epilogue

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 profi ting 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 fi nancial 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 “HOW COULD THEY DO THIS?” 349 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 fi ne.” Chanos refused to do what Schwartz asked of him. As the most visible short seller on Wall Street, his testimony could have buoyed confi dence 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. 350 MORE MONEY THAN GOD 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 LongTerm 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 ringleaders 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 “HOW COULD THEY DO THIS?” 351 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 hedgefund 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 wellconnected 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 hedgefund 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 fi rm, 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 352 MORE MONEY THAN GOD $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 profi t; 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 FEEL - ing 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, “HOW COULD THEY DO THIS?” 353 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 fi nancial 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 profi ts fl owed 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 354 MORE MONEY THAN GOD 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 “HOW COULD THEY DO THIS?” 355 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 fi guring 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 JONES HAD INstalled his growing firm in a large mansion on a broad lawn, a few miles 356 MORE MONEY THAN GOD 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; “HOW COULD THEY DO THIS?” 357 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 For the next two months, Jones continued to play the historical detective. Sometimes he thought that the S&P chart resembled the recession of 2001; sometimes it looked like 1987. But no matter which analogue appealed, Jones remained negative on the market outlook, and in the end his reading of the charts mattered less than the instinct behind it. What really counted was that Jones was looking at an asymmetrical bet, and he understood this intuitively. A leveraged financial system in a credit crisis is like a high-wire artist in a storm. The wire is going to wobble, and the artist may lose his balance and tumble a long way. But he is defi nitely not going to levitate upward. Over the course of his long career, Jones had been working up to this moment. He had watched leverage grow exponentially since the 1980s and had frequently expressed misgivings. During the dot-com mania of the late 1990s, he had written to Alan Greenspan, the Fed chairman, urging him to raise margin requirements on stock traders so as to slow the flood of cash that was inflating the tech bubble. A few years later, in the mid-2000s, he had received regular phone calls from a senior offi cial at the Fed, asking him what risks he sensed in the markets. He had answered repeatedly that debt was building upon debt: Nobody could know which part of the pyramid might crack; but the higher it grew, the greater the risk of a catastrophe. Clearly Tudor itself was part of this alarming edifi ce. At the end of each year, Jones would stay late at the office with Tudor’s 358 MORE MONEY THAN GOD president, Mark Dalton, reviewing the compensation of Tudor employees. At some point in these sessions, Jones would look at Dalton and say, “Can you imagine if the financial system ever had to liquidate? What if this enormous contraption that we’ve been part and parcel of building had to be unwound?” “I don’t even want to think about it,” Dalton would answer.15 ON FRIDAY, SEPTEMBER 12, 2008, AT AROUND SIX O’CLOCK in the evening, a column of sleek, dark cars approached the New York Federal Reserve building. The cars disgorged the chief executives of Wall Street’s leading banks, who were greeted by Treasury secretary Hank Paulson, New York Fed president Timothy Geithner, and SEC chairman Christopher Cox—it was the government personified. The subject of the meeting was Lehman Brothers, whose fortunes had continued to slide disastrously since David Einhorn’s speech in May; and the government delegation was intent on delivering a clear message—there would be no public money for a Lehman bailout. As the politician at the meeting, Paulson felt he had already risked taxpayers’ money enough. He had approved government support for the rescue of Bear Stearns and for the rescue of the giant mortgage lenders Fannie Mae and Freddie Mac; he had been denounced by Senator Jim Bunning, Republican of Kentucky, for “acting like the minister of finance in China.” The way Paulson saw things, Lehman presented an opportunity to draw a line: to teach bankers a salutary lesson that they must face the consequences of their own errors. Of course, the markets might react badly if Lehman went under. But the Treasury secretary and his colleagues believed that the risk was worth running. After all, Lehman had been in the emergency wing for months, and its trading partners had presumably prepared for its collapse. The government team would try to find a private buyer for Lehman; but if it could not do so, it would step aside, betting that Lehman’s failure would not cause chaos.16 If Paulson and his colleagues had seen the world as hedge funds do, they would not have made this fateful call, which led to the worst freeze-up in “HOW COULD THEY DO THIS?” 359 the financial system since the 1930s. The Paulson team was walking into a version of the trap that had snared the Bank of England in 1992: It looked at the odds of various outcomes in the way that policy makers do, but it failed to ask the trader’s question—what is the payout in each instance? From a policy maker’s perspective, Lehman’s failure might engender chaos or it might not; if you thought there was a fi fty-fifty chance of calm, you might choose to take the risk, especially if you were anxious to teach banks a lesson in responsibility. But from a trader’s perspective, this calculation was naive; a fi fty-fifty chance of calm meant that chaos was virtually certain in practice. Hedge funds from London to Wall Street would conduct a thought experiment: In the calm world, markets would be flat; in the chaotic world, markets would crater; if traders shorted everything in sight, they would lose nothing in the first instance but make a killing in the second one. Faced with this asymmetrical payout, every rational hedge fund would bet aggressively on a collapse. And because they were going to make those bets, collapse would be inevitable. Paul Tudor Jones had no trouble reaching that conclusion. There was no need to parse the details of how many institutions had readied themselves for the possibility of Lehman’s demise; as Jones put it later, “You knew Lehman Brothers would be the kickoff for a big down move. You knew that.”17 Everybody understood that Lehman was part of a bewildering daisy chain of interlocking transactions. Everybody understood that the financial system was leveraged up to its eyes. And the sheer symbolism of Lehman’s implosion would be an awe-inspiring thing. Lehman Brothers was a venerable institution that had survived the Depression and world wars; its failure would scream out that nothing was safe—“it would make everybody say, ‘Oh my God, is my son good for the loan I lent him?’ ” Jones exclaimed. “The optics of that would be so bad that everyone was going to shoot first and ask questions later,” he carried on. “The question mark would completely totally create financial panic and chaos.”18 The news of Lehman’s bankruptcy started to leak out around lunchtime on Sunday. Even if many hedge funds had positioned their portfolios for bad news, it soon became clear that they were not fully inoculated. American funds belatedly realized that Lehman’s London operation 360 MORE MONEY THAN GOD would declare bankruptcy under British law, which meant that hedge fund accounts that might have been “segregated,” or safe, under American rules would now instead be frozen. Hedge-fund lawyers rushed into their offi ces from weekend homes in the Hamptons, frantic to determine whether their assets with Lehman were subject to the British rules or the American ones. They put their outside counsels on speed dial and peppered them with questions. Investors called in a panic, demanding to know the size of their exposures. Nobody had clear answers, which only compounded the hysteria. By the evening, the size of the impending tsunami had begun to sink in. Eric Rosenfeld, the Long-Term Capital partner who had lived through the traumatic failure of his own fi rm, recalls hearing the news of Lehman’s bankruptcy on his car radio. “I couldn’t believe it. I was shocked. I was almost hyperventilating. How could they do this?”19 When the markets opened on Monday, Paul Tudor Jones experienced the extreme highs and lows that only he was capable of. On the one hand, he was perfectly positioned in his own trading book; he had seen the wave coming, and he rode it down, as the S&P 500 fell 4.7 percent by the close of trading that evening. On the other hand, it was the worst day of his professional life. Tudor had tried to withdraw the remainder of its assets from Lehman Brothers the previous week, but the request had arrived a day late, so the firm had $100 million frozen in Lehman’s London operation.20 Tudor wrote off the entire sum as a loss, but that turned out to be the least of its problems. Tudor had made a mistake that was as egregious in its own way as Paulson’s miscalculation on Lehman. It had allowed the fi rm’s emergingmarket credit team to build a giant portfolio of loans to firms in emerging markets. Banks in Kazakhstan, banks in Russia, Ukrainian dairy farms— Tudor had them all, and they accounted for a significant portion of the assets in the fi rm’s flagship BVI fund. Like Brian Hunter at Amaranth, Tudor had spotted a genuine opportunity at the outset: Loans to emerging markets could give the