The Wall Street Journal: September 22, 1998
Why a World-Wide Chain Reaction Set Financial Markets Into a Spin
By Michael Siconolfi, Anita Raghavan, Mitchell Pacelle and Michael R Sesit.Once again, Russia is the Evil Empire. This time, it isn't some ill-starred military adventure. Instead, the world is blaming Russia for the chaos sweeping through financial markets over the past month. Russia's abrupt decision in mid-August to let the ruble's value fall and default on part of its debt is widely viewed as the reason for widespread selling in everything from Brazilian bonds to U.S. stocks.
But has Russia -- which has an economy that accounts for less than 1% of the world's gross domestic product -- even one spinning out of control -- really wreaked billions of dollars of market losses? Not by itself, it hasn't.
What the virtual collapse of Russia's markets did was touch off a global flight from financial risk of all kinds. Russia's actions were the trigger for that panicked flight, but once started, it behaved like a chain reaction.
Big bets by sophisticated investors, many made with borrowed dollars and many having nothing to do with Russia, suddenly went bad. In a scramble to shore up their crumbling finances and meet lenders' demands for more collateral, those investors were forced to sell out of other, safer investments. And as these investments in turn tumbled under the selling pressure, the urge to flee became contagious, spreading quickly until it hammered just about every financial instrument except super-safe U.S. Treasury securities and German government bonds -- which soared.
The result is that in the past five weeks, international investors have lost an estimated $95 billion on the stocks and bonds of so-called emerging markets, according to J.P. Morgan & Co. Throughout, huge amounts of debt, built up over years to finance securities purchases, have been unwound. Some victims have disclosed staggering losses.
Long-Term Capital Management, a fund for wealthy investors run by bond legend John Meriwether, has lost $1.8 billion. Credit Suisse First Boston Corp. is out at least $400 million after tax, according to someone familiar with its situation. And Bankers Trust Corp., a firm that had been trying for two years to lower its risk profile, has had its entire third-quarter profit wiped out by losses totaling $350 million before taxes.
Even Merrill Lynch & Co., the most broadly diversified firm on Wall Street, has taken a $135 million hit. And in many cases, securities firms' losses are worse than disclosed because they are using financial reserves to mask their full extent.
To be sure, the trading losses follow year upon year of lush profits by many of the same firms now being punished for aggressively playing international markets. "What we're seeing is the dark side of a truly global marketplace," says Merrill Lynch's chairman, David Komansky. "Going forward, this is what a global, wired economy will look like during a market correction."
While U.S. and European stocks have taken their lumps -- the Dow Jones Industrial Average is 15% below its peak in July -- the losses in these markets are nothing like the carnage in many others, including many kinds of bonds. When Mr. Komansky got home one night, his wife asked him what the U.S. stock market did. His weary reply: "I have no idea -- I've been worried about the global bond markets."
Much of the damage has been concentrated at securities firms and banks, and especially hedge funds -- investment pools for rich investors that often use arcane trading strategies and borrowed money in a quest for outsize returns. Their holdings of Russian stocks and bonds, needless to say, took a beating. But interviews with scores of Wall Street executives, traders and bankers show that some of the biggest hedge funds, as well as many securities firms in the U.S., Europe and Japan, made three major bets unrelated to Russia that have gone disastrously awry:
Indeed, no firm has been more emblematic of the global scope of the losses than Salomon Smith Barney. Even though co-chairman Jamie Dimon had ordered its traders to liquidate their positions in Russia in July, weeks before Moscow defaulted, Salomon has suffered after-tax losses totaling $360 million.
- In a bid to take advantage of tiny price discrepancies among types of bonds, Long-Term Capital and many other firms borrowed to finance big purchases of riskier bonds while betting that U.S. government securities' prices would fall.
- Hedge funds, among them Julian Robertson's Tiger Management, made big wagers that while Japan struggled vainly with its worsening economic malaise, investors would continue to sell the Japanese yen and buy American dollars.
- Securities firms, chief among them Travelers Group's Salomon Smith Barney, made billion-dollar bets that as European monetary union approached, differences in the yields of various government bonds would narrow.
Just $10 million of that stemmed directly from investments in Russia. A further $50 million was from lending to a hedge fund that invested in Russia and went bust. The rest came from bond-market bets that had little or nothing to do with Russia but went bad anyway, as investors' headlong rush for safety confounded expectations of the way various kinds of bonds would behave.
