Path: bloom-picayune.mit.edu!snorkelwacker.mit.edu!americast.com!americast.com!americast-post Newsgroups: americast.forbes From: americast-post@AmeriCast.Com Organization: American Cybercasting Approved: americast-post@AmeriCast.com Subject: How the market overwhelmed the central banks Date: Fri, 6 Nov 92 11:08:08 EST Message-ID: "Copyright 1992 Forbes, Inc. Any further reproduction or redistribution without the express written permission of Forbes and ACC is prohibited." How the market overwhelmed the central banks Here's one for the ''Guinness Book of World Records'': Though the world is chock-a-block with billionaires, George Soros may be the first person to make over $1 billion in the span of a single month. That's right: one month. By Thomas Jaffe and Dyan Machan SEPTEMBER 1992 was a month inter- national money managers won't easi- ly forget. Especially George Soros, the legendary chairman of the Quan- tum group of funds. Soros and clients of his four Netherlands Antilles-do- miciled pools cleared a cool $1.5 bil- lion in just one month as a result of the upheaval in Europe's markets. Nor is that all the Soros crowd has made this year: Between the end of August and early October the net asset value of his flagship $3.3 billion (assets) Quan- tum Fund rose 31%, and it is up 51% year-to-date. As of mid-October his assets under management had swelled to $7 billion. There were other big winners in the currency turmoil that toppled the pound sterling, the lira and other soft European currencies and humbled the central banks of Europe. The big winners include Bruce Kovner of Cax- ton Corp. and Paul Tudor Jones of Jones Investments. Kovner's funds made an estimated $300 million, in- creasing assets to about $1.6 billion; Jones' funds were up some $250 mil- lion, to $1.4 billion in assets. The month of wild trading and sheer excitement that wrecked the European Exchange Rate Mechanism were also good times for leading U.S. banks with big foreign exchange op- erations, especially Citicorp, J.P. Morgan, Chemical Banking, Bankers Trust, Chase Manhattan, First Chica- go and BankAmerica. Together, in the third quarter, they netted before taxes over $800 million more than what they normally earn in a quarter from trading currencies. What did these people do to make so much money? They bet on the inevitable. They bet that the pound and the other weaker European cur- rencies were overpriced against the deutsche mark. They bet that the politicians and the central banks could not much longer maintain arti- ficially high exchange rates in the interests of European unity. Europe's Exchange Rate Mecha- nism was set up in 1979 by the then- members of the European Economic Community to keep the various Eu- ropean currencies relatively stable against one another. Relatively nar- row fixed trading ranges were estab- lished within which the prices of 11 European currencies were supposed to fluctuate. But the system could work only if the various countries coordinated their economic policies. If one nation had, say, higher inflation than another, there would be great strain on the system. Differences in interest rates also would strain the system. When differences in interest rates and inflation rates among the 11 got out of line, the central banks had to intervene to buy and thus support the weakening currency against spec- ulators and currency hedgers. In former times, powerful central banks could usually frustrate specula- tors. They did so by simply buying massive amounts of the weaker cur- rency and flooding the market with the stronger currency. But times are changing. While the central banks can mobilize tens of billions of dollars, trading in foreign currency markets now runs to a trillion dollars a day. Andrew Weisman, director of cur- rency fund management for French bank Credit du Nord, makes no apol- ogies for the speculative operations mounted by his and other banks against the fixed rates. ''The central banks brought September's debacle upon themselves,'' he asserts. Why does he say this? Because the ex- change rates they were defending may have made political sense for the Eu- ropean leaders committed to the Eu- ropean Community but no longer made any economic sense. Soros and the others who won big when the market overwhelmed the banks were mostly involved in one variation or another on a basic tech- nique: Go short the weakest curren- cies. Going short a currency can be done in a number of ways. The sim- plest is simply to borrow money, say, Italian lire, and convert the borrowed money into, say, deutsche marks at the fixed rates. Then you wait for the lira to drop sharply against the DM, buy in the now cheaper lira to repay your debt and pocket a lot of extra deutsche marks. In September the lira was trading at 765 lire to the mark. Four weeks later it took 980 lire to buy a single DM. A speculator who had performed this operation would have made a profit equal to 28% of the borrowed sum. But his profit would have been much more than 28%. Speculators with substantial credit lines like Soros can borrow on a margin of 5% and get 20-to-1 leverage. That means you can borrow $1 billion for speculation by putting up just $50 million in cash. The result: Instead of having made 28% on your lira bet, you would have made 560%, or $280 million. There are other ways, of course, to play the currency markets: through futures and options, for example. Soros actually evolved a complex play. George Soros generally avoids the press, and in this moment of great triumph, he is as elusive as ever. But it is clear that he had concluded the European central banks were holding lousy hands in their game against the speculators and hedgers. That's why he was willing to bet the ranch. Though Soros would not talk with FORBES, his spokesman did. He told us Soros has expected financial tur- moil in Europe ever since the Berlin Wall collapsed in November 1989, leading to the reunification of Germa- ny. These events, thought Soros, would doom the Exchange Rate Mechanism. A Soros spokesman explains: ''To have one [pan-European] currency and make it stick, you needed one economy. But