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

by Sebastian Mallaby

  The allegations of market manipulation should not have been the only public concern about the shadowbanks, however. To an extent that was generally not realized at the time, hedge funds were changing monetary policy. As they responded to the Fed’s low short-term rates by aggressively buying longer-dated Treasuries, the link between short-term and long-term interest rates grew tighter. A cut in the Fed’s rate, which in the old world might have taken weeks to feed through into lower long-term rates, now fed through a lot faster. In some ways this could be a good thing: If the Fed wanted to stimulate the economy, it was helpful that hedge funds chased long bond rates downward. But the new world could be dangerous too. The bond market might respond to the Fed quickly, but the real economy was bound to lag. If the Fed held interest rates down until Main Street began to feel the benefits, Wall Street was likely to inflate a giant bond bubble.

  Moreover, such bubbles threatened to be newly scary. A world in which hedge funds could corner a Treasury auction was a new kind of world: a world built on breathtaking leverage. The American system was pyramiding debt upon debt: The government was borrowing from hedge funds, which in turn borrowed from brokers, which in turn borrowed from some other indebted somebody. If one player in this chain collapsed, the rest could lose their access to those borrowed funds. That could force them to dump assets fast. A bubble could burst instantly.

  At the start of 1994, this prospect was not on anybody’s mind, least of all Michael Steinhardt’s. In January he authorized one of his lieutenants to buy a staggering position in Canadian bonds, adding to the bets he already had in the United States, Japan, and Europe. Then, together with his wife and friends, he headed off to China on another vacation.

  ON JANUARY 21, 1994, FEDERAL RESERVE CHAIRMAN Alan Greenspan made his way over to the White House. Fueled by low interest rates, the economy had first recovered and then grown smoothly for thirty-four consecutive months, but now Greenspan was visiting President Clinton and his entourage to deliver an unwelcome message. Even though inflation was quiescent, it was time to preempt its resurgence with a small rate hike. By acting early, Greenspan hoped to avoid the overheating that would force him to slam on the brakes later. He aimed to pilot the economy toward a “soft landing.”

  “Wait a minute!” Vice President Gore objected. In the past, a small rate hike had signaled the beginning of a long series: In 1988–89, the Fed’s short-term rate had gone from 6.5 percent to nearly 10 percent in a dozen small increments. If the markets expected the same this time, long rates might shoot upward in anticipation of more tightening to come. The bond market would crash. The hard landing that Greenspan said he wanted to avoid might become a reality.11

  Gore was raising the sort of question that Greenspan loved to answer. The Fed chairman had spent much of his career as an economic consultant in New York; more than most Washington figures, and perhaps more than the British mandarins who had lost the battle over sterling, he understood the markets. The possibility that a rate hike might cause a nasty Wall Street backlash was one he had certainly considered, but he was focused above all on the reaction in the stock market. Having entered record territory in 1993, the S&P 500 index appeared ripe for a correction. The bond market seemed to be of secondary importance.

  Greenspan assured Gore that long-term interest rates were governed mainly by inflation expectations. If the Fed raised short rates, it would signal that the authorities were going to be vigilant on price pressures. The result would be lower inflation expectations, which in turn ought to mean lower long-term interest rates. The rate hike that Greenspan proposed should be bullish for the bond market.

  A fortnight after that exchange with the vice president, on February 4, 1994, Greenspan presided over the next meeting of the Fed’s interest-rate committee. He proposed to head off inflation with a gentle rate hike of twenty-five basis points, from 3 percent to 3.25 percent; more than that risked triggering a backlash from the traditionally volatile stock market.12 In comments that would later seem a touch too confident, Greenspan instructed his colleagues on the ways of investors. “I’ve been around a long time watching markets behave and I will tell you that if we do 50 basis points today, we have a very high probability of cracking these markets,” he cautioned. “I think that would be a very unwise procedure.”13

  Greenspan’s sense of the stock market was right. After the Fed announced its quarter-point rate hike, the S&P 500 index dipped, precisely the sort of gentle correction that the Fed chairman had wanted. But Greenspan’s assurances about the bond market proved mistaken. He had told Gore that a hike in short-term rates would calm inflation fears, which logically would allow long-term rates to ease. Instead, the Fed’s twenty-five-basis-point tightening produced a swift increase of the same magnitude in the ten-year Treasury rate. Something mysterious was stirring.14