fund exposure to strong currencies; the loans paid high interest rates that more than compensated for the default risk; and as “HOW COULD THEY DO THIS?” 361 other hedge funds piled into the same trade, they drove up the currency and loan market, boosting returns and encouraging the bosses at Tudor to allocate extra capital to the strategy. But once Lehman collapsed, the true risks in emerging markets were revealed. Suddenly, storied banks in the United States could not raise money anymore, and banks in Kazakhstan or Russia seemed certain to face trouble. The loans in the emergingmarket portfolio immediately lost around two thirds of their value, costing Tudor over $1 billion.21 For a trader like Paul Jones, the worst thing was that he was trapped in these positions. When he speculated in futures, he always knew he could turn on a dime; indeed, he never created a position without putting in a “stop” that would take him out if he began to suffer losses. But the emerging-market loans were utterly illiquid: After Lehman declared bankruptcy, nobody wanted to hold any loans at any price, so there was no way to get rid of them. “I realized that our emerging-market trading book was going to get absolutely hammered and there was nothing I could do about it. . . . That was the worst moment of my whole life,” Jones said later.22 In his anguish and his helplessness, he thought back to what he had read about the only disaster that approached this one in scale. “I used to always think, ‘Holy cow, how’d these guys in 1929 lose it all? How could anybody be so boneheaded? You’d have to be a complete moron!’ And then that day, I thought, ‘Oh my God. I see how these guys in ’29 got hurt now. They were not just sitting there long the market. They had things that they couldn’t get out of.”23 Jones’s losses from emerging-market loans dwarfed the gains from his own trading book. Tudor had been up 6 percent or 7 percent for the year on the eve of Lehman’s failure, an impressive performance given that the stock market was down substantially. But by the end of the year, Tudor was down 4 percent, even though Jones himself had seen the storm coming.24 Tudor was forced to impose “gates” on its funds, suspending investors’ access to their capital. A chastened Paul Jones promised to narrow Tudor’s focus and stick to the liquid markets he knew best. The age of the diversified alpha factory was perhaps receding. 362 MORE MONEY THAN GOD THE FAILURE OF LEHMAN BROTHERS SPELLED THE END of the modern investment-bank model. Lehman and its rivals had borrowed billions in the short-term money markets, then used the money to buy assets that were hard to sell in a hurry. When the crisis hit, shortterm lending dried up instantly; everyone could see that the investment banks might face a crunch, and of course the fear was self-fulfilling. To stave off this sort of bank run, commercial banks have government insurance to reassure depositors and access to emergency lending from the Federal Reserve. But investment banks have no such safety net. Believing that they were somehow invincible, they had behaved as though they did have one. The next domino to fall was Merrill Lynch, the investment bank famous for its “thundering herd” of nearly seventeen thousand stockbrokers. On the weekend that Lehman’s fate was decided, Merrill Lynch’s chief executive, John Thain, shuttled between the New York Fed and meetings with Ken Lewis, his counterpart at the Bank of America. Over a series of negotiations that culminated at 1:00 a.m. on Monday morning, Thain agreed to sell Merrill for a song. Almost a year earlier, Merrill had rebuffed an offer from Bank of America that was worth $90 a share. Now, with the investment-bank model in tatters, Merrill was willing to do a deal for $29 a share without hesitation. One of Wall Street’s oldest names was collapsing into the arms of a Main Street commercial bank. As one newspaper wrote, it was as if Wal-Mart were buying Tiffany’s. Now that Bear, Lehman, and Merrill were gone, the two remaining investment banks, Morgan Stanley and Goldman Sachs, came under pressure. All of Wall Street knew that their reliance on short-term funding, coupled with extremely high leverage, made them vulnerable to a bank run; and the Morgan and Goldman stock prices began to show up permanently at the top of the CNBC screen, in what traders called the “death watch.”25 The trouble at the giant insurer AIG only made things worse. By writing credit default swaps, AIG had sold protection against the danger that all manner of bonds might go into default—it was the “HOW COULD THEY DO THIS?” 363 kind of crazy risk taking you got when you located an ambitious trading operation inside the bosom of a well-capitalized firm, imbuing the traders with a heady sense of invulnerability. Inevitably, AIG’s credit default swaps lost billions when the likelihood of default spiked up amid the crisis following Lehman. On Tuesday, September 16, the government was forced to rescue the firm, lending it an astonishing $85 billion. The day after that, rumors that Morgan Stanley was exposed to AIG’s mess helped to drive Morgan’s stock down 42 percent by the middle of the afternoon. Hedge funds clamored to get their assets out of Morgan, desperate to avoid being caught in another Lehman-type trap. Morgan’s chief executive, John Mack, raged against short-selling conspirators who were supposedly driving him under. It was a repeat of the battles that Bear Stearns and Lehman had waged against hedge funds in their own moments of crisis. Around the same time, Ken Griffin of Citadel calculated the odds that his hedge fund might fail also. He had aspired to build a firm like Morgan Stanley or Goldman Sachs, and he had some of the same vulnerabilities. He had leveraged his capital by more than ten to one—a far less aggressive ratio than the thirty-to-one that was typical of investment banks but well over the single-digit multiple that was normal for hedge funds.26 And because Citadel had issued a small quantity of five-year bonds, there was a market for credit default swaps on its debt, so traders could telegraph anxieties about its liquidity.27 Griffin constructed a quick probability tree. He put Morgan Stanley’s chances of survival at 50 percent. If Morgan went down, the odds of Goldman following were 95 percent. If Goldman failed, the odds of Citadel collapsing were almost 100 percent, since the forced selling by Morgan and Goldman would destroy the value of Citadel’s holdings. If you put that sequence together, Citadel’s chances of survival clocked in at only around 55 percent. “That’s a pretty bad day—when you realize twenty years of your work now comes down to whether or not some firm that you have no infl uence over fails,” Griffin said later.28 Yet if Citadel shared some of the vulnerabilities of the investment banks, the way it dealt with the crisis was different. Following the path 364 MORE MONEY THAN GOD that Lehman had traveled back in the summer, Morgan and Goldman lobbied regulators to clamp down on short sales of their stock. It was an awkward demand for the two firms to make: Morgan and Goldman were short sellers themselves, since their own proprietary traders were happy to take both sides of any position; and both had built up a fl ourishing primebrokerage business, financing and executing short sales by hedge funds. But in the frenzied days after Lehman, neither Morgan nor Goldman was going to stand on principle. As their stock prices cratered on Wednesday, the two firms worked the phones; and by the end of the day, both New York senators, Chuck Schumer and Hillary Clinton, were calling on the Securities and Exchange Commission to give Morgan and Goldman the short-selling ban that they demanded. On Thursday SEC chairman Christopher Cox expressed doubts about helping the bankers, but he found himself alone. “You have to save them now or they’ll be gone while you’re still thinking about it,” insisted the Treasury secretary Hank Paulson.29 At around 1:00 p.m., the Financial Services Authority in London announced a thirty-day ban on short selling of twenty-nine fi nancial firms, signaling that the authorities would now do whatever it might take to save flagship companies. On Goldman’s trading floor, some three dozen traders greeted the news like infantrymen who have been rescued by air power: They stood up, placed their hands over their hearts, and sang along to “The Star-Spangled Banner,” which someone was playing over the loudspeaker system.30 Later that evening, the SEC went one better than London, banning the short selling of shares in about eight hundred fi nancial companies. The ban brought Morgan and Goldman some brief breathing room, but it amounted to a frontal government assault on hedge funds’ viability. Stock-picking funds lost hundreds of millions of dollars as a result of the rule change: “We went from playing chess to rugby at halftime,” one Tiger cub complained; and the claim that the ban protected the financial system was a stretch, since corporations ranging from Internet incubators to retailers were included.31 But even as they tried to pull the hedge funds down with them, the investment banks were not out of the woods; and they immediately resumed their lobbying. During the good times, “HOW COULD THEY DO THIS?” 365 Morgan and Goldman had reveled in the fact that they were not deposittaking banks, subject to the Fed’s regulatory oversight. But now they performed a swift U-turn: They demanded to be swept under the Fed’s purview because they wanted guaranteed access to its emergency lending. On the evening of Sunday, September 21, Morgan and Goldman got what they desired. The Fed extended its protection to them, and their vulnerability ended. Because it was classifi ed as a hedge fund, Citadel did not get the same access to emergency Fed lending. On the contrary, the government had kicked it in the teeth, since the ban on short selling cost it dearly. Citadel had built up a giant portfolio of convertible bonds, which it hedged by shorting stocks: The idea was that the options embedded in the bonds were underpriced relative to the underlying equity. The ban on short selling made it impossible to hedge new