The Wily Rabbit Has Three Burrows
September 11, 1992. Manhattan, New York.
Three blocks south of Central Park stood a forty-six-story building sheathed in black glass, its mirrored exterior catching the city and darkening it into something colder.
The building was called 888 7th Avenue.
Completed in 1969, it was one of the landmarks of Midtown West, distinguished by the vast arched lobby at its base and the reflective glass that wrapped its upper floors.
When the elevator doors opened on the thirty-third floor, a plaque greeted visitors.
The plaque read: Quantum Fund.
Quantum Fund was the company’s name, and its true business was classified as a hedge fund.
Literally speaking, a hedge fund sounded like a fund that built a fence around risk, but in reality it was the opposite.
Where ordinary investment funds bought stocks or bonds and waited patiently for them to rise, hedge funds did everything else.
They made money when prices rose and when they fell.
They borrowed to sell, borrowed to buy, and used leverage to control positions dozens of times larger than their capital.
In the early 1990s, the most aggressive and notorious speculators in the world were hedge funds.
And at the very pinnacle stood Quantum Fund.
“……”
A man stood silently, gazing through the black glass wall.
Even the blue sky outside, seen through that tinted barrier, looked like a mass of bruised storm clouds.
His own face was just as dark.
Thinning hair dusted his broad forehead; beneath it sat the high cheekbones typical of his Hungarian blood and the deep hollows around his eyes.
His gaze was cold and dry, like jerky left out in the dead of winter, and there was not a trace of emotion in it.
George Soros.
A man of sixty-two who controlled more than eighteen billion dollars in assets.
On Wall Street, he was called The Financial Butcher, and in Europe people watched him warily as a man who could bankrupt a nation.
The nickname had not been handed to him for nothing. In 1985, even before the Plaza Accord was signed, Soros had already built up an enormous short position against the dollar and struck hard, betting the U.S. currency would fall.
Within forty-eight hours of the accord being announced, he had pocketed 150 million dollars, and one bank that had been on the other side of the trade had been driven nearly to collapse.
That George Soros was now laying out another enormous move.
Only—
“There’s a variable, George.”
Across from Soros sat a tall man.
Stanley Druckenmiller.
Thirteen years younger than Soros, in his forties, with a sharp jaw and short-cropped brown hair that made him look less like an investment chief on Wall Street than an instructor at West Point.
He was the chief investment officer of Quantum Fund, and for the past four years he had won Soros’s trust by handling every major project put before him.
When Soros set the direction, Druckenmiller determined the size. When Druckenmiller proposed the entry point, Soros gave the approval.
On Wall Street, the pair was called a two-headed monster.
“This morning, right after the London market opened, selling in pounds surged.”
“……”
At Druckenmiller’s words, Soros furrowed his brow.
Druckenmiller spread the papers in his hand across the table.
GBP/DEM.
A graph showing the exchange rate between the British pound and the German mark.
“We checked with the prime brokerage desks at both Goldman Sachs and Salomon Brothers. There are signs someone has built a massive short position.”
A short position.
In plain English, it meant betting on a fall.
Ordinary investing was called a long position—buying and holding something, whether it was a stock or a currency.
If you bought a stock at 100 dollars and sold it at 150, you made 50 dollars.
If it rose, you profited; if it fell, you lost. Simple, intuitive.
Shorting was the opposite.
You made money when prices fell.
How? By borrowing something you didn’t own and selling it immediately.
Say you expected the pound to drop.
First you borrowed one million pounds from a bank and sold the borrowed pounds in the market at once.
If the exchange rate was 1.8 dollars to the pound, you took in 1.8 million dollars.
Then you waited.
Suppose, as predicted, the pound crashed to 1.5 dollars.
At that point, you used 1.5 million dollars to buy back the one million pounds and repay the bank.
You had received 1.8 million dollars and spent only 1.5 million to close the position, leaving 300,000 dollars in profit.
That was the mechanism of a short position.
The problem was that it was a double-edged sword.
In the worst case, a long position could only lose the original principal.
Even if the stock went to zero, you could not lose more than your investment.
But a short position was different.
If the price rose, the losses could balloon without limit.
Because you still had to buy back what you had borrowed.
