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

by Sebastian Mallaby

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  SOROS VERSUS SOROS

  To create the mining city of Noril’sk, Stalin resorted to slavery. His secret police arrested hundreds of engineers on fabricated charges and hauled them off to the Siberian Arctic, where there were no trees or plants or vegetation. Perhaps two hundred thousand zeks, or political prisoners, died in the process of building the city and its mine; years later the annual melting of the snow continued to flush out the skulls and bones of Stalin’s victims. By the mid-1990s, some 260,000 inhabitants huddled in this bleak setting, fighting temperatures that fell to –40 degrees Celsius and choking on the sulfurous smog that billowed from Dickensian smelters. The sun vanished during the five months of the polar night. “Time somehow passes,” one resident told a visitor, “but we remain.”1

  Geographically and psychologically, it was hard to imagine a setting more remote from the fast-paced trading rooms of Manhattan. But in 1990 Paul Tudor Jones and a few other hedge funders vacationed at a fishing camp on the nearby Ponoi River.2 The visitors reveled in the Arctic wilderness, pitting their wits against powerful salmon; and with the instinct that wealthy people sometimes develop, they resolved that since they liked the camp so much the right thing was to buy it. When they got to negotiating the fishing rights with the provincial government, they heard a story that caught their attention. At a meeting in Helsinki that was ostensibly about fishing, one of the Russian officials had mentioned Noril’sk, lamenting that the creaking Soviet infrastructure at the mine was on the verge of collapsing. Thorpe McKenzie, the former partner of Julian Robertson’s at Tiger who was negotiating on behalf of the hedge-fund fishermen, pricked up his ears. Noril’sk’s mine contained more than half the world’s palladium. A breakdown in production would have global consequences.3

  McKenzie returned to the Ponoi River annually for the next few years; he hosted Russian officials at his fishing camp and pumped them for information about the mine and its prospects. He researched the structure of the palladium market and found that the metal had three principal uses: dentistry, for which demand was more or less stable; catalytic converters for automobiles, for which demand was growing thanks to environmental regulation; and cell phones, a new market that looked to have some promise. Aside from Noril’sk, the other major suppliers of palladium were in Africa, which faced its own infrastructure challenges. Having sized up the situation, McKenzie concluded that demand for palladium would outgrow the uncertain sources of supply. He bought some of the metal for his own account and passed the word along to Julian Robertson. By 1994 Tiger had bought $40 million worth of palladium, and a young Tiger commodities specialist named Dwight Anderson was dispatched to investigate.

  Anderson was one of those turbocharged young men whom Robertson hired, and an appetite for adventure came in useful on this mission. He flew to Moscow, which was then just emerging as a go-go town for Western deal makers, then boarded an ancient Aeroflot aircraft for the onward flight to Siberia. When he touched down in Noril’sk in the half-light of a bleak November day, he could make out the carcasses of wrecked aircraft that littered the airport; evidently they had been plundered for spare parts to keep the rest of the fleet going. Anderson gritted his teeth and tried not to think about the safety of the flight he would take home. But when he visited Noril’sk’s mine the next day, he was surprised at how well it was working.4

  Anderson had seen many mines before, but this one was different. It was nothing like the Appalachian coal mines, where men crouch as they go underground; it was nothing like the open-pit mines in the western United States or the spectacularly deep shafts in southern Africa. The Siberian approach to mining was truly Soviet in scale: You could drive underground in a vast truck and tour a bewildering warren of caverns. The scale of the excavation exceeded anything that could possibly have been needed to extract the ore, but this excess was a blessing. If one tunnel or one trolley system developed a problem, there would be several alternative ways of getting the ore out; if a mechanical drill broke, there would be two defunct ones near to hand, and their carcasses could be plundered for spare parts like the abandoned planes at the airport. Noril’sk’s redundant scale allowed it to keep going, and Anderson soon concluded that the stories of a collapse in production had been deliberately exaggerated. Local officials understood that rumors of a collapse were bullish for palladium prices. Since they all had stakes in the mine’s sales, they seized every chance to tell visiting foreigners about an imminent production breakdown.