convertible positions, so demand for convertible bonds cratered and Citadel was left with shocking losses.32 By the end of September, its main funds were down 20 percent for the month; and the more Citadel’s equity base shriveled, the more its leverage ratio went up. Since its creation in 1990, Citadel had grown from nothing to $15 billion in assets and 1,400 employees. Now its survival was in question. Griffin assembled his lieutenants to consider the firm’s options. If he cut leverage by selling convertible holdings, rivals would see he was desperate and would start squeezing his portfolio. If he did nothing, on the other hand, he would soon run out of cash and be unable to meet margin calls. Meanwhile, Griffin and his team were focused on an additional danger. If trading partners started to worry about Citadel’s survival, they would mark down the estimated value of its derivatives contracts, forcing Citadel to cough up cash until its coffers were empty. That was what brokers had done to Askin Capital, Long-Term Capital, and pretty much every failing institution since then. In the first weeks of October, Citadel fought a two-front war against these enemies. It jettisoned assets that were not part of its main strategies, thus raising capital without telegraphing its distress too obviously. It closed derivatives contracts with other firms, replacing them in some 366 MORE MONEY THAN GOD cases with contracts on an exchange—unlike brokerages and banks, the exchange was not going to squeeze them.33 Where it was not possible to close out derivatives contracts, Citadel took comfort in what was arguably one of its greatest strengths: a state-of-the-art back offi ce. Unlike many hedge funds, Citadel maintained the computer infrastructure, data feeds, and financial models to track the daily value of every derivative contract purchased from a bank; the better it understood what these things were worth, the harder it would be for counterparts to push the daily marks against it. This sort of plumbing was Citadel’s pride and joy. Recalling Long-Term Capital’s promise to do without a back offi ce—to create “Salomon without the bullshit”—a Citadel staffer joked that LongTerm had things upside down. Salomon’s back office had constituted the firm’s true edge. The LTCM partners were the bullshit. Citadel’s computer infrastructure increased Griffin’s chances of saving his company. But his key advantage lay in the terms of his funding. Unlike investment banks, which were willing to do the lion’s share of their borrowing on extremely short terms, Citadel’s treasury department had been more careful. It had analyzed the mix of assets in its portfolio, calculating how long it would take to sell each kind; then it had lined up a blend of loans with the same mix of maturities. The idea was that Citadel should only rely on overnight funding to the extent that it had assets that could be sold overnight; harder-to-sell investments were backed by harder-to-yank borrowing. Citadel’s five-year bond issuance, unusual for a hedge fund, was part of this focus on borrowing longer term, and Griffin’s team had also negotiated bank loans that were locked in for as long as a year. Even a crisis was not going to push Citadel into a death spiral of fire sales—or at least that was the theory. In practice, of course, it was hard to feel so confident. Citadel had planned for a crisis, but not a crisis on this scale, and nothing could insulate it from what was going on around it. Other hedge funds, which had done less to lock in their financing securely, faced margin calls that forced them to dump convertible bonds and other positions; the weight of their selling caused Citadel to suffer yet more losses. Rumors that Citadel might be about to go under seemed to surface at dizzying speed. Citadel had “HOW COULD THEY DO THIS?” 367 been hit with margin calls! The Fed was calling Citadel’s trading partners, asking the size of their exposures! The truth was that the Fed was indeed calling around Wall Street, telling banks not to pull loans; but whether this saved Citadel or served to fuel the rumor mill could be debated. On some days in October, CNBC parked a truck outside the Citadel Center. A new deathwatch was beginning. On the morning of Friday, October 24, a young Griffi n lieutenant named Dan Dufresne set off to catch a train to the office. Soon after he left home, he took a call on his cell phone from the New York offi ce of a European bank. As head of Citadel’s treasury department, Dufresne stayed in touch with all the banks that financed Citadel’s positions. “Hey, Dan,” the voice said. “Just so you know, there are rumors that are picking up momentum in Europe that the Fed is in your offi ce in Chicago, organizing a liquidation of your assets.” Dufresne decided he would get a cab. He was not going to discuss Citadel’s alleged demise in a crowded commuter train. “I’m hearing from our guys in London that this is happening,” the voice pressed. “Is it? I’m sure it’s not, but you need to know that it’s picking up speed.” Dufresne assured his contact that it was just another rumor. He talked to him for maybe ten minutes, but as soon as he hung up he got another phone call. It was the same rumor again. By the time Dufresne had reached his desk at the Citadel Center, there had been a third call and a fourth one. Dufresne’s colleague Gerald Beeson had been in the office early. He had been peppered with questions from European trading desks since fi ve o’clock that morning. Dufresne and Beeson suspected that financial journalists had gotten hold of this rumor and were bouncing it off everyone they knew. They must have called every bank in London. The rumor was spreading faster than Citadel could douse it. A little while later, James Forese, Citigroup’s head of capital markets, placed a call to Ken Griffin. According to the rumors Forese was hearing, Griffin was visiting the Fed in Washington, looking for a bailout. Credit default swaps on Citadel’s bonds were trading at distressed levels. 368 MORE MONEY THAN GOD They were signaling more trouble even than Lehman’s had on the eve of bankruptcy. After dialing Citadel’s number, Forese was put on hold for a minute. Then Griffin picked up and started talking. “You’re calling me for one of three reasons. One, to see if I’m alive. Two, to see if we have any money . . .” Forese cut him off. “The reason I’m calling is to offer you help. If you need to liquidate portfolios and need someone to discreetly handle that, you know we would do that for you.” “We’re losing a lot of money,” Griffin conceded. “But we’ve got a lot of liquidity.” Because Citadel had locked up long-term funding with its counterparts, it was not facing margin calls. Because it had the back-offi ce systems to track the precise value of everything it owned, the banks were less aggressive than they might have been in moving the marks against it. Besides, Citadel had sold plenty of assets to raise cash. It had been more proactive than Bear or Lehman in preventing its leverage from spiraling upward. Forese wondered whether all this would be enough. “You guys are getting killed in the rumor mill,” he ventured. “I know. I can’t get rid of the rumors,” Griffin conceded. The rumors were making people think that Citadel was about to dump its portfolio of convertible bonds. The threat of a fire sale was driving down prices, compounding Citadel’s difficulties. Every time a Citadel executive got a panicky phone call from a trading counterpart, he explained why the rumors were false. But no matter how many panicky callers Griffi n’s team assuaged, the rumors were growing more hysterical. “You need a good window to get your story out,” Forese said. “I don’t know what the forum for that is,” Griffin answered. The last thing he wanted to do was stage a conference call that appeared to confirm the market’s worst suspicions. Bear and Lehman had done calls. A fat lot of good it had done them. Forese remembered that Citadel had issued some fi ve-year bonds. Without signaling panic or anything out of the ordinary, the firm could convene a phone call for the bondholders. What’s more, doing the call “HOW COULD THEY DO THIS?” 369 in that format would give the message extra weight. Griffin could get in trouble with the regulators if he gave his bondholders anything other than the truth. That would make Griffin’s assurances believable. “That’s a pretty good idea,” Griffin allowed. He hung up and summoned his lieutenants.34 Around ten-thirty in the morning, Griffin’s inner circle convened around a whiteboard. Somebody jotted down the half dozen points that Citadel needed to get across. Griffin wanted Gerald Beeson, the supercharged chief operating officer, to do most of the talking. Another note was added to the whiteboard: “Speak slowly.” “How many call-in lines?” somebody asked. When a big company such as Coca-Cola held its quarterly investor call, it usually arranged about 250 lines. But Citadel had only a handful of bondholders. “Five hundred,” somebody ventured. “A thousand,” Beeson countered. The call was scheduled for 3:30 p.m., but there was no way it could begin on time. Well over a thousand callers attempted to dial in—traders, investors, financial reporters. This was to be the culmination of the Citadel deathwatch, the biggest financial drama since Lehman’s failure; on some Wall Street trading floors, the call was played over loudspeakers. There was a twenty-five-minute delay as more phone lines were arranged. Those who managed to get in on the call were treated to some grating techno music. Eventually, Beeson began to give his pitch. Yes, it was true that Citadel’s two flagship hedge funds were down 35 percent. But the firm was a long way from running out of cash. Its financing was secured. It had an untapped $8 billion credit line. There was no way it would go under. Adam Cooper, Citadel’s general counsel, held up a sign in front of Beeson to remind him not to speak too fast. “To call this a dislocation doesn’t go anywhere near the enormity of what we’ve seen,” said Beeson, emphasizing that Citadel would still survive. “We will prosper in the new era of fi nance,” Griffi n added, mustering all the confidence