  In the era before shadowbanking, Greenspan’s reassurances might have proved justified. But the new shadowbanks were not as focused on inflation as the Fed chairman expected. The way the shadowbankers saw things, the first Fed hike in half a decade created uncertainty, and uncertainty meant risk; and because even a small fall in the bond market could wipe out the thin capital base of leveraged hedge funds, the mere possibility of a fall forced them to reduce risk by selling part of their holdings. The new logic of leverage changed the central-banking game. In response to the rate hike, the shadowbanks dumped bonds and forced long-term interest rates up—the opposite of what Greenspan had expected.

  A week after the Fed’s action, on Friday, February 11, there was another shock to the bond market. Trade talks between the Clinton administration and Japan broke down, with the American side seeking revenge by signaling that a stronger yen would be in order. Within a week, the yen had jumped 7 percent against the dollar, wrong-footing several hedge funds. Stan Druckenmiller had an $8 billion bet against the yen, a position almost as massive as his wager against sterling; in the space of two days, he lost $650 million.15 According to the traditional central-banking logic, this should have had no impact on inflation expectations and bonds, but the sheer scale of hedge-fund leverage ensured a vicious chain reaction. Losses from the yen shock forced hedge funds to dump assets and raise capital; and since hedge funds held a lot of bonds, the bond market was knocked backward. Over the course of the next two weeks, the ten-year Treasury yield jumped more than a quarter of a percent.16 A world in which hedge funds traded everything was a world of unpredictable connections.

  The next victim was Europe. In February the central banks of Germany, Britain, France, and Belgium had pushed short-term rates downward, signaling that they saw no inflation risk and hence little reason for long rates to move upward. But in the aftermath of the yen shock, traders’ logic asserted itself once again. Europe’s long-term interest rates spiked up: In the space of a fortnight, the yield on the German government’s ten-year bonds rose by thirty-seven basis points, Italy’s rose by fifty-eight basis points, and Spain’s rose by sixty-two.17 Hedge funds and banks’ proprietary trading desks had lost money on U.S. Treasuries and the yen. They were responding by dumping European bonds, never mind the continent’s economic fundamentals.

  Once hedge funds began to flee Europe, the stampede built on its own momentum. Brokers that had been willing to lend freely to the shadowbankers suddenly reversed themselves now that their trades were going wrong: Rather than accepting $1 million of collateral, or “margin,” to back every $100 million of bonds, the brokers demanded $3 million or $5 million to protect themselves from the danger that a hedge fund might prove unable to repay them. To meet the brokers’ margin calls, hedge funds had to liquidate holdings on a grand scale: If you are leveraged one hundred to one, and if your broker demands an extra $4 million in margin, you have to sell $400 million worth of bonds—quickly. As hedge funds liquidated bond positions, the selling pressure drove their remaining holdings down, triggering yet further margin calls from brokers. The scary pyramiding of debt, which had fueled the bond bubble in good times, now accelerated its
implosion.

  Some two weeks after the yen shock, on March 1, yet more bad news buffeted the markets. New data suggested that U.S. inflation was more of a threat than had been feared; in keeping with the Greenspan view, the yield on ten-year Treasury bonds jumped by fifteen basis points. But although economic logic explained the reaction in the United States, no such logic could explain what happened next: Bond markets in Japan and Europe cratered. Far from being spooked by an expected surge in inflation, Japan was grappling with the threat of deflation, and yet ten-year Japanese interest rates jumped by seventeen basis points on March 2. As brokers issued yet more margin calls to hedge funds, the logic of leverage transmitted the trouble to Europe. In order to raise capital, hedge funds off-loaded an estimated $60 billion worth of European bond holdings, and long-term interest rates spiked upward.18

