The Alpha Masters: Unlocking the Genius of the World's Top Hedge Funds (34 page)

The Rise of a Trailblazer

His first exposure to investing was at Stuyvesant High School when he entered a citywide stock-picking competition sponsored by New York
Newsday
. Over an eight-week period, 7,500 competitors got to pick five stocks per week; at the end of the eight weeks, the contestant who made the most money won the game.

Weinstein recalls, “I hadn’t studied statistics yet, but I knew I wasn’t looking to come in 937th out of 7,500. I was looking to come in first and so I shouldn’t do what most of the kids in the contest were likely to do, which was to pick popular companies like Nike or Wal-Mart. Even though I only had an intuitive understanding of concepts like variance and volatility, I knew that if you want to come in first in an eight-week contest, you’re going to need stocks that are going to move a lot, and that fundamental analysis was worthless over that short time frame. I figured that something that moved a lot yesterday was likely to move a lot today, so I looked at the stock tables in the
New York Times
, back in the 1980s when people actually read the newspaper to see how their stocks did the previous day, and found a table of the largest gainers and losers—in other words, the most volatile stocks. And almost randomly from that group I picked my stocks.”

As Weinstein readily admits, this strategy had the same chance to go down as it did to go up, but he won despite the odds. What was his prize? “I got to visit the New York Stock Exchange,” he says, “and give a speech in one of the fancy boardrooms in front of some senior members of the NYSE. Weinstein laughs at the memory, but he was on his way. At the age of 15, he interned after school at Merrill Lynch; at 18 he had a summer job at Goldman Sachs; at 24 he joined Deutsche Bank and was named vice president at 25, director at 26, and managing director at 27.

Weinstein joined Deutsche Bank in January 1998, when the market for credit derivatives—financial contracts for hedging (or speculating) against a company’s default—was in its infancy. “Not only was it brand new, but few people understood the mechanics of how to price a credit default swap,” says Weinstein. A CDS is the most common credit derivative. “Foreign exchange derivatives, interest rate derivatives, equity derivatives—those instruments had been around for 25 years before J. P. Morgan and Deutsche began figuring out how to structure and trade credit default swaps.”

This was an ideal situation for young Weinstein. For years, while his peers had all followed equities, Weinstein had been fascinated by the complexity of credit. “If you analyze a company and decide you like the stock, all you can really do is buy the stock or a call option on the stock. But in credit you can express the same bullish view in so many ways because there are a variety of instruments to work with—companies generally issue dozens of bonds and loans with different maturity dates and in senior or junior parts of the capital structure. And that’s even before you get to the various types of credit derivatives.” And so this promising young man found himself at a moment of tremendous opportunity in an area that he loved, where there were essentially no veterans let alone experts.

Interesting things began to happen. Just before Weinstein joined Deutsche, there was the 1997 Asian financial crisis, where Korean banks verged on collapse. Then Thailand couldn’t pay its debts. Then a few months later, Russia defaulted on its debt, indirectly leading to the collapse of the colossal hedge fund Long Term Capital Management, threatening American, European, and Japanese banks with catastrophe. Suddenly the availability of credit around the world was very limited.

Having earlier bought credit derivatives on the cheap, Weinstein was able to monetize those positions as the crisis unfolded, rewarding Deutsche with significant profits. Importantly, the bank also distinguished itself by actively buying bonds at a time when everyone else was desperate to sell. Deutsche was suddenly a major force in a surging field.

As all this was happening, Weinstein’s two bosses moved on. The junior partner in a three-man department was now a one-man band, and achieving astonishing results. Deutsche’s high command could have easily patted Weinstein on the back and inserted a veteran manager above him, but they could see what everyone else saw: Weinstein was the show, and they rewarded him appropriately.

“When people recognized the value of finally being able to hedge credit risk,” says Weinstein, “the CDS market grew like a weed. For many years then on, the amount outstanding increased at greater than 100 percent per year until it was finally larger than the corporate bond market. Meanwhile, over the following few years the credit market seemed to continue to suffer one shock after another. “In 2000, Owens Corning and Laidlaw went from being rated investment grade to defaulting on their debt within two months due to legal liabilities. Then came 9/11, Enron, WorldCom, and the Tyco and Adelphia scandals,” notes Weinstein, ticking off the developments. Then there was . . . I mean, it was ridiculous, right?”

But after 2002 came a period of stability for the credit markets. Weinstein recounts, “Then we had this period of rebound. But a new kind of opportunity arose. LBOs [leveraged buyouts] became far larger in size and scope than ever before. Household names like Texas Utilities, Toys R Us, Tribune, and I’m just on the letter T, right? And the most profitable way to speculate on the rise of LBOs, ironically, wasn’t through the stock—it was by purchasing CDS. In the ensuing leveraging of the balance sheet, the average investment grade company would see its credit spread widen by 400 to 800 percent, whereas the stock might only go up 20 to 40 percent.

“Lehman Weekend” at the Fed

Over the years at Deutsche, as Weinstein’s team increased its scope, it more closely resembled a hedge fund, and began to be treated as one by the investment banks that provided salespeople to service the team’s trades. It was only natural that Weinstein began to think about launching his own hedge fund. By 2005 he was sharing these thoughts with his bosses at Deutsche.

Highly reluctant to lose Weinstein, they gave him wider authority and responsibility within the bank. By 2006, Weinstein was running junk bonds, corporate bonds, convertible bonds, and credit derivatives globally. At the same time, Deutsche encouraged his entrepreneurial ambitions within the bank structure, and in a significant concession, allowed him to brand his proprietary trading group, to facilitate an eventual lift-out from the bank. And why not? Weinstein’s earnings were certainly extraordinary. In 2006 the proprietary unit alone was managing $3 billion and earned $900 million for the bank. The following year, it managed $5 billion, and earned $600 million for the bank. “I loved working at DB,” Weinstein says. “I was very happy there for a long time. I got to be part of a firm that was very entrepreneurial, and that gave me responsibility and the opportunity to build businesses at an early age.”

