More discussion as to GSCO's motives:
You be the judge.
nytimes.com
October 18, 1998
How Goldman Sachs Escaped the Russian Economic Bloodbath
By JOSEPH KAHN and TIMOTHY L. O'BRIEN
he House of Unions, like so many buildings in Russia, has served many different masters. In the
18th century, a Crimean prince commissioned its construction in Moscow. Russian nobles later
converted it to a private club. Lenin, Stalin and Brezhnev lay in state behind its bright green facade.
And in June, as Russia lurched toward a financial crisis that set off global shock waves, the House of
Unions was rented for a glittering celebration of capitalism, with one of the country's most ardent
bankers, Goldman, Sachs & Co., as its host. Goldman flew in former President George Bush, paying him
more than $100,000, and entertained Russia's former prime minister. But between toasts to U.S.-Russian
ties, the talk was about what really mattered to Goldman and many Wall Street brethren: deals.
True, Russia was a mess, the government's bank accounts were almost empty and
even the postal system was near collapse. But Goldman wanted to become
Russia's leading deal maker, paid handsomely to finance the government and
newly private businesses. Now was the time to prove that Goldman could come
through with money in a crisis.
So in the days preceding its elegant soiree, Goldman helped the government raise
money by selling $1.25 billion in bonds. A few weeks later, it arranged a
complex deal in which short-term debt was exchanged for long-term debt to give
Russia financial breathing room.
It was not enough. By late August, the Russian government stopped paying what it
owed on much of its debt. Buyers of the bonds that Goldman sold now hold
nearly worthless paper. Goldman itself escaped the blood bath: in the course of
those bond deals it earned tens of millions of dollars in fees and protected
hundreds of millions of dollars it had at stake in Russia. When the government
defaulted, Goldman said its losses were "absolutely minimal."
Senior Goldman executives expressed regret that Russia's economic program
collapsed and that the deals that bear Goldman's imprimatur did not always work
as intended. But they defended the firm's role there as "very constructive" and
attributed the country's troubles to problems that had little to do with investment
banking. Goldman maintains a small office in Russia.
But the firm's troubled bond deal and the skillful protection of its own money are
a window on the role that many investment banks played in the breathless rise
and fall of the newly liberated Russian economy. To critics, including Russian
officials, analysts and some investment bankers who worked in Russia, Wall
Street helped hook Russia on easy money, rarely saying no or advising clients to
take it slow. They fed the seemingly insatiable appetite for borrowed money.
Bankers helped the Russian government borrow billions from foreign investors
before it could reliably collect taxes to pay them back. Bankers flattered the
country's oligarchs, an emerging class of elite businessmen, with generous loans
that many commercial banks shunned as too risky. They helped regional
governments raise money for farms through "agro bonds," even though the system of money-draining
Soviet-style collectives never ended.
With the help of investment bankers, Russia built a roaring bond market, but never developed a
bricks-and-mortar banking system that provided loans the conventional way. Nor did Russia attract
much investment from multinational companies. Such companies have committed about $8.7 billion to
the country, while Russia's governments and businesses have incurred more than four times that much in
short-term debt that must be repaid within a year.
"What the Russian problem reflects is that today's bankers often don't have long-lasting concerns about
customer-client relations," said Paul Volcker, the former chairman of the Federal Reserve and an
occasional adviser to Russian government officials. "You just do the deal and get out."
Volcker noted that Russia was part of a broader problem in many emerging markets, where local
companies and governments have tried to raise money quickly by issuing securities even before they are
ready to handle the demands of shareholders and debt payments. "Greed prevails over prudence," he
said.
Russia's experience stands in sharp contrast to the developing world's other heavyweight, China. In the
last seven years, foreign companies have invested about $181 billion in China, much of it to finance
long-term industrial joint ventures or wholly owned foreign factories. Though investment bankers
eagerly knocked at the door, Beijing has restricted the freedom of its companies and local governments
to borrow money abroad, fearing such money could leave as quickly as it came.
Some Wall Street bankers acknowledge that in pursuit of profits they glossed over some warning signs
about Russia -- corporate corruption, failure to pay loans on time, gross accounting irregularities and tax
evasion -- because they were blinded by the country's enormous natural wealth. Others say they were
lulled into complacence by a presumption of international backing for the Russian experiment with
markets. Many bankers acknowledge privately that they courted Russia more eagerly, and sometimes
with less discretion, than they did many other darlings of the developing world, including many
countries where capitalism had much longer to gestate.
"In a short time, we went from having a sovereign government that was not considered credit worthy to a
situation in which virtually every regional government and every top company was coming to the
investment banking community or being approached by them to talk about stocks and bonds," said Jim
Dannis, head of European emerging markets for Salomon Smith Barney. "We very rapidly had an
oversupply of services, followed by a sudden collapse."
The Rush: A Market Ripe For the Picking
rom November 1996, when J.P Morgan and SBC-Warburg jointly marketed Russia's first
international bond since the days of the czar, to August, when the country defaulted on its debt, there
was a stampede of bond and stock deals. The rush was so great that bankers sometimes nearly tripped
over themselves in pursuit of clients that some thought marginal even at the time.