that he could manage. After twelve minutes, the call was over. Griffin got off the phone and went to answer questions from his staff 370 MORE MONEY THAN GOD in a town-hall meeting. Beeson spent the afternoon on a series of calls with reporters. He hammered home the same message. Citadel had moved aggressively to raise cash. Its credit lines were all secured. Even though the government had rescued Morgan Stanley and Goldman Sachs while leaving hedge funds in the cold, Citadel was not going under. The next day the CNBC truck was gone from its usual position outside the Citadel Center. For the time being at least, the fires had been doused.35 FOR THE NEXT SEV ER A L WEEKS, CITA DEL’S LOSSES CONtinued. By the end of the year its two flagship funds were down a stunning 55 percent; the $9 billion that evaporated was the equivalent of at least two Long-Term Capitals. But although nobody said so, Citadel’s humiliation was a model of how the financial sector should work. Investors who had risked their capital with Griffin, and been rewarded for years, were forced to take extraordinary losses—exactly as should happen. But the fi nancial system was not destabilized, and taxpayers were not called upon to throw Citadel a lifeline. The episode showed that leveraged trading fi rms with billions under management do not necessarily need government rescues when markets go berserk; careful liquidity management can substitute for the Fed’s safety net. The old-line investment banks had built castles of leverage on foundations of short-term loans; when the crisis came, the whole edifice toppled. But because he shared the paranoid culture of hedge funds, Griffin had leveraged himself a bit more cautiously and relied less on short-term loans; when the moment of truth came, Citadel survived it. And so it turned out that an upstart Goldman imitator could be better for the financial system than the real Goldman—not to mention incomparably better than Bear Stearns or Lehman Brothers. Citadel’s experience dramatized the wider experience in the hedgefund industry. Hedge funds had danced through the minefields until Lehman’s collapse in September, but they were whipsawed in the panic that followed. They based their strategies on short selling, and the government banned that. They based their portfolios on leverage, and leverage dried “HOW COULD THEY DO THIS?” 371 up as brokers hoarded capital. By the end of 2008, most funds had lost money; almost 1,500 had gone bust; many a titan found his reputation justly deflated. And yet, even in the worst period of their history, hedge funds proved their worth. The industry as a whole was down 19 percent in 2008, but the S&P 500 fell twice that much. And unlike the banks, investment banks, home lenders, and others, hedge funds imposed no costs on taxpayers or society. This point was largely lost amid the crisis. The bursting of the hedgefund bubble left no room to think about the policy meaning; the titans had flown so high that the spectacle of their fall was mesmerizing. Back in the fi rst half of 2008, Phil Falcone of Harbinger Capital had returned 43 percent and stalked the New York Times; in September he lost more than $1 billion in a week thanks to Lehman’s collapse and the SEC ban on short selling. In February 2007, an alpha factory called Fortress had gone public amid great fanfare, creating paper wealth of $10.7 billion for its helicopter-riding chiefs; by December 2008, Fortress’s assets had collapsed by almost a third, and the firm was forced to fire two dozen portfolio managers. John Meriwether and Myron Scholes, veterans of the Long-Term Capital saga, had each set up new hedge funds in 1999 that did well for several years; by the end of 2008, both were near the precipice. Chris Hohn of the Children’s Investment Fund finished 2008 down 42 percent and seemed to lose his intellectual moorings too. “Quite frankly activism is hard,” he said, as though surprised by his discovery.36 Stunned by these reversals, investors scrambled to get their money out. Hedge funds might have fallen far less than the S&P 500, but customers expected them to be up in any sort of market, as though the magicians who ran them had abolished risk rather than merely managing it. Even the macro hedge funds, which gave up only a small sliver of their earlier gains in the months after Lehman, were not exempt from this storm: They had to contend with $31 billion of net redemptions because everybody was withdrawing cash from everybody. Hedge funds responded with the tool to which Tudor had resorted—they locked investors in by suspending quarterly redemptions and “gating” their money. Sometimes investors were lucky to be taken prisoner: The gates averted the need for disastrous 372 MORE MONEY THAN GOD fire sales of assets and were accompanied by a suspension of management fees. But other times the gates were an outrage. One prominent hedge fund was said to have charged a departing investor a fee for early redemption; then it blocked the redemption, refused to return the fee, and carried on charging a management fee on top of that. The larger the hedge fund, the more peremptory and arrogant the managers tended to be—and frequently it was the bigger funds that had the worst performance. The big alpha factories were stuck in losing positions when liquidity dried up: Tom Steyer’s Farallon, which had been managing $36 billion at the start of 2008, shriveled to $20 billion in 2009. Meanwhile, nimbler boutiques—closer in spirit to the Steyer of the previous decade—frequently escaped with minor scratches. Rock Creek Capital, a savvy fund-of-funds, calculated that hedge funds with assets under $1 billion were down a relatively modest 12 percent in 2008. Meanwhile the funds that Rock Creek tracked with $1 billion to $10 billion in assets were down 16 percent, and those with more than $10 billion were down 27 percent. And yet, for all the losses, hedge funds’ mystique survived the crisis. They were repellent and attractive, objects of envy and yearning; they remained the wizards of modern capitalism’s favorite pastime, the unabashed pursuit of money. In November 2008, after two months of market pandemonium, five hedge-fund barons were called to testify in Congress, in what promised to be a show trial: The billionaires would be scolded for upending the economy. But some way through the proceedings, an unexpected tone emerged. Peering down from his dais, Representative Elijah Cummings, Democrat of Maryland, recounted his neighbor’s reaction to the day’s hearing. It was not a reproach, an accusation, nor even an expression of pity. It was a simple question, tinged with awe. “How does it feel to be going before five folks that have gotten more money than God?”37 Conclusion: Scarier Than What? Early in the first hedge-fund boom, in 1966, bankers at Merrill Lynch, Pierce, Fenner & Smith agreed to underwrite a convertible debt offering for Douglas Aircraft. As they worked with their client, they learned that Douglas was cutting its earnings forecast to $3.50 per share, about a quarter lower than projected. A little while later they heard that Douglas’s earnings might come in at under $3; and then they were informed that earnings would be, ahem, zero. This was a bombshell. The news would send Douglas’s share price into a free fall; and Merrill’s bankers, who were privy to the information by virtue of their role as insider advisers, were strictly forbidden to leak it to Merrill’s brokerage customers. But not for the last time at an investment bank, internal controls failed. On June 21 the facts about Douglas Aircraft’s collapsing prospects made their way to Lawrence Zicklin, a Merrill Lynch broker who handled the firm’s hedge-fund clients.1 Zicklin had a direct wire from his desk to Banks Adams, a segment manager who ran money for A. W. Jones. The wire had been installed a year earlier, and its presence signifi ed that Zicklin was expected to tell Adams everything he knew the moment he knew it. The Jones men were paying Merrill generous commissions, and they expected service in return; Zicklin was not about to make the stunning Douglas Aircraft news some 374 MORE MONEY THAN GOD kind of holy exception. According to an administrative proceeding filed by the Securities and Exchange Commission, Zicklin called Adams, who immediately placed orders to sell 4,000 shares of Douglas short. Then Zicklin also phoned Richard Radcliffe, the ex-Jones man who had set up a new hedge fund with Barton Biggs, and Radcliffe shorted 900 Douglas. John Hartwell, a mutual-fund star who was running a model portfolio for Jones, got the call too. He dumped 1,600 Douglas shares instantly. The next morning the Wall Street Journal ran a bullish story on the aircraft industry. As far as the average investor was concerned, nothing was amiss with Douglas, and its stock actually advanced a dollar. But that day some of the best-connected money managers attended one of the regular lunches hosted by Bob Brimberg, a legendary broker. Brimberg combined a formidable intellect with a formidable physique: He was as wide as a truck, and the scale that his partners had installed by his desk failed to stop him from becoming wider. At a typical lunch at Brimberg’s, the host would ply his guests with meatballs and corned-beef sandwiches and cocktails. Then he would demand to know what they were buying and selling; and no money manager would risk an outright lie, because he would not be invited back again.2 On June 22, Brimberg pumped his guests as usual. Somebody said something about Merrill Lynch and Douglas, and that afternoon the guests were jumping on the phones, calling the Merrill desk to demand confirmation. By the end of the next day, thirteen Merrill clients had dumped 175,800 shares in Douglas. Six of the thirteen were hedge funds, an impressive tally for an industry that was still little known outside Wall Street. The sales became the subject of a drawn-out inquiry by the Securities and Exchange Commission, which forced several of the funds into expensive settlements. Almost half a century later, hedge funds were still getting privileged information and still getting into trouble. This time the center of the scandal