Hedge Hogs: The Cowboy Traders Behind Wall Street's Largest Hedge Fund Disaster

280 Pages·2013·1.42 MB·English

by  Barbara T. Dreyfuss

Copyright © 2013 by Barbara Dreyfuss All rights reserved.
Published in the United States by Random House, an imprint of The Random House Publishing
Group, a division of Random House, Inc., New York.
RANDOM HOUSE and colophon are registered trademarks of Random House, Inc.
Library of Congress Cataloging-in-Publication Data
Dreyfuss, Barbara.
Hedge hogs : the cowboy traders behind wall street’s largest hedge fund disaster / Barbara T.
Dreyfuss.
p. cm.
eISBN: 978-0-67960501-0
1. Hedge funds. 2. Investment advisors. I. Title.
HG4530.D73 2013 332.64′524—dc23 2012015889
Jacket design and illustration: Michael Boland www.atrandom.com
v3.1
To fight, to prove the strongest in the stern war of speculation, to eat up others in
order to keep them from eating him, was, after his thirst for splendour and
enjoyment, the one great motive for his passion for business. Though he did not
heap up treasure, he had another joy, the delight attending on the struggle between
vast amounts of money pitted against one another—fortunes set in battle array,
like contending army corps, the clash of conflicting millions, with defeats and
victories that intoxicated him.
—EMILE ZOLA, Money
CONTENTS
Cover
Title Page
Copyright
Epigraph
Introduction
1. Going All In
2. The Man from Calgary
3. Lone Star Gambler
4. A Fund for Everyone
5. Amaranth
6. Widow Maker
7. Pitching to Grandma
8. The $100 Million Man
9. King of Gas
10. Paying the (Inflated) Tab
11. “Gonna Get Our Faces Ripped Off”
12. Pump and Dump
13. $6 Billion Squeeze
14. “You’re Done”
Epilogue
Author’s Note and Acknowledgments
Notes
About the Author
INTRODUCTION
This book was sparked in a roundabout way by my twenty years on Wall
Street. It was an accidental career. I started out as a social worker at a
foster home program for abandoned and abused children in New York
City, then worked in various positions at area hospitals. When I moved
to Washington, D.C., my experience in the health care system led to a
job at a newsletter company writing about government health policy.
Most of my subscribers were executives of hospitals and other health
providers.
One day a guy named Mark Melcher rushed into our office to hand-
deliver a check for a subscription he insisted must start immediately. He
was opening a research office for a large brokerage house, Prudential-
Bache Securities, to provide information about Washington to Wall
Street clients. He was going to focus on health care and politics. Others
would look at tax and budget policy. Wall Street was abuzz with
questions about new hospital payment policies and regulations, he
explained, and my newsletter provided little-known information about
them. He subscribed for a couple of years and we discussed health policy
over many lunches. When he learned I was looking for a more
challenging job, he offered me a spot as a health policy research analyst.
I didn’t really see it as the start of a Wall Street career when I went to
work for Prudential-Bache in 1984. After all, I wasn’t in New York and
the pay was only slightly better than what I was already earning. Rather,
I thought Mark a fun person to work with and an experienced, astute
analyst who could help me hone my writing and research skills and my
understanding of health care policy.
When he hired me, Mark already had over a dozen years’ experience
on Wall Street, writing and speaking about Washington policy on
pharmaceutical and other health issues. He was highly regarded by
clients—portfolio managers and health care analysts at mutual funds,
insurance companies, banks, and money management firms. Like Mark,
many had a decade or two of Wall Street experience and were probably
closer to fifty than thirty. A few had started their careers working in
pharmaceutical or other health care companies or had business school
degrees. Although friendly and ready to laugh, they were serious, smart
professionals and asked detailed, thoughtful questions.
Wall Street seemed a bit formal back then. Institutional investors,
mostly men, dressed in monogrammed white shirts with gold cuff links,
fancy suspenders, and suits. Their offices sported conference rooms with
lots of mahogany and paintings.
I kept in close phone contact with our firm’s top clients and traveled
around the country to meet them. A large number managed money at
mutual funds, firms such as Fidelity and T. Rowe Price, which were
exploding as a result of 1980 tax changes allowing employees to put
money into 401(k) pretax retirement savings accounts. Others worked at
money management firms investing corporate, union, municipal and
state pension funds, along with the fortunes of families such as the
Rockefellers and Mellons.
These portfolio managers were long-term investors, maintaining the
same holdings for weeks, months, years. Each mutual fund and money
management company had rules for determining which stocks or bonds
to buy or sell, along with parameters for how much to invest in each.
Pension plans and wealthy clients also imposed restrictions on money
managers. The emphasis was cautious, methodical money management,
not speculative, risky activity.
At some firms, committees decided investments and okayed changes in
holdings. At others, a portfolio manager had to consult colleagues before
buying a hot new stock. The discussion might cause a portfolio manager
to reassess his action, or his co-workers might endorse the move and
piggyback onto the purchase. Often money managers had firm-wide caps
on the number of shares held in one stock. Some firms controlled the
number of transactions per manager per quarter. Others regulated the
number of stocks, so if a portfolio manager bought a new stock, the firm
might need to simultaneously sell something. Some firms limited cash on
hand, so when managers sold they also needed to buy. These portfolio
managers were known as the buy side of Wall Street, because they
bought services from the investment banks and brokerage houses. The
banks and brokerage firms handled the actual trading of stocks and
bonds and were paid commissions. They also provided research on
companies and industries to guide portfolio managers in their investing.
This is where I came in. My job was to look beyond the hype of
corporate CEOs and public relations professionals and determine what
legislation or regulations were in the works that might impact drug
companies, hospital firms, and medical device manufacturers.
The federal government was a dominant player in health care through
Medicare, Medicaid, and the Veterans Administration. It accounted for a