when one country was booming because it had essentially done a leveraged buyout of East Ger- many, while the others were in a recession, this made it inappropriate for the others to rely on Germany's monetary policy in trying to maintain their own currencies.'' After German reunification, in Sor- os' view, it was only a matter of time before the European Exchange Rate Mechanism came unglued. By this year it was clear to just about everyone that some European curren- cies--the British pound and Italian lira, for example--were fundamental- ly overvalued in relation to stronger ones such as the deutsche mark and French franc. As Britain and Italy struggled to make their currencies attractive, they were forced to main- tain high interest rates to attract for- eign investment dollars. But this crimped their ability to stimulate their sagging economies. While the British and Italians tried to deal with weak economies, Germany embarked on a policy of trying to restrain its own economy, overstimulated by the spending on eastern Germany. There were plenty of players be- sides George Soros betting against the central banks and the ERM. For- eign exchange traders at money cen- ter banks and investment banks like Goldman, Sachs are constantly aware of what is happening in the interna- tional money markets. When large institutions, mutual funds and multi- national corporations that do massive currency hedging to protect their profits started selling the weaker Eu- ropean currencies in September, the traders immediately picked up on the jump in volume they were handling for their customers. They could easily estimate just how great the selling pres- sure was and how much the central banks would have to spend to prop up those currencies. Then, the banks and investment houses got into the game for their own accounts. It was obvious, for in- stance, that the Bank of England wouldn't be able to support the pound suc- cessfully, so the banks started to use their own capital to heavily sell the currency short. Some of the more aggressive, like Citicorp and Bankers Trust, made roughly an extra $200 million apiece pretax from the trading turmoil in September. And it may have been even more. But the magnitude of these gains won't show up in the third quarter's results. When trading prof- its are that large, the banks often roll them over into succeeding quarters to minimize their tax bill. We mentioned that Soros played a complex game. Here's how it went. Soros expected the following: the breakdown of the ERM and a substan- tial realignment of European curren- cies; a dramatic drop in European interest rates; a decline for European stock markets. So, rather than simply shorting the weak currencies, he also placed simul- taneous bets on interest rates and securities markets that would be af- fected by the currency realignments. In carrying out this operation, Soros and his aides sold short sterling to the tune of about $7 billion, bought the mark to the tune of $6 billion and, to a lesser extent, bought the French franc. As a parallel play they bought as much as $500 million worth of British stocks even while they were shorting sterling, figuring that equities often rise after a currency devalues. Soros also went long Ger- man and French bonds, while short- ing those countries' equities. Soros' reasoning on the French and German markets was that upward valuation was bad for equities but was good for bonds because it would lead to lower interest rates. ''When the Italians finally devalued the lira and the Germans lowered rates slightly,'' says the Soros spokes- man, ''it was almost like we'd been preparing for an exam for six months and now were finally taking our test.'' After the lira was battered, Soros read that Helmut Schlesinger, presi- dent of the Bundesbank, had openly stated that Germany's central bank would not go to the wall for the pound. Soros has said that he saw this as a ''clarion call for everyone to get out of sterling.'' Because of his strong credit, Soros was able to maintain all these posi- tions with just $1 billion in collateral. He was margined to the eyebrows, but he wasn't really gambling. "The profits that people like Soros recently made seem astronomical,'' says Gil- bert de Botton, chief of London's $5- billion-plus (assets) Global Asset Management. ''But do not rap them on the knuckles on one of the few occasions where they actually could make money. Even the pros have lost their shirts from time to time because of the absolute power of the central banks.'' Soros knew this, but all his experi- ence, all his instincts told him that this time he was betting with odds over- whelmingly in his favor. Here's how his leveraged positions worked out: The pound dropped 10%, the mark and franc both rose roughly 7%, the London stock market gained 7%, German and French bonds were up about 3% apiece, and the German and French stock markets briefly rallied, but basical- ly remained flat. FORBES has learned that since early October Soros has substantially de- creased the size of his hedge. He has bought pounds and sold marks to cover most of his short position in sterling. But Soros is still holding on to his British stocks, and continues to be bullish on European bonds. Soros sees interest rates drop- ping in Europe and thinks that the Continent is headed into a deep recession. He has taken no pride in being referred to as the man who beat the central banks. One money manager who knows Soros well says: ''George actually wants to be perceived as help- ing central bankers.'' Was betting against them being helpful? In the sense that he was essentially betting on the inevitable, maybe yes. The volatility in European curren- cies continues. Soros and other shrewd investors will no doubt con- tinue trying to profit off the turbu- lence. But it will be a long time before a chance to make a killing like this year's appears again. "This information is the property of Forbes, Inc., ACC takes no responsibility for its content, or the actions of any individual or institution, predicated on the information herin. 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