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

by Sebastian Mallaby

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  “HOW COULD THEY DO THIS?”

  On a Thursday evening in March 2008, James Chanos walked out of his office in midtown Manhattan and set off to meet Carl Bernstein, one of the journalists famous for breaking the Watergate scandal. Chanos felt some professional affinity with investigative reporters: He ran a hedge fund, Kynikos Associates, that specialized in digging up financial dirt at companies, shorting their stock, and profiting when the bad news surfaced and the stock cratered. In the bull market of the 1980s and 1990s, short selling had been an unrewarding niche, and Chanos had resembled the investigative newsman who toils in obscurity and seldom lands on the front pages. But the sluggish market of the 2000s had been glorious. Chanos had been among the first to see through the fraudulent energy company Enron. He had shocked the world in 2005 by claiming that the giant insurer AIG had “Enron-like” characteristics. And in 2007 he had returned over 30 percent, largely by shorting financial institutions that were slow to admit losses from the mortgage bubble.1 By March 2008, behemoths such as Citigroup and Merrill Lynch were fessing up to billions of dollars’ worth of trouble, but Chanos had much to celebrate.

  That Thursday evening, as he threaded his way through the evening crowds in Manhattan, Chanos took a call on his cell phone. The caller ID announced that the call was from someone at Bear Stearns—a bank whose relations with hedge funds had turned testy. Concerned about Bear’s stability following its enormous mortgage losses, a string of famous funds had closed the “margin accounts” they held at Bear to leverage their trades; and because Bear borrowed against the assets in those accounts, Bear’s access to funding was collapsing. Bear executives suspected that hedge funds were ganging up to short their stock, deviously reinforcing these raids by closing their margin accounts.

  Chanos took the call on his cell phone and kept walking along Madison Avenue.

  “Jim, hi, it’s Alan Schwartz.”

  Chanos realized he was speaking to Bear’s chief executive. “Hi, Alan,” he responded.

  “Jim, we really appreciate your business and your staying with us. I’d like you to think about going on CNBC tomorrow morning, on Squawk Box, and telling everybody you still are a client, you have money on deposit, you have faith in us, and everything’s fine.”

  Chanos thought for a moment. Bear had wailed loudly and publicly about short sellers; now it was coming to a short seller for help. The rabbit was pleading with the python.

  “Alan, how do I know everything’s fine? Is everything fine?”

  “Jim, we’re going to report record earnings on Monday morning.”

  “Alan, you just made me an insider,” said Chanos, annoyed. “I didn’t ask for that information, and I don’t think that’s going to be relevant anyway. Based on what I understand, people are reducing their margin balances with you, and that’s resulting in a funding squeeze.”

  “Well, yes, to some extent, but we should be fine.”

  Chanos refused to do what Schwartz asked of him. As the most visible short seller on Wall Street, his testimony could have buoyed confidence in Bear, but Chanos was not going to risk his own credibility by vouching for a bank that might be imploding. Besides, he was leaving at seven o’clock the next morning for a vacation in the Bahamas. He proceeded on his way to the Post House restaurant, just off Madison Avenue, where he dined on steaks with Bernstein and his five Kynikos partners.

  If Chanos had resented Schwartz’s suggestion when he first heard it, his mood morphed into unrestrained outrage over the next day or so. At six-thirty on Friday morning, when Squawk Box was on the air, word began to spread that the Fed was brokering a rescue for Bear Stearns; the closing of its hedge funds’ margin accounts had been followed by a collapse of confidence and a classic bank run. Schwartz had known the previous evening that his bank was going down, and yet he had tried to inveigle Chanos onto television anyway. “That fucker was going to throw me under the bus,” Chanos recalled later.2

  Chanos’s exchange with Schwartz captured the transformed relationship between banks and hedge funds. Back in 1994, Bear Stearns had sunk the wayward hedge fund Askin Capital, forcing it into default and seizing a good portion of its assets. In 1998, Bear had informed Long-Term Capital Management that it was toast, refusing to clear its trades and slamming its door on the Fed-brokered rescue. But in 2008, the tables had turned: Bear Stearns was toast, hedge funds had the power, and Wall Street buzzed with sinister stories about how hedge funds had abused it. A vivid Vanity Fair account of Bear’s failure gave credence to the notion that Bear had been the victim of a hedge-fund conspiracy, even citing a “vague tale” that at a breakfast the following Sunday, the ring-leaders had celebrated Bear’s demise and plotted a follow-up assault on Lehman Brothers. One of Lehman’s top executives heard that the breakfast had taken place at the Four Seasons Hotel and that the short sellers had ordered mimosas made with $350 bottles of Cristal to toast their achievement.3 But even as the story grew in the telling, the Securities and Exchange Commission investigated the allegations and prosecuted no one, and the very image of the breakfast strained credulity.4 If hedge-fund chiefs had conspired to bring Bear down, they would have been breaking the law. They would not have incriminated themselves by gathering right after the event to chest-bump in public.5