  Anderson could see that something else might collapse, however. As he built his contacts in Russia, he confirmed that the Russians were selling more palladium than they mined: They were ripping the stuff out of disused Soviet military equipment and selling it. Sooner or later, this plundering would have to stop: Somewhere around the year 2000, Anderson calculated, there would be no more missiles to be scrapped, and the price of palladium would skyrocket. And so, following Anderson’s investigations, Tiger held on to its palladium position, even though the logic for owning it had changed. The position lost money for the next three years; but then, as we shall see, things started to get interesting.

  TIGER’S SIBERIAN FORAY WAS PART OF A LARGER PHENOMENON. In the early 1990s the closed parts of the world economy opened up to Western capital, and hedge funds seized the opportunity. Before 1990, westerners were barred from the Kola Peninsula, whether to fish or to inspect mines; before 1990, likewise, the countries of East Asia and Eastern Europe allowed only a trickle of foreign money into their equity and bond markets, which were in any case too small to hold much opportunity. But around the turn of the decade, when Thorpe McKenzie led his first group of anglers to Siberia, emerging markets came into their own. The outstanding stock of developing-country bonds shot up from around $40 billion to $100 billion in the space of a year, and blistering growth continued through the rest of the decade. Traditional asset managers warmed to peripheral economies only gradually, but hedge funds moved fast. By the early 1990s, they were filling their coffers with the debt of countries such as Peru and reaping healthy profits.5 In 1992 Soros and Druckenmiller launched a new fund called Quantum Emerging Growth to take advantage of this new frontier. The following year Louis Bacon’s Moore Capital followed suit with a specialized emerging-market vehicle.

  From the point of view of developing countries, there was much to like in this new order. Hedge funds were willing to provide capital when others were not; once hedge funds led the way, other Western asset managers would eventually follow; and because foreigners were generally sophisticated in their choice of which companies to finance, their presence frequently boosted the quality of capital in an economy as well as the mere quantity.6 But the global spread of hedge funds also entailed risks. Hedge funds could provide capital to an emerging economy and juice its growth for a few years, but they could also yank their money out and cause growth to crater. As Britain’s government had discovered in 1992, and as Alan Greenspan had discovered two years later, deep and fast-moving capital markets could force wrenching movements in currencies and interest rates, shattering the illusion that economic statesmen were the masters of their nations’ destinies. If this was true in the rich world, it was even truer in frail emerging economies. At the end of 1994, Mexico succumbed to a full-blown currency crisis. And Mexico’s troubles turned out to be a dress rehearsal for a far bigger drama—one that was in large part conceived at Soros Fund Management.

  In the years after the sterling trade, Stan Druckenmiller had led the Quantum Fund to yet more profits. In 1993, the golden period for the bond market, Quantum was up 63 percent; the following year, despite the bond crash, it still battled to a gain of 4 percent; in 1995 it was back in stride again with a return of 39 percent.7 But during these years, Druckenmiller began a long-running debate with Soros about the proper size of their hedge fund. The sterling trade had shown that bulk could be a weapon in facing down a government, but it had also shown that Quantum was unnecessarily large. Soros and Druckenmiller had believed that given th
eir fund’s size, they should sell $15 billion worth of sterling, but they had only been able to sell $10 billion; it followed that if their fund had been one third smaller, they would have aimed to sell $10 billion and actually sold that amount, yielding a percentage gain on their capital that would have been a third higher. For Druckenmiller, a stellar performance number was the main goal: His earnings were tied to it and his ego was invested in it. For Soros, on the other hand, the calculation was different. His ego was invested as much in the size of his empire as in the scale of his returns: Owning a global firm made him a global player, raising the profile of his writings and philanthropy. Soros was known as the only private citizen to have his own foreign policy, and he reveled in the fact that eminent statesmen beat a path to his office. One day a Soros employee overheard the boss tell Druckenmiller that Henry Kissinger was visiting.