And yet Weinstein remained eager to be on his own. When he finally told Rajeev Misra, his boss, of his decision, it came at a time when Misra himself had just negotiated his own exit from the bank; if Weinstein were to leave immediately, Deutsche would find itself uncomfortably thin at the top. Anshu Jain, the head of the investment bank, offered to let Weinstein spin out into a hedge fund on the condition that he stay one additional year to transition his responsibilities. . . . Weinstein agreed.

That year turned out to be the turbulent 2008. Sensing a period of difficulty, Weinstein’s group was positioned cautiously. Consequently, says Weinstein, “all through the Bear Stearns collapse and into the summer, we were slightly ahead for the year, which was a decent result.” Then came the collapse of Lehman Brothers. “That in itself wasn’t the problem for a fund that is both long and short, but it was the secondary effect, where people actually thought Goldman Sachs and Morgan Stanley could go under, that was stunning.”

As part of Deutsche’s senior management, Weinstein spent that dramatic “Lehman Weekend” at the Federal Reserve Bank in New York, in the company of senior government officials and the top executives of the other large banks, attempting to work out contingency plans. Weinstein worked in the credit group. Their assignment was to try to figure out what sort of transactions the banks would need to do with each other to reduce their exposures to Lehman if it failed. “The counterparty exposures between banks were immense,” says Weinstein. “The Fed wanted us to focus on how we could reduce those exposures on a Sunday assuming that Lehman would default the next day. But the exercise was really like moving deck chairs on the Titanic. Because collectively there were over a million trades between Lehman and the banks.”

Weinstein’s fund at Deutsche Bank lost 18 percent in 2008, his only losing year since he began investing in the credit markets. Per his preexisting agreement with the bank, he soon went out on his own. The fund has been a spectacular success. Given Weinstein’s long record, it quickly attracted many investors, and has amassed over $5 billion of capital. Of that, $700 million is invested in a separate Tail Hedge strategy, which aims to protect client assets against significant market declines. And since inception, Saba Capital has had a 12 percent per annum net return.

What accounts for Weinstein’s great returns, even in years that have generally been tough for hedge funds? For one thing, the fund hit the ground running: As a result of the preparatory work done throughout 2008 on the planned spinout, Saba was able to begin investing only six weeks after the team’s departure from the bank, and the speedy transition meant that Saba kept current on the markets and maintained continuity. Then there are the qualities that have sustained Weinstein throughout his career—intelligence, discipline, pluck, enthusiasm for his work, and a distinct ability to stay calm even under the most trying of circumstances. A colleague at Deutsche Bank recalls that even during the difficult period of the Lehman crisis, you couldn’t tell from looking at Weinstein whether he was up or down that day, and that his leadership was steadfast.

For his part, Weinstein offers this explanation, “One of the reasons we’ve attracted capital is because the credit strategies we employ are somewhat uncommon within the hedge fund space even though CDS is generically fairly well understood at this point, and has a large number of participants. So, on the one hand, CDS has been around for 15 years now, but many founders of successful credit funds got their start back in the 1970s and 1980s at Drexel or Goldman and so CDS is not in their DNA.”

Years ago, Weinstein had the insight to seize on the enormous potential of CDS. And he quickly followed with the creativity to develop new strategies for trading it. In particular, he came up with a differentiated approach for trading on the relationship between credit derivatives and bonds, and likewise the relationship between credit derivatives and stocks.

The Technicalities of the Trade

As an example of the way his firm works, Weinstein discussed the case of American Axle, an auto parts maker based in Detroit that ran into trouble in 2009. That was a desperate time for the auto industry; GM and Chrysler had defaulted, as had the parts manufacturers Lear, Visteon, and Delphi. “The market thought American Axle was on the ropes, too,” Weinstein says.

One of Saba’s analysts disagreed, pointing out that if the company received an infusion of just $100 to $200 million, it could survive. On the other hand, its failure would have far-reaching repercussions. Crucial parts that it made for GM trucks and sport utility vehicles (SUVs) would disappear from the supply chain, further damaging the auto industry. The government had already signaled its determination to sustain the sector with its Cash for Clunkers program, pointing to the probability of some type of bailout. But the best incentive for Saba to trade on American Axle was that the bonds were selling for 33 cents on the dollar, which optically seemed appealing.

“In general,” says Weinstein, “our fund is looking for asymmetric investments, ones where we can make a lot more than we can lose, and buying bonds at 33 might sound like it meets that test: the bonds could go back up to 80. But obviously, a drop to 12 cents like what became of GM bondholders would inflict a significant loss.”

With the company’s next bond payment uncertain, its fate would be determined within weeks, if not days. Saba had to make a decision. “The usual approach if your analyst likes it but it’s very dicey is to just buy a little bit. Or you could do what we did, and try to understand if there is a way to structure the trade—to do more than just buy the bonds—so that we could have the upside while limiting the loss scenarios.”

Weinstein surveyed a variety of people who knew the company and its finances. Almost everyone told him that the company was likely to default; one dealer wanted to short the bonds. Weinstein began to consider a less familiar product used in the credit derivatives market, called recovery swaps.

“Recovery is a very uncertain thing,” Weinstein says. “The recovery swap allows you to hedge away not the chance something defaults, like a credit default swap does, but to hedge the loss amount given a default. Basically, it locks in the recovery rate that the two parties to the trade agreed to at inception. Recovery can really surprise in either direction since people estimate it before the exact facts that lead to the default are known.”