  The frenzy of selling created sharp losses across Wall Street. Paul Tudor Jones, whose great strength was to sense how other traders were positioned, failed to spot the danger in Europe, and in the spring of 1994 his fund was down sharply. The same went for the other members of the Commodities Corporation trio, Bruce Kovner and Louis Bacon. David Gerstenhaber, the macro trader whom Julian Robertson had hired in 1991, was by now running his own hot fund; he blew up spectacularly. Proprietary trading desks did badly too; in 1994, Goldman Sachs experienced its worst year in a decade. The insurance industry was reckoned to have lost as much money on its bond holdings as it had paid out for damages following the recent Hurricane Andrew; “I’m starting to call this Hurricane Greenspan,” quipped one insurance analyst.19 For a few hours on March 2, no less a firm than Bankers Trust teetered on the brink of bankruptcy. Trading was suspended on the New York Stock Exchange, and New York Fed president William McDonough phoned top bankers up and down Wall Street in an attempt to rally confidence. Ultimately, Bankers Trust survived. The storm of deleveraging had pushed a Wall Street powerhouse to the edge, but it had not pushed it over—at least not this time.

  The greatest casualty of the bloodbath was none other than Michael Steinhardt. He had returned from his vacation in China to find that the U.S. bond market had sold off, and he had suffered modest losses. His biggest bets were in Japan, Canada, and especially Europe, where he had accumulated an astonishing $30 billion bond portfolio; he consoled himself that the Fed’s tightening in the United States would not hit foreign markets too severely. But then the logic of deleveraging kicked in, and every bond market was whipsawed. For Steinhardt’s vast and leveraged portfolio, each basis-point move upward in European interest rates entailed a $10 million loss; and by the end of February, he had bled a stunning $900 million.20 He was down almost 20 percent, and his troubles were not yet over.

  Steinhardt had not merely misjudged the markets’ direction; he had misjudged their liquidity. The supposed beauty of macro trading, remember, was that bond and currency markets could absorb huge quantities of capital—far more than individual stocks could. In the boom years of the early 1990s, hedge funds and other foreign traders had encountered no difficulty in establishing vast positions in European bonds: They had bought up about half of Germany’s government and government-guaranteed bonds, for example. But they had been able to accumulate these positions without moving the price adversely for a simple reason: They were building their holdings gradually, and if a particular bond proved difficult to buy, they had no problem waiting a few days for another opportunity. But when a shock hit the markets and brokers issued margin calls, hedge funds had to sell out in a rush—and at exactly the same time as others were rushing to sell also. Everybody scrambled to sell to everybody else. The liquidity was gone. Nobody was buying.

  In the old days of equity block trading, Steinhardt had known the brokers personally; he could rely on them even in a serious crisis. He was, after all, a major client; they wanted to keep his business. But Europe’s bond markets were a different game. Steinhardt was dealing with brokers based a continent away—anonymous voices in a different time zone. The European bond brokers didn’t know Steinhardt and he didn’t know them. When the liquidity crunch came, they were not willing to help Steinhardt get out of his positions.

  Seated at his bow-shaped desk, staring at seven blinking computer screens, Steinhardt witnessed the implosion of his fund. He had a desperate sensation of not being able to catch his breath; it was as though he were drowning.21 He ate little and slept less; known for his explosive blowups, he now took to conferring in whispers with his top lieutenants behind closed doors as his traders fought to get out of their positions. The traders seemed to think that if they waited, there would be a better opportunity to sell. But prices kept falling like stones. Everybody was looking for a bid, but the market seemed to consist exclusively of sellers.

  John Lattanzio, a veteran Steinhardt lieutenant, marched over to the firm’s bond trading desk.

  “Just sell ’em!” Lattanzio barked. This was no time to wait for a good price. “Just sell ’em!”

  “I can’t,” the trader answered flatly.22

  Seeing no other way forward, Steinhardt resolved to dump his bonds at any price—even if that meant offering up the sort of discounts that he used to extract from block sellers of equities. At the end of a four-day selling burst in early March, his traders had dumped $1 billion in European bonds.23 Meanwhile, the battle to escape Japan and Canada continued. The Canadian central bank would periodically call up nervously to ask whether Steinhardt’s traders were done selling.