"Russia was the match, but the markets were ripe for dislocation," Mr. Dimon says. And they haven't settled down yet. The scramble to unload almost any kind of risky investment has been so urgent that some markets, particularly for riskier bonds, are paralyzed, leaving firms holding far more of them than they want. The firms' continuing efforts to cut their holdings suggest more declines ahead.
Beyond that are fears that other nations will follow Russia's lead. Already, Malaysia has applied rigid controls that limit foreign investors' ability to get their money out. Stock markets around the world remain volatile as investors worry about a crisis of confidence erupting in another developing nation.
"It's not like in '87 when the market plunged and by 6 p.m. you knew what your losses were," says Max Chapman Jr., chairman of Nomura Securities Co.'s three regional units outside Japan. "This one is more insidious. It is getting you from all places. If you're a global player, you get kind of dizzy."
Until this summer, Russia made some sense as a place to invest. The Asian turmoil that began with a mid-1997 devaluation of the Thai baht hadn't reached Moscow. Yields on Russia's government debt were high. Major firms such as Goldman, Sachs & Co. and Chase Manhattan Corp. were competing to underwrite government bonds and lead syndicated loans to Russian companies, while hedge-fund investors such as George Soros and Leon Cooperman were there, too. With such stars paving the way, other investors felt comfortable in the Russian market. Some Wall Street traders bought Russian bonds for their personal accounts.
"Interest rates were so high it was almost as if they were giving money away," says Dana McGinnis, a San Antonio manager of three emerging-market hedge funds. His McGinnis Advisors invested a large chunk of its $200 million in Russia.
Then in August, Russian political and economic conditions, which had been slowly worsening, began to disintegrate. Investors increasingly anticipated a ruble devaluation. Yet some, such as Mr. McGinnis, weren't worried. They thought they had purchased protection: the right to convert rubles into dollars at fixed rates, through contracts they had made with Western and Russian banks.
Marc Hotimsky, global-bond chief for Credit Suisse First Boston, met with officials in Moscow and was assured that Russia would meet its obligations and wanted a stable ruble. Leaving the country on Friday, Aug. 14, he says, he "had a sense the situation in Russia was critical, but I didn't think they would default."
On Monday, they did. Although Russia didn't tamper with the government's foreign-currency debt, it announced it would restructure its treasury bills and impose a moratorium on repayment of $40 billion in corporate and bank debt to foreign creditors. It said it would let the ruble's value against the dollar fall by up to 34%. (The ruble didn't stop where it was supposed to, as devalued currencies often don't.)
Wake-Up Call
The news came as a jolt to Rodolfo Amoresano. As chief of emerging-markets proprietary trading for Nomura's New York unit, he was sitting on a $200 million position in Russian treasury bills, traders other than Mr. Amoresano say, after returning from Russia with assurances that the government wanted a stable ruble. Awakened at 3 a.m. by the news, he dashed to the office to warn others of the danger, the traders say. Then he boarded a plane back to Russia to try to sort out the mess.
The bills were supposedly protected by forward currency contracts entered into with big Russian banks. But Russia's debt moratorium apparently allows its banks to ignore their forward-contract obligations for 90 days; terms of the freeze are so confused that parties are still haggling over what they mean.
Those holding Russian securities were stuck. There was no trading. No bids, no offers. A trading strategy that had been profitable -- Nomura's New York unit had made a total of about $100 million in Russia in the prior three years, the traders say -- suddenly was destroyed. Nomura ended up with Russia-related pretax losses totaling $350 million, including $125 million in Mr. Amoresano's "book." (The rest came from the London operation.) A Nomura spokesman declines to comment.
Investors in Russian securities weren't the only ones affected; so were those who had lent to such investors. Creditors of hedge funds, convinced the funds wouldn't get back all the money they had put into Russia, issued demands for more collateral, known as margin calls.
The funds had to raise capital to meet the calls, but they couldn't do so by selling Russian securities, with those markets paralyzed. So they began selling other assets, including U.S. stocks.
One who got a margin call was Mr. McGinnis in San Antonio. His funds had $100 million of Russian bonds, bought with leverage; he, too, found that his currency contracts didn't protect him when Russia defaulted. He says Citicorp, First Boston and Lehman Brothers Holdings Inc. demanded more collateral. To raise it, he says, he began dumping "everything else."
