or so.”

  “What could you gain on the trade?” Druckenmiller asked.

  “If this thing busts out, you’d probably make fifteen or twenty percent,” Johnson answered.

  “How likely is that to happen?” Druckenmiller pressed.

  “On a three-month time frame,” Johnson responded, “about ninety percent.”

  By now Druckenmiller and Soros were looking at each other. They could hardly stay sitting in their chairs.20

  “How much would you do in your own fund?” Soros asked, referring to a portfolio that Johnson ran for Bankers Trust.

  Johnson indicated that he would leverage himself up to take advantage of this trade. He might do three to five times capital.

  “Oh my God,” Druckenmiller said quickly. His eyes had widened and his huge frame was taut. You could almost hear the big inhale that a basketball player takes before he springs for the basket.

  “Well, they only have twenty-two billion pounds’ worth of reserves,” Johnson continued, a sum equivalent to some $44 billion. Quantum could only sell sterling so long as someone was willing to buy it. Given Schle
singer’s comments, there were few private buyers left; the main buyers were the Bank of England and other central banks that were trying to support sterling. Once the Bank of England ran out of reserves, it would be impossible to place further bets against sterling. So $44 billion might be the limit.

  “Maybe we can get fifteen of that,” Druckenmiller said. He was suggesting that he might multiply his existing sterling bet fully ten times over.21

  “How long do you think they can hold out?” Soros asked.

  Not more than a few months, Johnson estimated.

  Then Druckenmiller got Scott Bessent on the conference phone to ask his opinion. Bessent went even further than Johnson. The British government had no stomach for higher interest rates. Given a choice between an even deeper recession and devaluing the pound, the government would choose devaluation.22 The British might let sterling go sooner than anyone expected.

  Johnson left the meeting with a sense of premonition. He could feel the coiled energy of the two men. When the right moment came, they would destroy the British currency.23

  THE NEXT FEW DAYS MARKED A WATERSHED IN THE RELATIONSHIP between governments and markets. A financial tidal wave broke across Europe, demonstrating how huddles of traders in midtown Manhattan could have consequences globally. Druckenmiller and Soros were the central players in this drama, but they were not the only ones. Other hedge funds that traded currencies, including the Commodities Corporation trio, joined in the attacks on Europe’s weaker currencies; so did the trading desks of banks and the treasury departments of multinational companies. Through the 1970s and 1980s, nobody had imagined that these private players could overwhelm powerful central banks—the Plaza accord of 1985 had confirmed governments’ influence over exchange rates. But since the mid-1980s, cross-border flows of money had roughly tripled.24 Hedge funds and other players now commanded large war chests, and the balance of power had shifted. In August 1992, the administration of George H. W. Bush orchestrated the concerted purchasing of dollars by eighteen central banks. But by now so much private capital was sloshing through the currency markets that the central banks’ efforts failed to budge the dollar.25