The leverage that moved the world

There had been many years of success, of rapid growth fueled by the money of international investors anxious to get in on a good thing. But then, with startling suddenness, things went sour. The leader admitted that some bad investments had been made and that even good investments had been financed with too much debt and too little equity. But much of the problem, he insisted, was other people's fault: investors who pulled out their money at the first whiff of difficulty, forcing a sudden financial restructuring that aggravated the losses; hedge funds that, seeing his weakness, speculated against him. And so, to the shock of many, he suddenly changed the rules, imposing new restrictions on the ability of short-term investors to withdraw funds. "If we had been smart," he declared, "we would have tied up these guys for a long, long time when we were kings of the world rather than excrement."

No, this isn't another article about Malaysia and its fiery prime minister. The individual in question is Julian Robertson, manager of--yes--a hedge fund, Tiger Management, until recently the largest such fund in the world. In its heyday in the summer of 1998, Tiger had more than $20 billion under management, considerably more than George Soros' Quantum Fund, and was reputed to be even more aggressive than Quantum in making plays against troubled economies. Notably, Tiger was perhaps the biggest player in the yen "carry trade"--borrowing yen and investing the proceeds in dollars--and its short position in the yen put it in a position to benefit from troubles throughout Asia. But when the yen abruptly strengthened in the last few months of 1998, Tiger lost heavily--more than $2 billion on one day in October--and investors began pulling out. The losses continued in 1999--from January to the end of September Tiger lost 23 percent, compared with a gain of 5 percent for the average S&P 500 stock. By the end of September, between losses and withdrawals, Tiger was down to a mere $8 billion under management. And a furious Robertson, blaming flighty European investors for aggravating the problem, announced that henceforth the privilege of quarterly withdrawals would be revoked. (As my wife declared, after reading news reports on the move, "Julian Robertson just imposed capital controls!")

Of course, everyone makes mistakes, although Mr. Robertson's difficulties may inspire a bit more Schadenfreude than your ordinary, average business disaster. The large, loud, tough-talking Robertson has none of Soros' intellectual veneer or social graces; he might have been deliberately cast to play the role of Ugly American. And while he does not share Soros' ambition to be seen as a sort of philosopher-speculator, his prominence does constitute a sort of bully pulpit--with the operative word perhaps being "bully"--from which he has not hesitated to lecture nations on their failings. The irony of his current situation no doubt pleases many.

But the really interesting thing about Robertson's problems is the way they highlight the key role played in the recent travails of the world economy by hedge funds--or, to use the terminology preferred by the IMF, "highly leveraged investors." (Yes, HLIs. In the world of international organizations such as the International Monetary Fund--IMF--and the World Trade Organization--WTO--everything seems to have a three-letter abbreviation--TLA?) Never mind the allegations of conspiracy, the claims that hedge funds profit from countries when they are down. Where hedge funds really get important is when they don't make profits, when they themselves are in trouble. Indeed, the troubles of hedge funds played a remarkably large role in the financial instability of the world over the last few years.

The reason for this crucial role is that in the 1990s a handful of highly leveraged investors became key, even dominant, players in a number of financial markets. In the international arena, Tiger and a few other funds became the key conduit, via the carry trade, for the export of capital from Japan--that is, hedge funds came to play a central role in the exchange of yen for dollars. In the domestic U.S. arena, Long-Term Capital Management became a key purchaser of a number of crucial if slightly obscure financial instruments such as commercial-mortgage-backed securities. Exactly how central these hedge funds had become was not clear until they got into trouble. But then it turned out that without them the markets could barely function.

Why were these funds so important? Even the $20 billion that Tiger managed at its peak is not a large sum in the world financial scheme of things (the total wealth of the United States alone is in the tens of trillions). And Long-Term Capital Management, which nearly brought down the U.S. financial system, had less than $5 billion under management. What was different about hedge funds was, first, their ability and willingness to leverage up the money they managed--in effect, to use their limited wealth to buy or short-sell much larger values of assets on margin; and second, their willingness to play outside the mainstream markets. Hedge funds were never important in the market for Microsoft stock or U.S. Treasury bills; but when it came to the secondary market in Danish mortgages or the forward market in the Thai baht, it was a different story.

Underlying the ability and willingness of hedge funds to take huge positions in obscure markets was the belief, both by lenders and by the hedge fund managers themselves, that they had special expertise. In the case of Long-Term Capital Management, that expertise was technical: The sophisticated financial models implemented on their computers were supposed to allow them to diversify away risks. In the case of Tiger and Quantum, it was more a cult of personality: People believed in the ability of Messrs. Robertson and Soros to outsmart markets--and so did Robertson and Soros. Indeed, you probably can't become the manager of a really large hedge fund unless you have a slightly irrational faith in your own judgment; when success depends on being able to convince other people to let you take huge risks with their money, it is not the paranoid but the megalomaniac who survive. That is, until reality catches up with them.

When reality did catch up, it had unanticipated consequences both for the funds and for markets. Look, for example, at what happened to that yen carry trade last fall. Tiger and other funds had borrowed heavily in yen, betting on a decline in the yen against the dollar. When the yen started to rise instead, they suffered losses. Since the funds were already leveraged to the hilt, this reduction in their capital forced them to reduce their exposure, which meant paying off some of those yen borrowings. But that created a fresh demand for yen and supply of dollars in the foreign exchange market, which led to more losses, forcing even more repayment, pushing the yen still higher. The result in a short period of time was a drastic appreciation of the yen and billions of dollars in losses for Tiger. A similar process of self-reinforcing movement in asset prices when Long-Term Capital Management got into trouble drove interest rates on virtually everything except the most plain-vanilla of U.S. securities to dizzying heights, or in some cases led markets simply to close up shop. And more was at stake in these asset-market collapses than the money of hedge-fund investors: The sharp rise in the yen last fall threatened to send Japan into a deflationary spiral, the drying up of liquidity in the United States briefly seemed to threaten a general financial collapse.

Which is why, in a perverse way, Tiger's current problems are good news--for they take place against a background of a generally calmer world, one that has learned to live with a greatly reduced role for investors such as Mr. Robertson. Tiger and LTCM are still around, but they are no longer as central to the world financial picture as they were--which means that the particular sort of vicious circles that brought the world to the brink a year ago are less likely to happen today.

Some of my friends in the financial industry think that hedge funds were not just a, but the source of instability in the late crisis. In that case, the clipping of those funds' wings is a fundamental change in the situation. The world is really a much safer place now than it was three years ago. I think this is a bit too optimistic; there are unfortunately many other ways for a global financial system to get into trouble (and the yen, as it happens, is once again dangerously overvalued). But anything that makes the new global economy a bit more stable is to be welcomed.