It wasn't enough. In late August, Mr. McGinnis's funds sought Chapter 11 bankruptcy protection in San Antonio federal court.
Talk spread that Russian treasury bills might be worth only 10 cents on the dollar. "The second you hear that, you're feeling, 'I don't want to hold any other similar emerging-market debt,' " says Philipp Hildebrand, a strategist for the British affiliate of Moore Capital Management, a New York hedge fund. "You had an immediate and substantial collapse in risk appetite." Holders began selling bonds from South Korea, Greece, Turkey, Mexico, Brazil.
--------------------------------------------------------- Some Who've Taken Big Hits Institution Damage $330 million pretax trading BankAmerica losses so far in quarter Bankers Trust $350 million trading losses in July, August Republic New York Russia-related charges of $155 million $360 million in after-tax Salomon Smith Barney trading and Russia-related credit losses Nomura Securities $350 million in pretax Russia-related losses Credit Suisse First $400 million in after-tax Boston Russia-related losses Everest Capital One hedge fund down 52% in August, one down 37% Long-Term Capital hedge fund down 44% in August III Offshore Advisors One hedge fund filed for liquidation Sources: J.P. Morgan, Telerate ---------------------------------------------------------But buyers for what they wanted to sell were rapidly disappearing. "If you didn't sell by Aug. 25, you were probably stuck in the mud," says Peter Marber, president of Wasserstein Perella Group Inc.'s asset-management unit, whose two hedge funds incurred big August losses. From the Friday before Russia devalued until 10 days afterward, the J.P. Morgan Emerging Market Bond Index fell nearly 25%.
Trimmed Hedges
One hedge fund, III Offshore Advisors' High Risk Opportunities Hub fund, faced margin calls from lenders such as Salomon Smith Barney, First Boston, Lehman and Bankers Trust, according to a person familiar with the matter. To raise the money, the fund sought to collect on forward currency contracts it had signed with Deutsche Bank AG, Credit Lyonnais, Societe Generale Group and the ING Barings unit of ING Group.
Although those contracts hadn't yet come due, III Offshore partner Warren Mosler says the hedge-fund firm was entitled to demand some payment -- he puts it at $300 million -- based on the contracts' present value. But the European banks wouldn't pay, he says, and III Offshore, which is based in West Palm Beach, Fla., had to file to liquidate the hedge fund. The banks "defaulted," Mr. Mosler asserts. "What brought down the fund is these guys failed to meet their obligations."
Credit Lyonnais and Societe Generale decline to comment. A spokeswoman for ING says it is unaware of any dispute. Deutsche Bank says it "complied with all contractual obligations."
Even if a firm was prescient, it wasn't easy to move quickly enough. In July, Mr. Dimon hammered home his concerns over Russia and Indonesia to Salomon Smith Barney's risk-management committee. "I want out," Mr. Dimon said, according to some who were there.
The traders were resistant. Indonesia had already taken its licks, and prospects for an IMF-led credit made Russia's situation appear calmer. But the traders went to work, whittling down Russian-bond positions of more than $100 million. Salomon's repurchase-agreement desk, which does overnight financing for institutions such as hedge funds, also started to reduce its exposure to funds investing in Russia. But the effort wasn't rigorous enough. Salomon got stung by a loan of nearly $50 million it made to the III Offshore Advisors fund that is being liquidated. Mr. Dimon declines to comment.
Bonds Diverge
Now, as investors rushed for the sanctuary of U.S. Treasurys, the value of those bonds began to soar. Monday the 30-year bond's yield got as low as 5.05% before late trading pushed it back up to a still-ultralow 5.124%. But the same thirst for safety caused investors to flee from riskier bonds, including those of emerging markets, U.S. mortgage-backed securities, high-yield "junk" bonds and even investment-grade corporate bonds. "The whole world was on one side of the ship for three years, and now they wanted to go to the other side of the ship all at once," says Greg Hopper, a portfolio manager at Bankers Trust Global Investment Management.