  Even if the talk of a criminal conspiracy was overwrought, there was no doubt that hedge funds were shorting the banks—and that Lehman was their next target. The short interest in Lehman’s stock rose to more than 9 percent of its shares, meaning that almost one in ten had been borrowed and sold by a short seller. Lehman’s share price was down more than 40 percent since the start of the year, and the firm’s worried leaders felt obliged to counterattack. They accused hedge funds of a reckless policy of “short and distort,” and Lehman’s combative chief executive, Richard Fuld, virtually declared war. “I will hurt the shorts, and that is my goal,” he vowed at the firm’s annual meeting.6

  Fuld did his best to persuade the authorities in Washington to solve his problem. They should restrict short selling of Lehman shares, for instance by reinstating the defunct uptick rule, which prevented speculators from shorting a stock while it was falling. In April, Erik Sirri, a top Securities and Exchange Commission official, pressed Fuld for evidence that hedge-fund behavior justified this sort of treatment. What evidence did Fuld have that the funds were colluding to push Lehman under?

  “Just give me something, a name, anything,” Sirri challenged.

  Fuld would not answer. His lieutenants had provided the SEC with leads, largely consisting of rumors that traders were gunning for Lehman. But you couldn’t prove a conspiracy without the power of subpoena. The way Fuld saw it, it was the SEC that had that power, so there was something upside-down about the SEC turning to Lehman for the evidence.

  Frustrated in Washington, Fuld turned next to Jim Cramer, the well-connected TV pundit. He invited him over to breakfast and pumped him for information about the supposed conspiracy of short sellers.

  “Why don’t you just give me the names of people telling you negative things about us?” Fuld growled.

  “Look, there isn’t anybody,” Cramer protested.7

  Toward the end of May, at a high-profile investment conference at the Time Warner Center in New York, an infuriatingly boyish-looking hedge-fund manager named David Einhorn stood up in front of a large crowd and took the pressure on Lehman to the next level. This was the same David Einhorn whose firm, Greenlight Capital, had shorted Chemdex and other frothy dot-com stocks, and now the wind was at his back as he explained why Lehman was in trouble. The bank was underplaying problems on its balance sheet, Einhorn maintained: It held $6.5 billion worth of dicey collateralized debt obligations but had marked down their value by only $200 million at the end of the first quarter—a suspiciously small shift given the sharp slide in credit markets. Meanhile the bank had informed investors on a conference call that it would book a loss on its hard-to-value “Level Three” assets, but then had turned around and
reported a profit; again, Einhorn demanded an explanation. If Lehman was covering up the full extent of its troubles, the consequences would be terrible not only for Lehman’s shareholders but also for the financial system. Like a prosecutor intent on putting away a villain, Einhorn called upon regulators to guide Lehman to own up to its losses before taxpayers had to pay for them.

  “For the last several weeks, Lehman has been complaining about short sellers,” Einhorn concluded pointedly. “When management teams do that, it is a sign that management is attempting to distract investors from serious problems.”

  The day after Einhorn’s speech, Lehman’s shares dipped by almost 3 percent, and they continued to slide thereafter. Lehman executives did their best to discredit Einhorn’s attack, but the markets were against them. In June, Lehman reported a loss of $2.8 billion for the second quarter, and commentators credited Einhorn for forcing the bank to come clean about its true position.8 More than a few people wondered whether this was altogether a good thing. “There’s truth to his argument, but now is not the time,” one Wall Streeter said of Einhorn’s crusade. “Two years ago would’ve been heroic. If he brings down Lehman, the guarantors are going to be me and you the taxpayer.”

