SOURCE
Price Economics
Rohin Dhar - May 15, 2014
http://priceonomics.com/the-trade-of-the-century-when-george-soros-broke/
SUMMARY
TITLE: 'The Trade of the Century: When George Soros Broke the British Pound'
May 15, 2014
""I've learned many things from [George Soros], but perhaps the most significant is that it's not whether you're right or wrong, but how much money you make when you're right and how much you lose when you're wrong.”Stanley Druckenmiller, 1994"
-- 1992 George Soros brings BANK OF ENGLAND to its knees
-- Soros nets OVER 1 BILLION DOLLARS
-- by DEMOLISHING THE MONETARY SYSTEM OF GREAT BRITAIN
-- nation-shaking BET
-- hedge funds
-- RESTRICTIONS ON CAPITAL FLOWING ABROAD LIFTED
-- 24-hour news cycle only in infancy
-- SOROS MADE FORTUNE BETTING AGAINST BRITISH POUND
-- exchange rates between countries
-- equals macroeconomic tools of govt to stimulate economies
-- Soros led GROUP OF TRADERS to
-- BREAK ENTIRE FOREIGN CURRENCY SYSTEM OF BRITAIN
-- to profit at BRITISH TAXPAYER expense
Post WWII
-- European countries to INTEGRATE ECONOMIES more tightly
-- tighter economic relations aim reportedly:
-- to prevent wars every few decades
-- to create large pan-European market to compete with USA
-- culminated in EUROPEAN UNION (EU)
-- EU assumed single currency: 1999
-- 1979 precursor to single EU currency:
-- European Exchange Rate mechanism (ERM)
-- countries agree to FIX EXCHANGE RATES
-- versus FLOATING CURRENCY & letting CAPITAL MARKETS set rates
-- Germany had strongest economy in Europe
-- *comment: OCCUPIED GERMANY
-- so each European country set their currency's value in DEUTSCHMARKS
-- agreement to maintain exchange rate between NATIONAL CURRENCY
-- & Deutschmark (within acceptable margin of 6% plus or minus agreed rate)
-- however, fixed rates cannot just be set & 'forgotten'
-- currency is traded EVERY DAY
-- currency is exchanged to:
-- buy imports
-- sell exports
-- market 'applies pressure' based on what 'actual' rate 'ought to be'
-- based on SUPPLY & DEMAND for currency
-- to keep exchange rate FIXED
-- government must PARTICIPATE in MARKET & NUDGE currency in DIRECTION
1. take reserves of foreign currency & BUY OWN CURRENCY on open market
-- causing CURRENCY TO APPRECIATE
2. set INTEREST RATES
-- ie raise rates to entice buyers of own currency
-- lend that money at higher rates of interest
-- cut interest rates so capital shifts elsewhere in search of profit
-- however, INTEREST RATES affect ENTIRE ECONOMY
-- plus affect govt spending
-- INTEREST RATES are main lever govt uses to adjust economy
-- eg. if economic recession, govt may cut interest rates to spur:
- investment
- spending
-- eg. if high inflation, govt may raise interest rates to shrink supply of money
-- there are consequences to maintaining FIXED EXCHANGE RATE
-- described as external forcing function, tying govt hands on monetary policy
-- which limits govt doing what it needs to do to keep domestic economy on track
*comment: isn't it only 'external' if it is done in agreement with others, eg the ERM? Otherwise, couldn't a fixed exchange rate be done solo?