The shift wreaked havoc with some of the most complex and leveraged market bets made prior to the Russian turmoil. Among them were bets on the spreads between the yields on various kinds of bonds. Many hedge funds and investment banks had wagered that growing demand for riskier bonds around the world would cause these bonds' prices to rise and their yields to fall, but that yields would rise on the safest government bonds. The flight to safety caused the reverse to happen.
At Long-Term Capital's plush headquarters in Greenwich, Conn., traders watched in horror as one after another of the firm's bets exploded. Traders were left to follow "the action on the screens and marvel at the violence out there in the marketplace," a person familiar with the operation says. "When you have a global movement, all the trades go against you at the same time."
Declines in the hedge fund's net worth triggered internal controls requiring that risk be reduced. So it started dumping some securities and unwinding interest-rate bets. Through it all, the firm was being peppered with calls from Lehman and Salomon Smith Barney, two of its lenders, for information about trades and the extent of losses.
Rumors spread that Long-Term Capital was in trouble. They intensified after the New York Stock Exchange, as part of a broader Wall Street sweep, quizzed securities houses about whether Long-Term Capital was meeting its margin calls. It was.
Grim News
But on Sept. 2, Mr. Meriwether, who once was Salomon Brothers' vice chairman, broke the news to the hedge fund's investors: Its value had plunged 44% in August. The total loss was $1.8 billion. Yet, in a measure of how far the ripples had spread beyond Moscow, only 8.7% of the losses came in Russian markets, says a person familiar with the results.
Nor was Merrill Lynch spared. In the wholesale flight to safety, even U.S. corporate bonds got slammed, and Merrill Lynch, as a leading underwriter and market maker, owned a $5 billion portfolio of them. Making matters worse was that one way Merrill had tried to protect itself from such a decline was by selling U.S. Treasurys short, figuring that if corporate bonds fell, so would Treasurys; when they soared, this bet only worsened Merrill's losses.
Merrill's bond-related losses exceeded $100 million, pretax, traders say. Although the firm has said it had after-tax emerging-markets losses in July and August of $135 million, it won't provide a breakdown.
A broader concern in the bond market has been gridlock. In recent weeks, buyers have simply shunned a broad range of bonds, from U.S. junk bonds to any emerging-market debt. Some emerging-market bonds have vast spreads between the bid price and the offer, making it all but impossible to trade. Last week, recalls Andrew Brenner, a bond trader at Societe Generale, the bid-offer spread on a bond from a Brazilian state water utility known as Sabesp was 15 points-you could sell it at 70 and buy it at 85. "Obviously, I couldn't get anything done," Mr. Brenner says.
Indeed, not much of anything is going on in broad parts of the bond market -- even on days when the stock market rallies. On Sept. 8, as U.S. stocks were soaring on a bout of investor optimism, Donaldson, Lufkin & Jenrette Inc. executive David DeLucia received word from his top traders that buyers were nowhere to be found in much of the high-yield market. "There's still decent demand for high-quality names, but liquidity seems to dry up for names beneath that," Mr. DeLucia says.
Merrill owned Brazilian corporate bonds that it had hedged by taking short positions in Brazilian government bonds -- that is, it had bet on a decline in the government bonds' price by selling them without owning them. The minute bids for the bonds appeared on traders' screens, they were snapped up. "Any buying was quickly satisfied," Mr. Komansky says. "You couldn't cover your shorts. You couldn't sell your longs."
All the recent turmoil in the bond market has hammered home a lesson in protecting one's assets. Quips Mr. Komansky: "The only perfect hedge is when someone else owns it."
Masking Losses
Even when firms have disclosed their global market losses, these amounts often are severely understated. This is because many major brokerage firms have been tapping into reserves they had accumulated during the big bull market to mask the full extent of their recent trading deficits. Though Lehman Brothers, for example, recently announced an after-tax loss of $60 million from emerging-markets woes, Wall Street traders say the firm actually had total pretax losses of about $200 million. Lehman declines to comment on its use of reserves.
Traders say Lehman's losses also were tempered by separate winning trades, including selling emerging-market stocks (which have plunged) and purchasing U.S. government bonds (which have soared). "We lost some money in hedging some securities positions, but offsetting that we were long governments in a big way," says Richard Fuld, Lehman's chairman. "We had a view that during time of turmoil there would be a flight to quality."