  “Would you like a word with him?” Soros asked Druckenmiller.

  “Does he know anything?” Druckenmiller countered dismissively.

  “Oh, yes,” Soros answered, finding a way to vaunt his political connections while not seeming in awe of Kissinger’s star power. “I don’t like him, but he does know things.”

  Soros and Druckenmiller reached a compromise on the size of their hedge fund. Soros Fund Management would continue to accumulate assets, but they would not all go to Quantum. By 1996, just over half the $10 billion at Soros Fund Management was housed in three other funds: Quantum Emerging Growth, Quasar (which invested with outside hedge-fund managers), and Quota (which was managed by Nick Roditi, a secretive London-based macro trader). To run these new start-ups, Soros recruited new talent, including a Princeton-trained economist named Arminio Fraga. When the two men met in early 1993, Fraga, a Brazilian, had just left a position as a deputy governor at his country’s central bank. Within a few days, Soros had offered him a partnership.

  “Here, Stan, I hired this guy,” he told Druckenmiller breezily.

  Druckenmiller eyed Fraga, a slight, polite man with an academic demeanor. It was one of those moments when he might have been thinking, “How am I supposed to run this place when I can’t choose who works for me?” But his big frame gave nothing away.

  “Fine,” he said. “Let’s see if he’s any good.”8

  For the next four years at Soros, Fraga performed the benign function of hedge funds: to finance emerging economies that were shunned by traditional investors. He bought the bonds of big Latin countries such as Brazil and Venezuela; he branched out into exotica such as Moroccan loans; he bought shares in Brazilian utilities, which were absurdly cheap by international standards. Then in late 1996 Fraga attended a talk by Stan Fischer, the number two at the International Monetary Fund. The mood was mostly upbeat: Mexico’s currency had recovered from its crisis, and emerging markets were booming. Still, somebody asked Fischer the question “Who do you think is the next Mexico?”

  “I’m not sure there’s another one out there at the moment,” Fischer answered. “But I do see some imbalances in Asia. That might be interesting to look at.”9

  That comment, Fraga recalled later, “put a little light in my mind.”10 A few weeks afterward, Fraga read a joint IMF–Federal Reserve paper titled “The Twin Crises,” which laid out in terrifying detail how a currency collapse could interact with the collapse of a banking system.11 Casting his mind back to Fischer’s remarks, Fraga approached Druckenmiller.

  “Do you mind if I go and take a look at what is going on in Asia?” he asked him.

  “Sure,” came the answer. “Go.”12

  IN JANUARY 1997, FRAGA LANDED IN THAILAND. AS HE made the rounds of local officials, company executives, and economists, it quickly became clear that the country fitted the double-crisis model laid out in the IMF-Fed paper. Thailand’s exports had been hammered by the rise of China as a low-cost rival, and to make matters worse, Thailand’s currency was linked to a basket of currencies dominated by a strong dollar, further eroding its ability to compete in world markets. As a result, Thailand was running a large trade deficit, but it was refusing to adjust: Rather than abandon its link to the dollar and allow a falling currency to restore its competitiveness, the country was consuming more than it produced, paying for the difference with loans from foreigners. This arrangement left the Thais exposed. If the foreigners tired of lending to Thailand, the country would have to export enough not only to cover its import bill but also to repay outsiders. To boost exports and cut imports, the Thai baht would have to fall—sharply.

  At the time of Fraga’s fact-finding visit, the willingness of foreigners to finance Thailand was already crumbling. In 1996 a major Thai bank had collapsed, raising doubts about the wisdom of lending to the country. Thailand’s central bank had cut interest rates to stave off further bank trouble, but this had dampened returns for foreign creditors and given them another reason to go elsewhere. Fragile banks and a reliance on foreign capital were coming together in the way that the IMF-Fed paper had described, and it was clear to Fraga that this interaction could turn toxic. If a withdrawal of foreign money drove Thailand to devalue, the banks would be tipped from fragility into outright ruin. Much of the foreign lending to Thailand was denominated in dollars, and it had been channeled into real estate and other projects that generated revenue in baht. If the dollar jumped against the baht, these debts would become impossible to service.