was Raj Rajaratnam, a voluble Sri Lankan-born investor with a Bob Brimberg physique, who ran a hedge-fund company called the Galleon Group. He was less a master of the universe than a master of the Rolodex, as the SEC’s enforcement chief remarked; he had no amazing special sauce, but he had a lot of special sources. According to a criminal CONCLUSION: SCARIER THAN WHAT? 375 complaint brought by the Manhattan district attorney’s office in 2009, Rajaratnam’s contacts gave him advance warning that a technology manufacturer called Polycom would announce unexpectedly good earnings; Galleon allegedly turned that tip into a quick half-million-dollar profi t. The contacts whispered that the private-equity group Blackstone was about to bid for Hilton Hotels; Galleon allegedly pocketed $4 million. The contacts knew for certain that Google’s earnings would disappoint; this time the supposed windfall weighed in at $9 million. Rajaratnam’s Rolodex extended to a senior executive at Intel and a director at McKinsey, both of whom were apparently prepared to leak secrets in return for a share of the takings. According to the prosecutors, the conspirators sought to cover up their trail by frequently discarding mobile phones, a technique reminiscent of drug gangs. After an illegal trade, one of the accused allegedly destroyed his phone by tearing the SIM card in half with his teeth. In the face of all these allegations, Rajaratnam pleaded innocent. Clearly, hedge-fund managers are not angels. Their history is full of blemishes, from Michael Steinhardt’s collusive block trading to David Askin’s nonexistent mortgage-prepayment model. The very structure of a hedge fund has worried regulators since the early days. At the time of the Douglas Aircraft case, regulators fretted that hedge-fund patrons included rainmakers and senior executives at public firms—what if these well-placed folk leaked privileged facts to the men who looked after their money? Two generations later, these suspicions seem to have been vindicated in the Galleon affair, and it would be naive to suppose that other 1960s misgivings have lost their relevance. The Douglas case showed that the enormous commissions that hedge funds generate for brokers create a potential for abuse, and it’s a pretty fair bet that such abuses continue. There are criminals and charlatans in every industry. Hedge funds are no different. And yet, equally clearly, hedge funds should not be judged against some benchmark of perfection. The case for believing in the industry is not that it is populated with saints but that its incentives and culture are ultimately less flawed than those of other financial companies. There is no evidence, for example, that hedge funds engage in fraud or other abuses more often than rivals. In 2003 an SEC inquiry looked for such evidence 376 MORE MONEY THAN GOD and found none; and indeed a freestanding hedge fund is arguably less likely to receive illegal tips than an asset manager housed within a major bank, which is privy to all manner of profitable information fl ows from corporate clients and trading partners. For sensitive news to reach the wrong ears inside a modern financial conglomerate, it merely has to pierce the Chinese walls dividing equity underwriters or merger advisers from proprietary traders. For the news to reach a hedge fund, it has to take the additional step of exiting the building. What is true for fraud and insider trading is also true for most other accusations leveled at hedge funds: The charges might be better directed against other financial players, as we shall see presently. But the heart of the case for hedge funds can be summed up in a single phrase. Whereas large parts of the financial system have proved too big to fail, hedge funds are generally small enough to fail. When they blow up, they cost taxpayers nothing. AFTER THE BUST OF 2007–2009—AND AFTER THE CIRCUitous regulatory debate that has followed—it is hard to overstate this small-enough-to-fail advantage. The implosion of behemoths such as Lehman Brothers and AIG caused a freeze-up in the global credit system, creating the steepest recession since the 1930s. The cost of the bailouts compounded the crisis of public finances in the rich world, accelerating the shift of economic power to the emerging economies. The U.S. national debt jumped from 43 percent of GDP before the crisis to a projected 70 percent in 2010, while public debt in China, India, Russia, and Brazil remained roughly constant; meanwhile in Europe, countries such as Greece and Ireland teetered on the brink of bankruptcy. According to the International Monetary Fund, the cash infusions, debt guarantees, and other assistance provided to too-big-to-fail institutions in the big advanced economies came to a staggering $10 trillion, or $13,000 per citizen of those countries.3 The sums spent on rescuing well-heeled fi nanciers damaged the legitimacy of the capitalist system. In December 2009, President Barack Obama said plaintively that he “did not run for offi ce CONCLUSION: SCARIER THAN WHAT? 377 to be helping out a bunch of fat cat bankers.”4 But help them out is what he did, and populist anger at his openhanded policies is hardly surprising. Even more worryingly, neither Obama nor any other leader knows how to prevent too-big-to-fail institutions from fleecing the public all over again. The worst thing about the crisis is that it is likely to be repeated. To see why this is so, start with the catch-22 that bedevils government support for the financial sector. On the one hand, many fi nancial institutions are indeed too big to fail; if governments refuse to rescue them, seeking to protect taxpayers’ money, they open the door to a meltdown that will cost taxpayers even more—as the post-Lehman crisis demonstrated. On the other hand, each time the government pays the bills for the risk taken by financiers, it reduces the cost of that risk to market players, dampening their incentive to reduce it. If there were no deposit insurance, for example, depositors would face losses when banks went under; they might refuse to entrust their savings to risk-hungry banks, or might demand higher interest rates as compensation. Equally, if governments did not backstop banks (and now investment banks) by acting as lenders-of-last-resort, investors who buy bonds issued by banks might do more to monitor their soundness. The point is not that there should be no deposit insurance or lender-of-last-resort liquidity insurance, since letting big institutions fail is simply too costly. But the unpleasant truth is that government insurance encourages fi nanciers to take larger risks; and larger risks force governments to increase the insurance. It is a vicious cycle. You can observe this cycle at work in the history of banking. Over the past century, governments have repeatedly broadened the scope of lastresort lending, loosened its terms, and extended deposit insurance to a larger share of banks’ customers. As governments have underwritten more risks, risk taking has grown. Since 1900, U.S. banks have tripled their leverage from around four to twelve; they have taken more liquidity risk by using short-term borrowing to purchase long-term assets; and they have focused more of their resources on high-risk proprietary trading.5 The 2007–2009 crisis, in which governments extended the reach of deposit insurance, guaranteed savings held in supposedly uninsured money-market funds, and bent over backward to pump emergency liquidity into all 378 MORE MONEY THAN GOD corners of the markets, is likely to induce even more recklessness in the future. Put simply, government actions have decreased the cost of risk for too-big-to-fail players; the result will be more risk taking. The vicious cycle will go on until governments are bankrupt. There are two standard responses to this scary prospect. The first is to argue that governments should not bail out insurers, investment banks, money-market funds, and all the rest: If financiers were made to pay for their own risks, they would behave more prudently. For example, if investors had been forced to absorb the cost of the Bear Stearns bankruptcy in early 2008, rather than having the blow softened by a Fed-subsidized rescue, they might have prepared themselves better to absorb the costs of Lehman’s failure some months later. But this purported solution to the too-big-to-fail problem denies its existence: Precisely because some institutions are indeed too big to fail, they cannot be left to go under. What’s more, the behemoths and those who lend to them understand their inviolability all too well; the government may claim that it won’t rescue them, but everybody understands that it will have no choice when the time comes. Even the soft version of this laissez-faire prescription is unconvincing. One can speculate about a world in which regulators save really large institutions but allow medium-sized ones such as Bear to go under. But this is not the world we inhabit. Regulators will usually lean toward intervention because they don’t want a disaster on their watch. That is human nature, and there is no way to change it. The second standard response to the vicious cycle is to devise regulations that break it. Safety nets for banks may encourage risk taking, and risk taking may force the growth of safety nets; but this arms race can be stopped by imposing capital requirements on banks, monitoring their liquidity, restricting their proprietary trading—and generally by curbing their risk appetites. Up to a point, tougher regulation holds out hope; as I finished writing this book, governments across the rich economies were getting ready to try it. But the world has experimented with multiple regulatory efforts by multiple agencies in multiple countries, and it has learned to its cost that no regulatory system is foolproof. The fi rms that went wrong in 2008, for example, were overseen by a broad array of CONCLUSION: SCARIER THAN WHAT? 379 agencies applying a broad array of rules. American deposit-taking banks were overseen by the Federal Reserve, the Federal Deposit Insurance Corporation, and two smaller bodies, and they were required to abide by the Basel