If you borrowed and sold one million pounds when the exchange rate was 1.8 dollars, and the pound then surged to 3 dollars, what happened?
To repay the loan, you would need 3 million dollars.
You had received 1.8 million, but you would have to spend 3 million, leaving a loss of 1.2 million.
That was why shorting was riskier than going long, and why it demanded far more nerve.
To short a nation’s currency was almost the same as declaring war on that nation’s central bank.
And Stanley Druckenmiller was telling George Soros about an entity that had made that reckless declaration before they did.
“They got in ahead of us. The scale is ten billion dollars.”
“……”
Soros’s eyes narrowed.
Ten billion dollars.
Over the past six months, Quantum Fund had quietly built a pound short position worth about 1.5 billion dollars.
And that had only been possible by mobilizing the best connections and credit on Wall Street.
Someone had put together a position seven times that size in just two days? It made no sense.
But there was no chance Druckenmiller’s report was wrong.
“They opened the position through a special-purpose vehicle set up in the Cayman Islands. Multiple shell companies are cross-holding one another, so tracing the real owner will take days.”
“You said it started on September ninth?”
“That’s right. Two days ago.”
“The day we intended to move was September fourteenth... which means they moved five days ahead of us. And at seven times our size.”
“They seeded it with 100 million dollars in cash and levered it one hundred times. We believe they pulled margin simultaneously from prime brokers at Goldman Sachs and Salomon Brothers.”
“One hundred times?”
Soros frowned.
In the over-the-counter wilderness of currency trading, where day-to-day fluctuations were tiny, a trader could easily secure 100-to-1 leverage and often far more, even 200-to-1, so long as the collateral was solid.
Soros had himself used leverage as high as 250 to 1, so he knew the terrain well.
But that was only true when the collateral was certain and safe.
“No matter how money-mad those prime brokers are, they wouldn’t have handed out one hundred times credit on a hundred-million-dollar gamble. What the hell did they put up as collateral?”
“Apparently... real assets.”
“Real assets?”
“Yes. Large quantities of physical gold bullion and crude oil, bundled together as cross-collateral.”
“……”
Soros’s eyes widened.
Not paper financial assets, but actual physical gold and oil—solid metal and liquid substance with real mass and substance.
The perfect, secure collateral banks salivated over.
Soros rubbed his forehead.
What kind of lunatic brought in gold bars and crude oil out of nowhere, then went a step further and used them to raise 100-to-1 leverage against the Bank of England?
And did it right before their own grand project was set to begin!
“Are you telling me some oil magnate entered the foreign-exchange market? No—then what are the gold bars for?”
“We’re still confirming that. But there are only a handful of players in the United States who could put up that much gold and crude as collateral.”
“……”
Soros let out a slow breath.
This pound short had been a raid he and Stanley Druckenmiller had spent six months preparing with painstaking care.
It had begun last year, with German reunification.
In October 1990, when East and West Germany became one, the Bundesbank, Germany’s central bank, ran into an unprecedented problem.
Rebuilding East Germany’s infrastructure required astronomical sums, and to raise that money Germany issued government bonds. But to sell those bonds, it had to offer high interest.
The Bundesbank raised rates, and the problem was the ripple effect.
The ERM, the European Exchange Rate Mechanism, was a system that kept member currencies’ exchange-rate fluctuations within a fixed band.
Even if the situation was unavoidable, once the Bundesbank raised rates, the other European currencies tied to the mark had to follow suit and raise their rates as well.
If they didn’t, capital would flee to Germany and exchange rates would unravel.
Britain was no exception, but the British economy was already in recession.
Unemployment was nearing ten percent, and house prices were collapsing.
To revive the economy, rates had to come down—but as long as Britain was shackled to the ERM, it couldn’t lower them.
If rates were cut, the pound would weaken and smash through the floor set by the ERM: 2.778 pounds per mark.
That would be a breach of the agreement.
The country would have to choose between withdrawal and humiliating devaluation.
Soros saw the contradiction perfectly.
Britain was trapped in a pit from which there was no escape.
Once he identified and predicted that structural contradiction, Soros began moving the capital that followed him like the leader of a wolf pack.
For the past six months, Quantum Fund had contacted foreign-exchange dealers in London and Frankfurt, gradually accumulating pound-selling orders in increments of 30 million dollars a day so as not to stir the market.