  The tipping point for Fraga came during a visit to the Bank of Thailand. Together with David Kowitz, Soros’s expert on Asian equities, and Rodney Jones, an economist who worked for Soros in Hong Kong, Fraga was granted an audience with a high-ranking official at the central bank. Invoking his own experience as the deputy governor of Brazil’s central bank, Fraga offered some thoughts on the dilemma that Thailand confronted: On the one hand, the government was committed to defending its exchange rate, which would involve keeping interest rates high enough to attract capital; on the other hand, Thailand had a trade deficit and wobbly banks, which made devaluation and lower interest rates attractive. Fraga had a mild manner, and his Brazilian background helped; he seemed more like a benign emerging-market peer than a menacing Wall Street predator. So the official looked at Fraga and gave him an answer that was at once honest and naive. Until now, he said simply, Thailand had accepted whatever interest rates proved necessary to maintain the exchange rate within its designated band. But now priorities might have to shift. Given the growing troubles at the banks, getting interest rates down might matter more than defending the level of the currency.13

  The official might as well have offered up a suitcase full of money. He had conceded that Thailand’s currency peg was unsustainable, meaning that shorting the baht was a no-brainer. Fraga and his colleagues could practically visualize the suitcase, cash spilling from its seams; but in order to reel in their prize, they had to pretend they hadn’t noticed it. If their host realized the full power of his comment, he could snatch the suitcase back: The central bank could hike interest rates, raising the cost of borrowing the baht in order to sell it short; or it might resort to some administrative crackdown on foreign speculators. Ever polite and self-effacing, Fraga nodded pleasantly at the Thai official and allowed the discussion to move on. After a little while, David Kowitz gently led the conversation backward.

  “Excuse me. I’m out of my depth here,” he said humbly. “Can you just repeat what you said a few minutes ago, just to make sure I got it right?”

  The official repeated his statement, and the Soros team got what it was looking for. Their host had told them that he knew the game was up: He had confessed and reconfessed his nakedness. Whatever the official pronouncements on Thailand’s commitment to its exchange-rate peg, it was only a matter of time before the baht was devalued.

  After a stop in South Korea, Fraga returned to New York and reported back to Druckenmiller. The big man listened to Fraga’s story and quickly approved a trade, and over the space of a few days in late January, the Soros team sold short about $2 billion worth of the Thai currency.14 The sellin
g was both a prediction of a crisis and a trigger that could bring it on: To defend the baht against the pressure from Druckenmiller and Fraga, the government sold a chunk of its dwindling foreign-currency reserves and raised interest rates by 3 percentage points—a punishing hike given that Thai banks were tottering.15 But the rate hike came too late to scare the predators away. The Soros team had taken out baht loans of six months’ duration and had locked in the low interest rates that had existed before the government hiked them. Secure in their positions, Druckenmiller and Fraga could afford to wait until the end of July for the inevitable to happen.16

  In the months and years to come, a spirited argument would break out as to whether hedge funds precipitated Asia’s financial crisis. We will get to that question, but for now the opposite one stands out: Why didn’t Druckenmiller and Fraga do more to force a Thai devaluation? Back in 1992, the Soros team had sold $10 billion worth of sterling, around two and a half times the firm’s capital. But the $2 billion Thai trade represented just a fifth of capital—a fraction of the selling of which Druckenmiller was capable. By repeating the leverage of his earlier exploit, Druckenmiller could have sold an additional $23 billion or so of baht, multiplying the Soros funds’ returns and wiping out most of the foreign-currency reserves held at the Bank of Thailand. Its reserves thus depleted, Thailand would probably have capitulated within days, so a quick and magnificent profit apparently lay within Druckenmiller’s grasp. Why didn’t he seize it?17