I capital-adequacy standards: They did miserably. American investment banks were overseen by the Securities and Exchange Commission and required to abide by a different set of risk limits: Two failed, one sold itself to avoid failure, and two were rescued by the government. The government-chartered housing finance companies, Fannie Mae and Freddie Mac, had a special government department devoted to their oversight: They had to be nationalized. The giant insurer AIG crashed through the regulatory net; money-market funds, supposedly overseen by the Securities and Exchange Commission, required an emergency guarantee from the government. Meanwhile in Europe, the chaos was equally awful. London’s Financial Services Authority was thought to be a model regulator; Britain was nonetheless beset by a string of costly disasters. In continental Europe, banks were subject to an updated version of the Basel capital requirements. It did not make any difference. When so many regulators fail at once, it is hard to be confi dent that regulation will work if only some key agency is differently managed, better staffed, or cleansed of alleged laissez-faire ideology. Rather, the record suggests that financial regulation is genuinely difficult, and success cannot always be expected. Again, there are reasons why this should not come as a surprise. Determining what it takes to make a fi nancial institution robust involves a series of slippery judgments. The amount of capital needed should not be measured relative to assets, since assets could mean anything from a scary portfolio of mortgage bonds to a safely hedged book of government bonds. Instead, capital should be measured against risk-weighted assets, but then you have to define risk—and be prepared to argue about the definition. Further, it is not just the amount of capital that determines how resilient an institution is. Borrowing short-term makes you more vulnerable to a sudden loss of confidence than borrowing long-term, so the structure of an institution’s funding must be reckoned with. Trading illiquid instruments that cannot be sold quickly, whether they are complex mortgage securities or loans to Kazakh banks, is riskier 380 MORE MONEY THAN GOD than trading on a well-organized exchange, creating another dimension on which regulators are obliged to make a judgment. Competent offi cials can navigate such tricky challenges and sometimes do—regulators are like air-traffic controllers, who are ignored when things go well and excoriated after a disaster. But at each step of the way, the regulators’ desire for safety will bump up against financial institutions’ appetite for risk. Given the brainpower and political influence of large fi nancial firms, they are bound to win some of the arguments over judgment calls. Regulation will be softer than it should be. If financial behemoths cannot be left to go under, and if regulation is both essential and fallible, policy makers should pay more attention to a third option. They should make a concerted effort to drive financial risk into institutions that impose fewer costs on taxpayers. That means encouraging the proliferation of firms that are not too big to fail, so reducing the share of risk taking in the financial system that must be backstopped by the government. It also means favoring institutions where the incentives to control risk are relatively strong and therefore where regulatory scrutiny assumes less of the burden. How can governments promote small-enoughto-fail institutions that manage risk well? This is the key question about the future of fi nance; and one part of the answer is hiding in plain sight. Governments must encourage hedge funds. Hedge funds are clearly not the answer to all of the fi nancial system’s problems. They will not collect deposits, underwrite securities, or make loans to small companies. But when it comes to managing money without jeopardizing the financial system, hedge funds have proved their mettle. They are nearly always small enough to fail: Between 2000 and 2009, a total of about five thousand hedge funds went out of business, and not a single one required a taxpayer bailout. Because they mark all their assets to market and live in constant fear of margin calls from their brokers, hedge funds generally monitor risk better and recognize setbacks faster than rivals: If they take a severe hit, they tend to liquidate and close shop before there are secondary effects for the financial system. So rather than reining in risk taking by hedge funds, governments should encourage them to thrive and multiply and absorb more risk, shifting the job of CONCLUSION: SCARIER THAN WHAT? 381 high-stakes asset management from too-big-to-fail rivals. And since the goal is to have more hedge funds, burdening them with oversight is counterproductive. The chief policy prescription suggested by the history of the industry can be boiled down to two words: Don’t regulate. THIS VERDICT IS OPEN TO SEVERAL OBJECTIONS, AND THE first concerns the way that hedge funds treat their customers. Ever since the 1960s, the 20 percent performance fee has excited envy and alarm— surely this heads-I-win-tails-you-lose format promotes wild punts with clients’ capital? More recently, academics have advanced a subtle version of this criticism: The incentive fee may induce hedge funds to generate pleasingly smooth returns that conceal a risk of blowup. A fund can take in $100, stick it in the S&P 500 index, then earn, say, $5 by selling options to people who want to insure themselves against a market collapse. If the collapse occurs, the hedge fund gets wiped out. But, over a five- or even ten-year time frame, the odds are good that a collapse won’t happen, so each year the fund manager will beat the S&P 500 index by 5 percentage points—and be hailed as a genius. When this sort of trickery is rewarded with hedge-fund performance fees, the argument continues, rogues are bound to try it out.6 The upshot is that investors who ought to have the benefit of consumer-protection regulation will be left to get hurt. And when options-selling hedge funds blow up, markets will be destabilized. These complaints about hedge-fund incentives seem plausible—until you take a look at the alternatives. Investing in a hedge fund is safer than other behaviors that do not excite controversy—buying stock in an investment bank, for example. Hedge funds have a powerful reason to control risk better than banks, as we have seen: The majority of them have the managers’ own wealth in the fund, alongside that of their clients. Moreover, if hedge funds’ 20 percent performance fees seem to invite excessive risk taking, bank performance fees are far larger. In recent years, investment banks have distributed fully 50 percent of their net revenues as salary and bonuses; even though this comparison is not perfect, it puts the criticism of hedge-fund fees in perspective. Investment-bank compensation 382 MORE MONEY THAN GOD creates a larger incentive for managers to shoot for the moon, damaging financial stability when they miss it. And whereas the formula for fees at hedge funds is fixed ahead of time, banks reserve the right to decree the appropriate level each year. The payout can change on the managers’ say-so, and rank-and-file shareholders have no right to be consulted. How do hedge funds compare with mutual funds? On the face of it, hedge funds are scandalously expensive: Whereas mutual funds tend to charge a management fee of about 1 percent, hedge funds tend to demand a management fee of 1 percent to 2 percent plus the performance fee of around 20 percent. But to understand which vehicle is the rip-off, you have to distinguish between alpha (returns due to the fund manager’s skill) and beta (returns due to exposure to a market index). An investor can buy exposure to a simple index such as the S&P 500 for a mere ten basis points (tenths of a percent), so the actively managed mutual fund with a 1 percent fee is effectively charging ninety basis points for delivering alpha. Unfortunately, study after study has found that active mutualfund managers, as a group, do not beat the market.7 They are charging ninety basis points and delivering nothing. Their fee per unit of alpha turns out to be infi nite. Even if the average actively managed mutual fund is a rip-off, there is still a fair question as to whether hedge funds are better. This book has described the many ways hedge funds make money: by trading against central banks that aren’t in the markets for a profit; by buying from priceinsensitive forced sellers; by taking the other side when big institutions need liquidity; by sensing all kinds of asymmetrical opportunities. It stands to reason that talented investors, free of the institutional impediments that constrain rivals, and powerfully motivated by performance fees, can rack up impressive profits—even when they pursue conceptually simple stock-picking strategies like those of the Tiger cubs, discussed in the appendix. But in its focus on the pioneers who shaped the industry, a history of hedge funds is necessarily biased toward winners. Perhaps the average hedge fund that attempts these strategies loses money? Or perhaps whatever alpha it makes is gobbled up by those performance fees? The answer to these reasonable questions will continue to be debated. CONCLUSION: SCARIER THAN WHAT? 383 Hedge funds generate returns partly by taking exotic types of risk; because these are difficult to measure, a precise verdict on the size of hedge funds’ risk-adjusted returns is bound to be elusive. As a group, funds-of-funds report returns that are lower than the returns reported by the hedge funds in which they invest; the gap is larger than can be explained by fees, suggesting that reported hedge-fund returns are frequently exaggerated. Nevertheless, the tentative bottom line on hedge-fund performance is surprisingly positive. The best evidence comes in the form of a paper by Roger Ibbotson of the Yale School of Management, Peng Chen of Ibbotson Associates, and Kevin Zhu of the Hong Kong Polytechnic University.8 The authors start with performance statistics for 8,400 hedge funds between January 1995 and December 2009. Then