At the same time, they signed margin agreements with prime brokers at Goldman Sachs, Salomon Brothers, and Credit Suisse, diversifying their liquidity lines.
Tracking the Bank of England’s reserves revealed that while the official figure was around 44 billion dollars, the foreign currency immediately deployable in practice was only about 27 billion pounds.
They also monitored the central banks of ERM member states and found that the Italian lira and the Spanish peseta were under pressure as well.
It was possible that Britain would not be the only one to break, that a domino effect might begin.
Inside British politics, intelligence suggested a rift between Chancellor Norman Lamont and Prime Minister John Major.
Everything was helping George Soros.
Chancellor Lamont wanted Britain out of the ERM, while Major was digging in for the sake of appearances.
The more political factions fought for their own partisan interests instead of the national interest, the more delayed the decision became, and the more fragile the market’s defenses grew.
George Soros bared his sharpened teeth and claws at the British market.
The time to strike was this Wednesday, September 14.
That day, Quantum Fund planned to build an additional short position of more than 5 billion dollars and signal other hedge funds to join in.
But someone had moved first.
And not just first—first with an overwhelming ten-billion-dollar position.
Soros said irritably, “We’ll have to bring the schedule forward.”
“I’ve already contacted our London dealers.”
“Raise the target to ten billion dollars. Scrape together everything we can. We’ll match that unknown player pound for pound.”
“If we pull margin from all three prime brokers at once, we can build the position by tonight. But...”
“But?”
“I can’t help wondering how that mysterious player, already in the game with ten billion dollars, will react to our entry, George.”
“Hmm.”
“If someone were holding a ten-billion-dollar short against the Bank of England alone, they could get caught in a squeeze and forced into liquidation.”
At Druckenmiller’s concern, Soros shook his head.
“Looks like he has two cards in hand. Beyond that, I can’t say.”
“Two?”
“What’s the most terrifying weapon a central bank uses to kill short sellers?”
“A sudden spike in interest rates, of course. If rates rise, the cost of carrying a pound short rises too, and the risk of a margin call increases.”
“Exactly. But that guy won’t have borrowed pounds at a floating rate.”
“I see. A fixed-rate forward contract.”
“Even if the Bank of England raised rates to 100 percent, no extra cost would be incurred. It’s a trick I used often myself.”
“You used it up to 250 times leverage.”
“And you said his collateral was gold bars and crude oil, didn’t you? It’s probably cross-collateral. Most likely he’s relying on the time value of physical collateral.”
“...True enough. Unlike paper stocks that can be liquidated with a click, bullion and oil can’t be cleared out electronically at once.”
“A crude, brute-force play with physical assets. He probably made those brokers accept the enormous pile of real-world collateral in exchange for writing a grace period of at least seventy-two hours into the over-the-counter derivatives contract. You can see it without even looking. It could be longer than that.”
Even if the Bank of England dumped its reserves and thrashed the exchange rate for a day or two in a frenzy, the system could not burn through the physical collateral—or more precisely, the forced-liquidation delay attached to that collateral.
It was, in effect, a zombie wall that could not be killed for several days.
“Fixed-rate hedging to neutralize interest-rate attacks, and on top of that a physical time shield that blocks automatic liquidation by computer...”
Soros’s eyes flashed with razor-sharp light.
“He’s not just some lunatic. We need to find out who he is. We have to.”
“Understood. I’ve got contacts at the Cayman law offices, so we’re digging. We’ll know soon.”
At Druckenmiller’s answer, Soros nodded.
“For now, we may have begun as allies... but I can’t predict how he’ll play this game from here. Those two cards I mentioned are only my guess. I have no idea how many more burrows he’s dug.”
“At the very least, won’t he stay a partner until Britain is broken and he gets out? That would be to everyone’s mutual benefit. I don’t know who he is, but he probably won’t be hostile to us for a while.”
“Maybe. But I’ve got a different feeling.”
“?”
Druckenmiller tilted his head in confusion, but Soros continued, “For some reason, I’ve got a bad feeling... like the other side isn’t bound by the logic of capital... like he’s some unpredictable madman...”
By then, a cold bead of sweat had gathered on Soros’s forehead.