Britain
-- 1990:
-- inflation high
-- productivity low
-- exports uncompetitive
-- prime minister: Margaret Thatcher
-- Thatcher long opposed entering ERM, insisting price of pound be set by markets
-- Conservative party members, however, wanted to FIX exchange rates with Europe
-- John Major, Chancellor of the Exchequer (ie British head of treasury)
-- Major championed joining ERM
-- 1990 Britain enters ERM at rate:
-- 2.95 Deutschmark (DM) per British pound (GBP)
*British limited to keeping rate b/w 2.78 DM to 3.13 DM
*by provisos of the ERM agreement
-- Major replaces Thatcher as PM shortly thereafter
-- ERM seen as British monetary policy on 'autopilot'
-- given hands tied by exchange rate agreement
-- 1990 - 1992: inflation decreased, interest rates eased, unemployment low (by historical standards)
-- BUT 1992: MASSIVE GLOBAL RECESSION
-- British unemployment spiked: to 12.7% (from 7.7% 2 years prior)
-- were Britain not subject to the ERM agreement
-- Britain could stimulate investment & spending by cutting interest rates in unemployment crisis
-- but was UNABLE to do so pursuant to ERM
-- as it would have PUSHED THE VALUE OF THE POUND BEYOND AGREED AMOUNT
-- Britain had to ride out recession with hands tied
New York City
-- 1992: George Soros 62 years old
-- head of QUANTUM FUND, hedge fund he founded 1970
-- to BET on macroeconomic trends
-- at time he was wealthy, but not as wealthy as today or as public
-- in 1992, hedge funds weren't part of public consciousness
Hedge Fund
-- 'hedge' - investing capital to make a specific bet that something will happen
-- use of market instruments to 'hedge' against other risks
-- to isolate bet that hedge funds want to make
eg. AT&T mobile phone network
-- say you consider it a poor performer
-- opportunity to then 'short' the stock
-- making money when the stock goes down
-- but if the mobile phone market is booming
-- AT&T may still be attracting customers & stock could go up
-- in that case: money could be lost shorting
-- to 'hedge' against this risk: buy some Verizon stock also
-- if you think AT&T is crappy relative to Verizon
-- if mobile phone stocks increase:
-- money made if Verizon goes up more than AT&T
-- if mobile phone sector decrease:
-- money made if AT&T stock goes down faster than Verizon
-- creation of this position = 'hedge' of general risks, making specific bet
-- in this case AT&T poor prospect compared to Verizon
-- if hedge funds are very sure of their bet
-- they BORROW funds to put even more money behind bet
-- using mostly borrowed monies they can buy a LOT OF SHARES
-- without fronting much capital
-- hedge fund managers typically invest other wealthy people's money
-- hedge fund managers receive MANAGEMENT FEES to cover expenses, incl. salary
-- standard is 2% of funds under management
-- regardless of how fund performs, if you manage a large fund, you stand to make big bucks
-- but not billionaire level
-- hedge fund managers become billionaires placing successful bets
-- hedge fund managers earn about 20% of returns created by fund
-- summarising: hedge funds make isolated bets using financial instruments
-- & borrowing money to make potential rewards greater
Britain 1992
-- Jonathan Portes, economist says:
-- problem obvious
-- interest rate in relation to weak demand = much lower than needed
-- to maintain GBP position in ERM
-- GBP overvalued
-- large current account deficit (even in deep recession)
-- Britain joined ERM at wrong rate / sterling overvalued & stuck with
-- structural current account deficit
-- market also knew pound overvalued
-- pound trading at lower end of agreed band w. Deutschmark
-- British govt guarantee to keep pound propped up, prevented pound from plummeting
-- as long as Britain indefintely committed to buying pounds for 2.95 Deutschmarks
-- status quo maintained
“Markets can influence the events that they anticipate.”
- George Soros
-- 1992 pound held its position
-- until Germany throws Britain under bus
-- German central bank officials made on & off-record comments
Reimut Jochimsen
Bundesbank Council member
-- issues statement saying: potential for realignment within the ERM
-- GBP then weakened
Unnamed Bundesbank official official, quoted:
-- devaluation of serling inevitable & pound to fall
Prof Helmut Schlesinger
President
German Bundesbank
-- interviewed by: WALL STREET JOURNAL interview + German newspaper
-- terms: permission to quote involved first obtaining review by him of direct quote
-- BUT indirect quote / paraphrase, NO PERMISSION REQUIRED
-- newswire Sept. 1992 reports re Schlesinger indicating
-- not ruled out that even after realignment & cut in German interest rates
-- one or two currencies could 'come under pressure' ahead of referendum in France
-- Soros & entire financial markets see: GBP could 'come under pressure'
-- ie. could be devalued
-- one paraphrased quote result: market ceased to believe Britain could maintain currency exchange rate
-- the belief in the pound was all that kept it from plummeting
-- results: brought devastation to Bank of England
-- netted George Soros over billion dollars in profit
“There is no point in being confident and having a small position.”
- George Soros
-- a month prior, Soros & Quantum Fund were building $1.5 billion betting position
-- that pound would fall
-- Stanley Druckenmiller saw importance of German Bundesbank president report
-- Druckenmiller figured the Quantum gang should add to position (ie bet more)
-- Soros strategy: “Go for the jugular”
-- plan was to use the Schlesigner quote as opportunity to devalue pound
-- by short-selling sterling on unprecedented scale, to hasten plummet of pound
-- to increase Quantum gang's profit
LONG EXPLANATION OF SHORTING - in article
*I find it hard to focus on this, so I am going to skip
-- money is made if pound devalues
-- by buying and selling or exchanging money, or something
-- Soros was on a winner because everyone knew (b/c of Bundesbank statement)
-- that British pound was going to tank
-- so if pound to devalue, Soros & Quantum gang win
-- were pound increase they would have lost, but they knew it was IMPOSSIBLE
-- as the British pound was OVER-PRICED or overvalued re Deutschmark
-- biggest risk Soros was taking was that pound could maintain value
-- but, in that case, he & the Quantum gang wouldn't lose much money
-- so there was not a massive risk factor, but there was a massive potential gain factor
-- that morning, Soros & the Quantum gang
-- increase their short position against pound
-- from $1.5 billion to $10 billion
-- the perfect bet: mitigated down side & limitless up side
-- described as like betting on coin flip:
-- heads: pound devalues / make lots of money
-- tails: pound rate remains fixed / lose small amount of money on LOAN INTEREST
"... In fact, when Norman Lamont [the British finance minister] said just before the devaluation that he would borrow nearly $15 billion to defend sterling, we were amused because that was about how much we wanted to sell."