  IT WAS NOT JUST THE SHORT SELLERS WHO WERE FEELING their oats. One year earlier, in the week after the quant quake, George Soros had invited Julian Robertson, Jim Chanos, and a handful of other heavyweights to lunch at his estate on Long Island. Over a lunch of striped bass, fruit salad, and cookies, the group debated the economic outlook. The consensus among the guests was that a full-blown recession was unlikely, but Soros disagreed so strongly with this view that he returned to active investing.9 Since the departure of Stan Druckenmiller, Soros had farmed out most of his fortune to external managers. But now, at the age of seventy-seven, he retook the reins; by the end of 2007, his fund was up a remarkable 32 percent, and Soros himself emerged as the second-highest earner in the industry. It was just like old times, and other macro traders fared well too, riding an imploding credit bubble in the rich world and continuing growth in the emerging economies. Macro funds were short rich-world markets and short the dollar. They were long emerging markets, long oil, and frequently long other commodities. In the eighteen months to June 2008, the average macro fund was up about 17 percent, according to Hedge Fund Research—not a bad return in a period of financial crisis.

  The bubbling confidence of hedge funds was expressed in their new “activism”—the practice of buying large stakes in firms and demanding changes in their strategy. In the first weeks of 2008, a former ice-hockey player named Phil Falcone, whose Harbinger Capital had made a killing shorting subprime mortgages the previous year, muscled into the newspaper business. He bought 4.9 percent of the New York Times, then called upon the Times board to accept four of his allies as directors. The way Falcone saw it, the Times had a piece of the Boston Red Sox, a NASCAR squad, some regional newspapers and television channels; it was time to dump this peripheral nonsense and build out the core newspaper brand on the Internet. In March, the Sulzberger family, which owned the bulk of the Times’s voting shares, conceded two of the board seats that Falcone wanted; and Falcone responded by increasing his stake to 19 percent. In April, Arthur Ochs Sulzberger Jr., the Times Company chairman, backhandedly acknowledged the gravity of the challenge. At the annual shareholders’ meeting, he stood up on the stage and protested that “this company is not for sale.” Contrary to rumor, there were some things in New York that hedge funds did not control yet.

  Hedge fund activism flourished in London too, most notably in the person of Chris Hohn, who ran a hedge-fund-cum-charity styled the Children’s Investment Fund. A slice of Hohn’s profits flowed through to his philanthropic arm, which supported child-survival projects and AIDS programs. But Hohn was quite capable of mixing high-mindedness with hardball: In 2005, he bought a chunk of Deutsche Börse, the entity that owned the German stock exchange, and forced its chief executive to resign, telling him at one point, “My position is so strong that we can bring Mickey Mouse and Donald Duck onto the supervisory board.”10 Two years later, Hohn cajoled the Dutch bank ABN AMRO into selling itself to a trio of suitors; and in the summer of 2008 he followed up by buying 8.7 percent of the American railroad company CSX and demanding board representation. CSX fought back as best it could. It arranged for its friends in Congress to haul Hohn’s people before a committee. It sued him in New York court, alleging violations of the SEC’s disclosure rules. It appealed to rank-and-file shareholders to reject this evil British lunge for strategic American rail infrastructure. Finally, in an attempt to foil the agents from the temperate isle, CSX staged its annual meeting in June 2008 in a steamy Louisiana rail yard. “We saved you from the Huns twice,” a shareholder declared at that meeting, which took place in an enormous tent.11 But Hohn was not to be denied. Even though CSX’s managers tried to delay and fudge the vote, his candidates won four seats on CSX’s board by the middle of September.

  The sheer reach of the hedge funds was illustrated by their forays into emerging markets. A classic example came from Kazakhstan, a sprawling expanse of Eurasia that most Wall Streeters had only heard of via Borat. Thanks to its enormous oil reserves, Kazakhstan was growing at 8 percent or 9 percent a year, and the country was running an export surplus; it was a pretty sure bet that the currency would appreciate against the dollar. The question was how to cash in on this rise. Because of its oil revenues, the government had no need to issue debt, so there were no sovereign bonds for foreigners to purchase. Starting around 2003, hedge funds found a way around this obstacle. Rather than buying sovereign bonds, they lent directly to Kazakh banks, getting exposure to the Kazakh currency plus a higher interest rate on their money. They repeated versions of this trick all over the world, so that by 2008 hedge funds had lent to everyone from Brazilian coffee exporters to Ukrainian dairy farms. Ukraine’s capital, Kiev, became such a hot destination for hedge funds that its top hotel charged eight hundred euros nightly.

