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Inside a hedge-fund meltdown
As Refco's collapse echoes across the financial sector, let's examine the case of Victor Niederhoffer, a highflying hedge-fund manager who lost it all in one day.
By Jon D. Markman
(Editors note: Eight years ago this week Victor Niederhoffers trading firm imploded, erasing a fortune and setting off a series of events that resonates in the financial markets to this day. Last week it was reported that debt stemming from events of October 1997 figured in this months collapse of Refco Inc., a New York futures brokerage. Niederhoffer, a former MSN Money columnist, refutes links between his troubles then and Refcos today, and attempts to set the record straight with our writer Jon Markman.)
The stunning crash of futures brokerage Refco Inc. this month has cast an unflattering spotlight on the important but little understood world of high-stakes commodities trading.
It is a world where hundreds of billions of borrowed dollars change hands around the clock to speculate on the direction of currencies, hedge the price of corn and cattle, and bet on the volatility of the U.S. stock market. And it is a world where the fortunes of veteran pros and precocious amateurs alike can be won or lost faster than you can say eurobond.
One speculator who knows both sides of this world better than anyone is Victor Niederhoffer, a hedge-fund manager who made hundreds of millions in the futures market for customers from the early 1960s to the mid-1990s, and then lost a bundle in a single ill-fated day. His name has surfaced in the past week in connection with the demise of Refco, and so it seemed appropriate to visit and try to understand the brokerages blow-up from his perspective, starting with his business relationship with Refco eight years ago.
More than 200 major brokerages across the globe will let you set up an account to wager on futures, including giants like Goldman Sachs Group (GS, news, msgs). But for more than two decades, the cool sophistication and low prices of Refco made it the house of choice among both private traders and swashbuckling hedge-fund managers. In terms that stock traders can appreciate, it combined the cheap trades of an E*Trade Financial (ET, news, msgs) with the strong customer service of a Charles Schwab (SCH, news, msgs).
Striving to be No. 1
Niederhoffer opened up an account at Refco for his own trading not long after ditching the professorial life that he had enjoyed for a short while at the University of California, Berkeley. A statistics whiz, he developed a unique approach to making money by quantifying the predictive properties of daily and hourly movements between stocks, bonds and other markets. His style attracted the attention of industry lion George Soros, and soon he was trading an account worth more than $100 million for Soros and others.
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He spoke with Soros up to 10 times a day. The work was challenging but lucrative. An iconoclast, Niederhoffer soon spread his wings and figured out how to apply his techniques to markets as far afield as Turkish bonds, the Mexican peso and Japanese stocks. He also bought and sold private companies, made venture-capital investments and earned numerous awards en route to making his partners increasingly wealthy.
In 1996, he explained his methods and took a bow by writing an autobiography called The Education of a Speculator. Although it was well received, he came to see the books publication as an act of hubris, for the very next year would prove to be the start of his undoing. My big mistake was that I strived too hard to be No. 1, he said.
In 1997, Niederhoffer became enraptured by the siren of emerging markets, which was to that era what the Internet would become two years later. He made major speculative investments in Thailand, and when its stock market and currency fell 50%, he applied his usual technique of buying into the panic. By midyear, as the Asian currency crisis ravaged the region, he was losing money in illiquid investments there rapidly, and though he tried to pare down his positions, he could not get out.
His capital position worsened over the summer as the contagion spread to the U.S. markets, driving them steeply lower. Still, he kept trading here as he always had -- using an against-the-tide strategy that had frequently in the past taken him to the brink of ruin before paying huge dividends. He says he had a deal with his longtime Refco account manager at the Chicago Mercantile Exchange that if he were to receive a margin call, he would have several days to raise the cash to meet his obligation.
Refcos willingness to make accommodations to its best customers was part of the reason for its success, and may have played a role in its undoing.
'The worst situation imaginable'
On Oct. 27, the stock market closed at 3:30 p.m. for the first time in modern history on a circuit-breaker rule due to sharp losses. The situation was unprecedented and chaotic. No one knew the proper way to price relatively illiquid derivatives. Niederhoffer received a margin call that afternoon. Refco told him that prior arrangements were no longer in force due to uncertainty over how their authorities would calculate their own liquidity. Refco wanted cash from Niederhoffer to serve as a buffer from further market losses.
The next day, Niederhoffer said he thought he could get out of his positions successfully, but due to setbacks in Thailand he could not produce liquid collateral. Despite 15 years of working together through similar problems, he said Refco proposed that it resolve the situation by trading his fund's positions for their own account and transform some of them into cash. He reluctantly agreed. In a flash, Niederhoffer was out of business.
As you might expect, Niederhoffer contends that if Refco had just held onto his positions a few hours longer, they would have become very profitable as the market rallied violently that afternoon. But he recognizes that the company believed it could not take the chance that the position would go the other way, leaving it exposed to the danger of being out of compliance with capital requirements. I requested that I be given time to liquidate in an orderly way so wed both be better off, but they had their own agenda to make sure the thing didnt snowball," Niederhoffer says. "It was the worst situation imaginable.
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