- George Soros, 1992
Black September 1992
-- as EUROPE SLEPT
-- Soros borrowed pounds from anywhere he could
-- Quantum gang position exceeded $10 billion shorting the pound
-- other hedge funds:
-- got wind of brisk trade
-- got wind of report from Bundesbank
-- started to follow Quantum gang strategy, borrowing & selling British pounds
-- by time British treasury began their day, BILLIONS of British pounds sold
-- pound dangerously close to trading below levels mandated by ERM
-- British treasury begins buying pounds in the billions at 8:40am
-- but no effect on price of pound
-- WHOLE WORLD WAS SELLING
-- British govt did not have BUYING POWER to fight off worldwide sale
-- British govt spent est. £27 billion of RESERVES buying up pounds: to no effect
-- 9am: Norman Lamont, finance minister under Major
-- advises Major impossible to buy up enough pounds to keep currency propped
-- only option for British govt to keep currency trading at 'right level'
-- equals: DRAMATIC INCREASE of INTEREST RATES to attract buyers of pound
-- MAJOR REFUSED
-- Britain in recession & INCREASE OF RATES would FURTHER SHRINK ECONOMY
-- POLITICAL SUICIDE
-- blood in the water
-- GLOBAL CAPITAL kept betting against pound
-- hour later, Norman Lamont pleads with John Major
-- John Major relents
-- 11am - British govt announces: INCREASE interest rate from 10% to 12%
-- nothing happened
-- pound continues to plummet
-- Norman Lamont consults to John Major: rates increase - 12% to 15%
-- no effect
-- Soros, Druckenmiller & other currency speculators know victory is at hand
-- market expected Britain to devalue currency
-- no amount of interest rate or currency buying could change that
-- market expectation that Britain would exit ERM & devalue currency
-- described as 'self-fulfilling prophesy'
-- comment: how so? isn't it currency speculator manifested?
Black Wednesday - 16 Sept 1992
-- 7:30pm Norman Lamont announes Britain exiting ERM & floating currency on market
-- Soros, the Quantum hedge fund gang & currency speculators won
-- Britain floated its currency
-- pound fell 15% against Deutschmark
-- pound fell 25% against US dollar
-- when pound floated, Soros Quantum gang hedge fund
-- value increased instantly from $15 billion to $19 billion
-- months later, same fund worth almost $22 billion
-- Soros & partners in hedge fund made at least 20% - ie $1.4 billion
-- nature of Wall Street trading
-- to win big, someone else must lose big
-- in case of Black Wednesday:
ENORMOUS WEALTH TRANSFER FROM BRITISH TAXPAYERS
TO GEORGE SOROS & OTHER HEDGE FUND MANAGERS
-- In the lead up to devaluation,
-- British taxpayer lost out again:
-- treasury kept spending its foreign currency buying British pounds
-- which pounds became LESS VALUABLE after treasury floated the exchange rate
COST TO BRITISH TAXPAYERS ESTIMATED AT £3.3 billion
*comment: bet that doesn't factor in the cost of having shrunk the British economy (through interest rate raising), when the economy had to be stimulated, during an existing money-lender & speculator created 'financial crisis'.
-- John Major, Conservatives
-- centrepiece of monetary policy:
-- entering ERM
-- plan to bring austerity to Britain
-- Black Wednesday destroyed his credibility
-- party lost next election
-- Thatcher was right, article concludes: Britain had no business propping up currency artificially
*comment: I don't think that was the issue - the issue is that they were locked into agreement in which the pound was OVER-VALUED to begin with & their hands tied re interest rates
BLACK WEDNESDAY REAL PROBLEM
*era when handful of private hedge fund speculators can assemble MORE CAPITAL IN FEW HOURS THAN BANK OF ENGLAND HAD AT DISPOSAL
-- amount of money in 'GLOBAL MARKETS' so enormous it can bring British govt to knees in one day
-- article concludes regulations are a problem, as they create unexpected loopholes
*comment: LACK OF REGULATION *IS* THE PROBLEM HERE - regulate better
-- article says, event shows the power of the one-sided bet
-- 1992 bet described:
"well-designed macroeconomic trade against fixed exchange rates"
-- if Soros & his Quantum gang were wrong, down side was almost zero
-- up-side was enormous
-- article concludes:
"Bets like that almost never come along, but when they do, enormous transfers of wealth take place from the sheep to the wolves."
SOURCE
Price Economics
Rohin Dhar - May 15, 2014
http://priceonomics.com/the-trade-of-the-century-when-george-soros-broke/
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