they correct for “survivorship bias”: If you just measure the funds that exist at the end of the period, you exclude ones that blew up in the meantime—and so overestimate average performance. Next, the authors tackle “backfill bias”: Hedge funds tend to begin reporting results after a year of excellent profits, so including those atypical bonanzas makes hedge funds appear unduly brilliant. Having made these adjustments, the authors report that the average hedge fund returned 11.4 percent per year on average, or 7.7 percent after fees—and, crucially, that the 7.7 percent net return included 3 percentage points of alpha. So hedge funds do seem to generate profi ts beyond what they get from exposure to the market benchmarks. And despite much griping about excessive hedge-fund fees, there is alpha left over for clients. One final comparison seems worthwhile: How do hedge funds stack up against their rivals in private equity? The two vehicles are both loosely described as “alternatives” by the investment industry, and they have some things in common: They are structured as private partnerships; they use leverage; they charge performance fees. Increasingly, private-equity companies have started hedge funds, and vice versa, further blurring the distinction. And yet the promise to investors is fundamentally different. Hedge funds aim to buy securities or currencies that the market has mispriced: They play a game of numbers and psychology. Private-equity funds 384 MORE MONEY THAN GOD promise to improve the performance of individual firms. They install new chief executives and get their hands on the controls, revamping everything from advertising budgets to middle-management incentives. Their claim is not that securities are mispriced but that management can be improved by an intelligent owner. So can it? Much as with hedge funds, you have to separate beta and alpha. By owning a portfolio of unlisted companies, private-equity funds deliver exposure to corporate profits that resembles the exposure from a stock-market index: This is the beta in their performance. The hope is that the funds can justify their fees by doing better than that—by beating the index and generating alpha. As it turns out, the academic verdict is positive for private-equity funds that specialize in venture capital, but ambiguous for buyout funds that take public companies private. Using various methodologies, three influential studies have found that venture capitalists generate alpha of around 4 to 5 percent per year, whereas buyout funds appear to generate returns that are little different from the S&P 500 benchmark.9 Moreover, private-equity funds have a clear disadvantage relative to hedge funds. They demand that investors commit capital for as much as a decade. Of course, hedge funds are not a substitute for other investment vehicles. For ordinary savers, mutual funds that cheaply mimic an index remain the best option. But from the point of view of large investors, hedge funds compare well with most of their rivals. They are not more prone to insider trading or fraud, and they deliver real value for their clients. “Where are the customers’ yachts?” the author Fred Schwed demanded in his classic account of Wall Street. To which the response is: Ask Harvard! Ask Yale! Their endowments returned, respectively, 8.9 percent and 11.8 percent annually between 1999 and 2009—and this despite the losses in the credit crisis. Hedge funds are a major reason why universities can afford more science facilities and merit scholarships, and why philanthropies from the Open Society Institute to Robin Hood have more money to give out. And if hedge funds also serve rich clients well, thereby contributing to the troubling gap in modern society between the superwealthy and the rest, the answer is not to smother their trading. It is progressive taxation. CONCLUSION: SCARIER THAN WHAT? 385 IF HEDGE FUNDS ARE GOOD FOR THEIR CLIENTS, WHAT other arguments point in favor of regulating them? A long-standing line of criticism focuses on trend-following hedge funds, which allegedly drive prices to illogical extremes, destabilizing economies. What merit might there be in this objection? The first thing to be said is that most hedge funds make money by driving prices away from extremes and toward their rational level. This is what arbitrage funds do, including the fast-trading statistical arbitrage funds that are frequently excoriated. Equally, when a Julian Robertson– style stock picker buys underpriced companies and shorts overpriced ones, he is moving stocks closer to the level that reflects the best estimate of their value, helping to allocate capital to the firms that will use it most productively. Likewise, commodity traders who respond quickly to news of gluts and shortages tend to stabilize markets, not deepen the panic, because their responses generate price signals that force healthy adjustment. When a commodity trader bids up the oil price on the news of a coup in Africa, he is telling the world’s motorists to economize before unsustainable consumption pushes prices up even more sharply. Still, it clearly is true that markets sometimes overshoot, and that trend-following hedge funds can contribute to this problem. Warning motorists to ease up on the gas pedal is a good thing when there is a real oil shortage, but if hundreds of traders jump on the bandwagon and push oil prices needlessly far, they are merely hurting consumers and companies and setting up the market for a destabilizing correction. In 2007, for example, investors pushed the price of a barrel of crude up from $61 to $96, which was probably a fair response to booming demand in emerging markets. But in the fi rst half of 2008, oil rose to $145—a level that probably exceeded anything that was justified by the fundamentals. In the same way, currency traders are sometimes sending rational signals and sometimes driving currencies to irrational extremes. The SorosDruckenmiller sterling trade fits into the rational category: Germany’s postunification commitment to high interest rates made the sterling peg 386 MORE MONEY THAN GOD untenable. So does Thailand’s 1997 devaluation: The country’s growing trade deficit was incompatible with its pegged exchange rate. But clearly there are also times when the currency market overshoots. In 1997, Indonesia was running a small trade deficit and a flexible exchange rate, yet it suffered a far bigger devaluation than Thailand because political instability sent the markets into a panic. If trend-following can be destructive, could hedge-fund regulation dampen it? Of course, restrictions on hedge funds would limit contrarian trend-bucking as well as trend-following trading, and there are no data to prove what the effect would be on balance. But despite the proud tradition of trend-following hedge funds from Commodities Corporation to Paul Tudor Jones, hedge-fund regulation would probably exacerbate the markets’ tendency to overshoot. Because of the way they are structured, hedge funds are more likely to be trend bucking than other types of investors. Hedge funds combine three features that equip them to be contrarian. First, they are free to go short as well as long, unlike some other institutional investors. Second, they are judged in terms of absolute returns; by contrast, mutual-fund managers must be cautious about bucking the conventional wisdom, because their performance is measured against market indices that reflect the consensus. Third, hedge funds have performance fees. To muster the self-confidence to be a trend bucker, you have to invest heavily in research, and performance fees generate the resources and incentives to do that. John Paulson did not develop the conviction to face off against the mortgage-industrial complex without spending serious money on homework. He purchased the best database on house-price statistics, commissioned a technology company to help him warehouse it, and hired extra analysts to interpret the numbers. Even a self-described trend follower such as Paul Jones underlines the contrarian potential of hedge funds. Jones is a trend follower because he knows that contrary to the efficient-market view, investors frequently react to information gradually. Pension funds, insurance funds, mutual funds, and individuals all absorb developments on their own timescales, so prices respond incrementally rather than in one jump. But precisely because he understands the markets’ momentum, Jones has a knack for CONCLUSION: SCARIER THAN WHAT? 387 sensing when it has gone too far. He is the last person to exacerbate a trend, because once a move becomes overextended, he is looking to profi t from its reversal. That is why he bet against the trend on Wall Street by shorting the market on the eve of the 1987 crash. That is why he did the same in Tokyo in 1990. And in the summer of 2008, as it happens, Jones saw that the oil market was overheated too. “Oil is a huge mania,” he declared in a magazine interview a few weeks before the bubble burst. “It is going to end badly.”10 When a trend begins to distort the economy because it has lost touch with fundamentals, the most famous hedge-fund trend follower of them all is likely to become a trend breaker. The same can be said for hedge funds in general. In Europe’s exchangerate crisis, Soros and Druckenmiller did not simply lead an attack pack of trend followers against every currency indiscriminately. On the contrary, they actually made money betting that the French franc would resist pressure for devaluation. Equally, during the crisis in East Asia, hedge funds helped to precipitate devaluation in Thailand, because the trade deficit made the peg illogical. The crazy crash of the rupiah was driven not by hedge funds but by Indonesians who were rushing to expatriate their money. Far from jumping on that bandwagon, the Soros team pushed back against it unsuccessfully. Ultimately, another hedge fund, Tom Steyer’s Farallon, helped to begin Indonesia’s turnaround with its contrarian purchase of Bank Central Asia. The point is not that hedge funds are never guilty of herding—clearly there are times when they are. In 1993 Michael Steinhardt rode a red-hot