  Steinhardt had fallen into a trap that would come to be well known in the new leveraged markets. He had failed to sense when a trade had become crowded. In a world in which a broker’s margin call could force leveraged funds into fire sales, the key was to beware markets in which leveraged players were concentrated. Looking back on 1994, Steinhardt conceded his own naïveté. “The trade in European bonds was crowded, a fact that totally passed me by,” he confessed. When the dust settled at the end of March, Steinhardt’s funds were down 30 percent. About $1.3 billion of capital had been vaporized.24

  STEINHARDT’S HUMILIATION WAS QUICKLY FOLLOWED by another hedge-fund collapse, this one centering on a hubristic outfit called Askin Capital Management. Its eponymous manager, David Askin, had launched his business in the glory days of 1993, creating a $2.5 billion portfolio of mortgage securities. Askin had little experience of actually managing money—he was a financial analyst and salesman. But his pitch was that as the former head of mortgage research at the investment bank Drexel Burnham Lambert, he could make money from mortgages in any financial climate.

  Askin claimed to have an edge in analyzing the likelihood that a mortgage might be paid off early. Mortgages with a high risk of prepayment logically were worth less than mortgages that were likely to keep paying out, since prepayment would deprive investors of the income stream that they had counted on.25 Further, Wall Street was busy slicing mortgages into all kinds of exotic instruments. The interest payments and the principal payment on a mortgage were cut into two separate “strips”: If homeowners prepaid mortgages rapidly, the interest-only strips (known as IOs) would lose and the principal-only strips (POs) would gain; if prepayments lagged, the opposite would happen. Askin dabbled in IOs and POs, inverse IOs and inverse POs, and even in a creature known as the “forward inverse IO.” For a firm that nailed prepayment risks, the opportunities were endless.

  Askin’s pitch won over a roster of respected names, and his investors included firms such as the insurance giant AIG and charities such as the Rockefeller Foundation.26 But not for the last time in the story of hedge funds, the sales pitch was fraudulent. Askin claimed that his funds were “market neutral”—they would make money regardless of whether the bond market was up or down—but the truth was that he had little idea how his clever investments might perform in a crisis.27 He claimed to use sophisticated modeling to analyze prepayment risks, saying that his proprietary software was stored on his own computer. But no such model existed.28

  When the Fed raised interest rates in Februar
y, Askin’s funds began to fall in value. The surge in long-term interest rates raised the cost of mortgages and removed the incentive for homeowners to refinance; prepayments of existing mortgages declined, so that their duration stretched out like chewing gum. Despite his claims to market neutrality, Askin turned out to be acutely exposed to this duration change; indeed, for any given rise in long-term interest rates, his portfolio fell five times more than an ordinary bond would. At first Askin covered up this discovery by misreporting his results. But a revolt within his firm forced him to come clean, and on Friday, March 25, he admitted that his funds had fallen 20 percent in February.29 Moreover, the assassination of a Mexican presidential candidate on March 23 had ratcheted up the panic in the bond market: Investors responded to the killing by dumping Mexican bonds, then dumping all emerging-market bonds, then dumping rich-world bonds as they fought to rebalance their portfolios. For Askin, this was the last straw. The renewed surge in interest rates guaranteed that his March results would be awful.

  On the morning of Monday, March 28, the brokers began to issue margin calls to Askin. Bear Stearns demanded $20 million in additional capital; Kidder Peabody wanted $41 million; and by that afternoon Bear had upped its request to $50 million. The next day Salomon Brothers, Lehman Brothers, and a host of other creditors piled on, and soon it became clear that Askin would have to sell huge portions of his portfolio to satisfy his creditors. A team of Kidder mortgage traders showed up uninvited at Askin’s premises, demanding to inspect his books; they worked through the night, aiming to come up with a fair price for a chunk of Askin’s funds, but they soon confronted a problem. If Askin had owned his portfolio outright, Kidder could have made a bid, providing Askin with the cash to stave off his other creditors. But Askin’s holdings had been pledged as collateral to dozens of creditors, whose claims could not be unscrambled easily. Here was yet another lesson about leverage that was to haunt hedge funds in future years. Not only can it cause a fund to crash. It can complicate its burial.