third to half of most hospitals’ income and paid doctors, labs, and X-ray
technicians. Many nursing homes depended on Medicaid revenues.
Federal regulators set the rules governing health care providers. The
Food and Drug Administration approved all new pharmaceuticals and
medical devices. Surprisingly, given the significant impact Washington
had on health care, there were only two or three Wall Street analysts in
Washington at the time, following developments in Congress and
administrative agencies.
The Internet as we know it didn’t exist back then. C-SPAN and twenty-
four-hour television news broadcasts were in their infancy. There were
no telephone hookups to FDA meetings. Only a few investors came to
Washington to watch FDA and congressional meetings firsthand. But
decisions by the FDA and revelations at Capitol Hill hearings moved
stock prices. So my on-the-scene reporting was much in demand.
I attended FDA meetings on specific drugs, arriving early to peruse
handouts that often revealed their concerns. Many times I telephoned
our worldwide sales force from an FDA meeting to convey breaking
news, often negative for a company—an FDA review panel unexpectedly
turned down a widely hyped drug for approval, or medical reviewers
saw dangers in a new device. Within minutes our salesmen called
hundreds of clients and the drug or device company’s stock price tanked.
But going to hearings, meetings, and conferences was only part of my
job. Another was to analyze how interest groups hoped to shape
legislation or regulations. Washington is a chatty town; most jobs
revolve around Congress or regulatory agencies. Everyone wants to
discuss who is pressing for what amendment, proposal, or policy and the
likelihood of their success. Information comes from all around you. Once
a client and I were having lunch at a pricey downtown restaurant when
we overheard two people at the next table loudly debating the prospects
of tax policy changes for U.S. firms manufacturing in Puerto Rico. It was
a critical issue for drug companies because most had major plants
operating there. The two diners discussing this turned out to be a
lobbyist and a Puerto Rican government official. We soon joined their
discussion.
The portfolio managers I dealt with were not pressured for immediate
investment decisions. They had time for lengthy discussions. They
wanted to know not only the new regulations government policy makers
planned but also their long-term impact. We discussed changing medical
practices. Would hospitals close because of the growing number of
outpatient procedures? Would new drug treatments mean fewer
surgeries?
These investors were just as interested in how a company handled
itself at FDA meetings as they were in the specific clinical trial data
presented. Information I gleaned from the meetings helped them form an
investment thesis based on an assessment of the firm’s leadership,
culture, quality of clinical research staff, and long-term plans.
Merck, for example, was at the time nicknamed the “Golden
Company” by FDAers, praised for well-executed clinical trials and
comprehensive data. It was easy to see why whenever I attended an FDA
review meeting on a Merck product. The company would pack the
conference room with dozens of senior executives, academics, and
physician consultants flown in from around the world. With briefing
books three inches thick, they answered any questions thrown at them.
Merck’s presentations contrasted markedly with the sloppy data or
confused and disorganized presentations of other firms.
Not only were mutual funds and many money managers longer-term
investors, but they primarily made money when stocks went up in price.
They didn’t engage in shorting stocks, a strategy that earns money when
prices collapse. To short, an investor borrows shares of stock to sell and
later buys it to repay the lender. If the price has gone down by the time
he buys it, he profits.
Rules created in the wake of the Depression to protect investors
against risky trading limited mutual fund shorting. Called the “short-
short” rule, it imposed significant tax penalties if a mutual fund derived
more than one-third its income from holdings of less than three months
or short sales. Even when the law was changed in 1997, two-thirds of all
mutual funds still operated under self-imposed rules prohibiting
shorting. And of those allowed to short stocks, only a tiny number
actually did so. Because of this, mutual fund investors wanted stock
prices to rise and were not happy to hear negative news.
Corporate executives also wanted their stock prices to climb,
especially after tax changes in the mid-1990s spurred companies to
compensate executives with hefty stock options as well as cash.
Companies such as WorldCom, Rite Aid, Waste Management, Cendant,
and a host of others engaged in a myriad of financing schemes to prop
up their stock prices. None was more adept than Enron, which pioneered
new accounting practices that immediately booked as income expected
future profits on power plants and international projects. When those
projects fell apart, Enron resorted to shell companies to manipulate
earnings.
Some research analysts at investment banks and brokerage houses
helped the good times roll by writing glowing reports on companies,
even while privately panning them. They wanted to curry favor with the
company to foster banking deals, as investigations by New York attorney
general Eliot Spitzer later revealed. Companies were unlikely to work
with a broker whose analysts slammed them.
Generally this wasn’t an issue at my firm because we rarely had major
banking business. In fact, some well-known analysts sought jobs there
when they ran afoul of bankers at their old firm or wanted to do
research without pressure from bankers.
I worked closely with our drug, device, hospital, and insurance
company analysts. It was challenging work and particularly satisfying
when I could expose hypocrisy, distortions, or misinformation coming
from some of the corporations or interest groups.
There were times I was shocked to learn a company had not revealed
to its investors information that was widely circulating in Washington.
One time our analyst covering W. R. Grace, which had a significant
subsidiary involved with dialysis, asked me to check on whether there
were any new Medicare payment policies in that area. When I called
various government offices I soon learned that weeks earlier the FDA
had shut down the firm’s production of dialyzers after uncovering
serious manufacturing issues. Dialysis centers and the FDA were
scrambling to find other producers and there was fear of serious