bond market into bubble territory; the next year he paid heavily. But the point is that, because of their structure and incentives, hedge funds are more likely to be contrarian than other types of investors. The regulatory lesson is contrarian too. The best way to dampen trend following is not to constrain hedge funds. It is to let them go about their business. IN SUM, HEDGE FUNDS DO NOT APPEAR TO BE ESPECIALLY prone to insider trading or fraud. They offer a partial answer to the toobig-to-fail problem. They deliver value to investors. And they are more 388 MORE MONEY THAN GOD likely to blunt trends than other types of investment vehicle. For all these reasons, regulators should want to encourage hedge funds, not rein them in. And yet there is one persuasive argument for regulating hedge funds—or rather, regulating some of them. The persuasive argument is that hedge funds are growing. The case in favor of hedge funds is a case for entrepreneurial boutiques; when hedge funds cease to be small enough to fail, regulation is warranted. Equally, when hedge funds become public companies, they give up the privatepartnership structure that has proved so effective in controlling risk: Again, the case for regulation becomes stronger. Even though some fi ve thousand hedge funds failed between 2000 and 2009, and even though none of them triggered a taxpayer bailout, the Long-Term Capital experience serves as a warning. No public money subsidized Long-Term’s burial. But the Fed was sufficiently concerned to convene the undertakers. How large does a hedge fund have to be to warrant regulation? Unfortunately, there is no simple answer. The systemic consequences of a hedge fund’s failure depend on when it occurs. Part of the reason why LTCM triggered the intervention of the Fed was that it happened at a time when markets were already running scared in the wake of Russia’s default. By contrast, part of the reason why Amaranth’s failure had no systemic consequences was that it came at a time when Wall Street was comfortably awash in easy money. Still, even though it’s impossible to know in advance whether the failure of a given hedge fund would trigger government intervention, there are three major clues to the answer: the size of its capital, the extent of its leverage, and the types of markets that it trades in. Consider the case of LTCM. On the first test—size of capital—it looked unthreatening: At a bit under $5 billion, its capital was half the size of Amaranth’s. The second test, however, raised a forest of red flags: LTCM was leveraged twenty-five times, meaning that its sudden collapse would cause $120 billion worth of positions to be unloaded on the markets; and the fund’s derivative positions created another $1.2 trillion of exposure. Finally, some of the markets in which LTCM traded were esoteric and illiquid, so that a fire sale by LTCM could cause them to freeze up completely. The combination of these considerations caused the Fed’s Peter CONCLUSION: SCARIER THAN WHAT? 389 Fisher to get involved in LTCM’s burial. The lesson is that, as of 1998, a $120 billion portfolio attached to an enormous derivatives book was large enough to trigger regulatory concern, given the additional conditions of post-Russia panic and the fund’s participation in illiquid markets. Now consider the precedents from 2006–2008. In the case of Amaranth, the three tests would have correctly predicted that the fund’s collapse would not cause a problem. With capital of $9 billion, Amaranth was a large but not enormous hedge fund. Its leverage was normal, so its total portfolio was smaller than LTCM’s. And its disastrous natural-gas trades were nearly all conducted on exchanges, meaning that they could be liquidated easily. In sum, there were no red flags in any of the three categories, so it is not surprising that Amaranth’s failure generated more newspaper headlines than shocks to the financial system. Similarly, the three tests would have predicted the systemic insignificance of Sowood’s collapse the following year: A $3 billion fund with leverage in the normal range is plenty small enough to fail, particularly when its troubles are concentrated in the relatively liquid corporate bond market. The two most revealing lessons of this period come from the quant quake of 2007 and Citadel’s near failure a year later. In both cases, the first two tests would have raised a red flag. As a group, the quant funds deployed at least $100 billion of capital in the strategies that went wrong, and were leveraged about eight times, producing a combined superportfolio of at least $800 billion. Likewise, Citadel had $13 billion in capital and was leveraged eleven times, producing a portfolio of $145 billion, not counting derivatives positions. Yet although their total exposure was worrisomely large, neither the quant funds nor Citadel proved systemically important, because they passed the third test with flying colors. The quant funds traded exclusively in superliquid equity markets, so when the crisis came they could cut leverage rapidly. Citadel, for its part, had a big book of over-the-counter transactions with other firms that could potentially be difficult to exit. But to the extent that Citadel held these illiquid positions, it took pains to lock up medium- and long-term borrowing to back that portion of its portfolio—it managed its liquidity as LTCM had tried to do, but more successfully. By backing investments that could not be sold 390 MORE MONEY THAN GOD instantly with loans that could not be yanked instantly either, Citadel avoided tumbling into a death spiral of forced selling in illiquid markets. The lesson is that portfolios above a certain threshold may prompt regulatory concern; but if regulators are satisfi ed that the firm’s liquidity is well managed, they should leave it to go about its business. These experiences suggest a tiered series of regulatory responses. When a hedge-fund company builds up total leveraged assets of more than, say, $120 billion, it should undergo regulatory cross-examination about the size of its derivatives positions and its liquidity management. Obviously the choice of threshold will be somewhat arbitrary, but given that markets have grown considerably since LTCM caused trouble with its $120 billion portfolio, setting the bar at that level seems appropriately cautious. Next, when a hedge fund acquires total assets of more than, say, $200 billion, it should face the second level of oversight, which would include scrutiny of its leverage—and, if those tricky calculations of risk-weighted assets suggest that its capital buffer is too thin, the fund would be required to add some extra padding. Again, this seems a cautious bar: At $200 billion, a hedge fund would still be considerably smaller than a small investment bank such as Bear Stearns, which held assets of $350 billion as of 2006. Finally, if a hedge fund goes public, the presumption of competent risk management should be softened, and the firm should attract more frequent and insistent attention from regulatory examiners. This three-tiered oversight regime would deliberately leave nearly all hedge funds outside the net. As of January 2009, Institutional Investor magazine listed only thirty-nine hedge funds worldwide with capital over $10 billion. The other nine thousand or so funds, accounting for a bit over half the capital in the sector, would be left alone unless unusually high leverage got them over the $120 billion threshold. There would be no need to make the nine thousand register with government agencies and no need to saddle them with time-consuming oversight—unless they were suspected of insider trading or other violations. Unburdened by compliance costs, the vast majority of hedge funds would be free to grow and thrive, hopefully taking over some of the risk that is currently managed by too-big-to-fail behemoths. Meanwhile, the small number of hedge funds CONCLUSION: SCARIER THAN WHAT? 391 that pose genuine risks to the financial system would be handled in a different way. They would be treated as though they were investment banks, since that is roughly what they would be. In 1949, when Alfred Winslow Jones set up his hedged fund, the oldline merchant banks that ultimately emerged as modern investment banks were neither global nor public. Firms such as Goldman Sachs, Morgan Stanley, and Lehman Brothers began as private operations that deployed the partners’ capital in a flexible way, much like today’s hedge funds. They managed risk ferociously—they were speculating not with other people’s money but rather with their own—and they were largely unregulated. Over the next half century, however, the investment banks sold shares in themselves to the public and opened offices around the world, not so much because sprawling public enterprises are superior platforms from which to manage risk but because the rewards to the leaders of these fi rms were irresistible. Every investment bank that went public unlocked millions of dollars of instant wealth for the partners, who swapped illiquid ownership stakes for liquid stock. Every expansion into a new market created a fresh opportunity to risk shareholders’ capital and to collect the 50 percent quasi performance fee if the risks turned out to be lucrative. The incentives that are baked into a public company pushed the investment banks to take ever greater risk, until eventually they paid the price. When Goldman Sachs and Morgan Stanley became bank holding companies at the end of 2008, they were admitting that they could survive the consequences of their public-company status only if the Fed backstopped them. Today, hedge funds are the new merchant banks—the Goldmans and Morgans of half a century ago. Their focus on risk is equally ferocious, and they are equally lightly regulated. But the same logic that tempted the old merchant banks to go public will seduce some hedge funds too; already a handful have sold shares in themselves, and doubtless more will follow. When that happens, hedge funds will pose the threat to the financial system that they have wrongly been accused of posing in the past. The wheel of Wall Street turns. Greed and risk are always with us