  Of course, there were awkward questions about this emerging-market lending. In order to ride an appreciating currency, the hedge funds were exposing themselves to the default risks posed by coffee exporters, dairy farms, and so on. They were behaving like traditional commercial lenders—they were pretending to be banks!—and yet they lacked the capacity of real banks to do due diligence on borrowers. A second-tier company in Russia could now borrow directly from hedge funds without anybody spending time at its offices, inspecting its books, or figuring out how a loan could be recovered in the event of bankruptcy. The hedge funds might be lending against collateral that consisted of dairy herds on the other side of the world; the notion that they could show up in the Ukrainian countryside and take delivery of live cows was farcical. But in the heady atmosphere of the mid-2000s, nobody much cared. Hedge funds were the rising force in finance, and they could do no wrong; traditional banking and persnickety loan officers were too dull to bother with. The subprime credit crisis, which revealed the shockingly poor risk management at banks, did nothing to shake this verdict.

  Early in the crisis, in April 2007, Jim Chanos had attended a meeting in Washington. A team of German regulators had asked him, “So what are your views about hedge funds and financial stability?” Chanos had responded that the Germans were looking the wrong way: “It’s not us you should be worrying about—it’s the banks!” he had told them.12 A bit more than a year later, in mid-2008, Chanos was proved abundantly correct. Bear Stearns had failed; Lehman was under fire; and the two government-chartered home lenders, Fannie Mae and Freddie Mac, were leaking money at an alarming rate. Fannie and Freddie had a whole government agency dedicated to their oversight, and they were about to collapse into the arms of taxpayers. Meanwhile unregulated hedge funds were stalking targets from the New York Times to Kazakhstan, and dancing in between the land mines.

  But over the horizon, new threats were forming. The world was about to get more complicated.

  BY THE SUMMER OF 2008, PAUL TUDOR JON
ES HAD INSTALLED his growing firm in a large mansion on a broad lawn, a few miles outside of Greenwich. The place combined gentility with in-your-face exuberance; it was at once courtly and brash, not unlike its master. Two curving staircases ascended gracefully from a hushed entrance hall; there were marble floors and antique rugs and finely sculpted table legs; and Jones’s office was decorated with deer antlers and a glorious stuffed bear—“What else do you give a big bear at 50?” an inscribed plaque demanded. But the path to Jones’s office was guarded by a vast aquamarine mural of a killer shark, its teeth glinting with murder; and on one wall of his quarters, six enormous screens had been set into the wood panels, each gleaming with a market chart or cable-news feed. Pinned up by a window, a page torn from a yellow legal pad bore a scrawled message from Jones to himself: “Always look for a trending market.”

  In late June of that year, Jones got himself convinced that the trend was downward. The S&P 500 index had jumped sharply in April and kept rising in May, but Jones thought this was a sucker’s rally. The United States was in the grip of the greatest credit bubble of all time, and Jones studied every precedent there was—Japan in 1989, the United States in the late 1920s, Sweden in the 1990s. He pored over the price patterns in these historical analogues, hunting for hints about how the market might behave. Then on Saturday, June 28, at 3:05 A.M., he fired off a eureka e-mail to colleagues. “I hate being an alarmist, really,” began the subject line. “But the current WEEKLY S&P against the DAILY DJIA back in 1987 is really alarming to me.”13

  Jones’s thinking would have seemed a touch obscure to some investors. It started from the fact that, in 1987, declines in the bond market had spooked stocks, since higher interest rates meant that less money would slosh into the equity market. In the first half of 2008, Jones reckoned, rising oil prices had had the same effect: The inflationary pressure from dear oil was driving the Fed to keep interest rates up, draining liquidity from asset markets. Hitting upon this sort of parallel gave Jones an adrenaline-soaked high; the markets of 1987 and 2008 were “eerily similar,” he whooped in the e-mail—“same plot just different characters.” Next, Jones ventured an argument that inverted Franklin Roosevelt: “I am also really bothered by the absence of fear in the options market,” he wrote; investors should fear the lack of fear itself, since optimism left plenty of room for sentiment to deteriorate. Finally, Jones pointed to the fact that the Dow Jones Industrial Average had closed at its lowest level in 250 days, and this at a time when investor sentiment was bullish; “that has NEVER happened in the 21 year history of this indicator including ’87,” Jones reported in his e-mail. To cap it all off, the chart of the weekly S&P 500 index looked exactly like that of the daily Dow Jones average back in 1987; you could map one onto the other and see a perfect fit—that had to mean something! The suggestive power of two different indices plotted on two different time intervals tipped Jones over the edge. “I realized, oh my God, this is going to be the ugliest third quarter in history,” Jones said later.14