All that didn't stop some rumors from becoming entrenched. Lehman's already-battered stock was slammed an added 7% on Sept. 11 amid speculation the firm would file for bankruptcy protection. Senior officials scrambled to assure clients Lehman was secure. But so prevalent were the rumors that the New York Stock Exchange examined Lehman's books. Big Board Chairman Richard Grasso personally called Mr. Fuld later in the day to tell him the firm had passed the review. Monday, Moody's Investors Service confirmed Lehman's debt ratings and said the firm's ratings outlook is "stable."
Europe's Yields
Across the Atlantic, another problem was festering. Costas Kaplanis, head of Salomon Smith Barney's global-arbitrage trading group in London, had made good money over two years betting that the differences in yields on various European bonds would narrow as European monetary union neared. Among its billion-dollar trading positions, say people familiar with the situation, was a bet on a convergence in the yields of German and Italian bonds.
But in the flight to quality set off by the Russian crisis, the yields started diverging, because German bonds were regarded as safer than Italian bonds. Executives in New York ordered Mr. Kaplanis to unwind some of the bets and reduce others. The paralysis gripping bond markets hampered the effort, and the global-arbitrage group wound up with $180 million in after-tax trading losses.
More losses arose in Salomon Smith Barney's U.S. arbitrage group. Its traders had placed $1 billion bets on the London Interbank Offered Rate, or Libor, on the expectation that the spread between that rate and U.S. Treasury yields would narrow. Instead, it ballooned, leading to after-tax losses of $120 million.
At New York headquarters, Salomon Smith Barney's senior executives roamed the trading floors telling their traders not to be heroes by taking on risky positions that clients were trying to shed. They were urged to bid for securities 10% to 15% below the last trade, rather than the usual 2%, 3% or 4%. Clients asking the firm to bid on a million shares of stock were rebuffed or got steeply discounted bids. More frequently, traders told clients they would bid for much smaller blocks and try to parcel out the rest of the order.
Yen Bet Goes Bad
Steven Black, a Salomon Smith Barney vice chairman, told his troops to balance their priorities: "We can't trade just for the benefit of clients if it would be irresponsible to the firm's position or to shareholders. Anything we do should be prudent."
The U.S. dollar, like U.S. Treasury securities, is a haven for worried investors, but the market has been so topsy-turvy that even some bets on a stronger dollar went sour. With Japanese interest rates extremely low, hedge funds and others had borrowed huge amounts of Japanese yen and sold them in order to buy the higher-yielding securities of other countries. This meant, of course, that eventually the funds would have to buy yen to repay the loans.
In late August, a Japanese official said Tokyo was close to intervening to support the yen. Meanwhile, plunging U.S. stocks raised fear of a weaker dollar vis-a-vis the yen. hedge funds abruptly began buying yen to cover their borrowings.
That further strengthened the yen. Mr. Robertson's $21 billion Tiger Management fund, one of the biggest bettors against the yen, lost 10%, or $2.1 billion, in the first two weeks of September.
What's With Stocks?
Through it all, individual investors in many markets, including the U.S. stocks, were mystified. For the first time since the 1987 crash, falling prices weren't drawing large sums from people intent on "buying the dip." Nor were falling interest rates. Twice in the month following Russia's devaluation, the Dow Industrials slipped close to 20% below their July high, the level loosely regarded as marking a bear market. In one stretch, the Dow Industrials moved up or down at least 100 points in 10 of 12 trading sessions.
Exchange officials grew worried that two "specialist" firms, which buy and sell to meet demand and smooth out trading, would be in danger if the market continued to falter. Big Board officials met with principals of the firms, paving the way for one to get a capital injection from its partners and the other to be absorbed by rival firm.
In contrast to 1987, however, the systems underpinning the U.S. stock market haven't cracked. Trading has been relatively orderly, nothing like the violent selling seen on Oct. 19, 1987.
On Aug. 31, as the market spiraled toward what became a 512-point, 6.37% plunge, Mr. Grasso -- who has been a Big Board executive for more than a decade -- sought a reading from Edward McMahon, Merrill Lynch's chief of trading in exchange-listed stocks. Mr. McMahon had a simple but clear message: "No shouting. Bids wanted."
Translation: Traders were filling orders without panic -- a far cry from the frantic message he heard in 1987.
-- Matt Murray contributed to this article.
Copyright � 1998 Dow Jones & Company, Inc. All Rights Reserved.
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