In the summer of 1997, for example, many leading investment bankers crowded first-class sections on
Aeroflot flights from Moscow to the central Siberian city of Irkutsk, where the soil was underlain with
permafrost and a local energy company, Irkutskenergo, was thinking of raising money abroad.
Managers at the power plant had so many suitors that they made bankers prove their mettle: Those who
wanted to underwrite Irkutskenergo's bond were required to provide up-front loans of $50 million, then
guarantee in writing that the company would pay interest rates only modestly higher than what the U.S.
government pays, bankers who competed for the business said. Most scoffed, but several investment
banks accepted Irkutskenergo's terms. SBC-Warburg, the Swiss-British investment bank, eventually won
the company's nod to underwrite the bond.
There were a wave of stock deals, too. Shares of 28 Russian companies, including a department store,
several banks, half a dozen energy companies and a few industrial concerns, were offered to the public
by big Wall Street names including Salomon, Morgan Stanley Dean Witter, and Donaldson Lufkin &
Jenrette and trade on the New York Stock Exchange through direct or indirect listings. All those Russian
stocks now trade at one-fifth, one-tenth, even one-twentieth of their offering prices, meaning that
investors who bought in early and held have lost most of their money.
For an immature market, Russia also took on some of the financial trappings of developed countries,
with Wall Street help.
For example, Credit Suisse First Boston, the Swiss-American investment bank, pioneered a way for
foreign speculators to buy and sell high-interest Russian government debt. The bank was one of the most
active traders in Russia, adding to an already overheated market. It was also one of the biggest sellers of
Russian debt derivatives to foreign investors, earning big profits in 1996 and 1997 but losing what
analysts expect will amount to $500 million to $2 billion this year because of its heavy exposure in
Russia after the country defaulted.
Indeed, nearly every big Wall Street firm had an active and growing operation in Russia before the
collapse. From the start, however, Goldman, Sachs stood out. In 1992, under its chief executive, Robert
Rubin, who is now the U.S. treasury secretary, Goldman was named banking adviser to Boris Yeltsin's
new government, recruited to help attract foreign investment. Business was slow, however, and
Goldman pulled out of Russia entirely in 1994, angering some senior Russian officials, bankers said.
When Russian markets took off two years later, however, Goldman rushed back in -- and opened its
checkbook to make temporary loans as a prelude to winning investment banking business. Goldman's
willingness to shell out big, up-front loans bolstered Russia's confidence that Wall Street was unlikely
to shut off the financing spigot, and that even companies with spotty track records could count on a flow
of money from abroad.
Investors -- including big mutual funds and hedge funds -- also complain that Goldman was so eager to
prove its underwriting prowess to the Russian government that it flooded the international market for
Russian bonds in the final weeks before the country defaulted. Moreover, Goldman used a bond deal to
pay back one of its own temporary loans. It also used $550 million of its own capital to create
momentum for its second big bond deal, but reduced that exposure to Russian bonds shortly after the
deal was complete. Those moves raised some concerns among investors, especially because the bonds
are now worth much less than they were when they were first sold.
But Glenn Earle, a Goldman managing director who oversees the firm's Russian business as head of its
new markets team, dismisses such criticism as "largely carping from competitors and the
misrepresentation of sound transactions with the advantage of 20/20 hindsight."
"We made a very significant impact in the Russian market," Earle said. "We had the very high-profile
assignments, the most difficult ones, which we were pitching for along with all the other major banks. It
is obviously extremely unfortunate that the market turned out this way. But the speed and extent of the
collapse was both unforeseen and unforeseeable by our competitors and ourselves."
Still, the firm's tactics were among the most aggressive of Western banks scouting business in Russia's
still-untapped market, other bankers said. Goldman, for example, made loans as sweeteners to Russian
companies that were considered by most commercial banks to be risky borrowers. The idea was to lock
up new investment banking in the future by advancing them money, a practice common to many, but not
all, of its investment banking rivals.
Goldman officials said that they were not eager to make such loans and that they fended off many
Russian demands for cheap short-term financing. But they said that in some cases they considered it the
price of making business contacts in Russia's fledgling banking market.
Goldman made loans to at least four clients, the oil giant Yukos, the Russian banks Inkombank and
Menatep and its largest client, the Russian government. The firm said those loans were often arranged in
conjunction with other Western banks, and that its chief rivals recruited or tried to recruit the same
clients.
The Oligarchs: Goldman Courts A Young Tycoon
he loans sped Goldman's rush into Russia's feverish market. An early target: companies controlled
by the oligarchs, businessmen who control most of the country's big industries. A few such
businessmen have acknowledged that they took control of Russian national companies in auctions that
were deeply flawed, allowing them to buy once-prized national energy and mining companies at fire
sale prices. Analysts suspect that many big Russian conglomerates have siphoned cash from the
companies they took over, putting it in foreign accounts.
Russian officials speak openly of their worries that the conglomerates, many of them publicly listed,
often flouted the law. "Most of the companies were ignoring most of the regulations and used to violate
them all of the time," said Dmitri Vasiliev, who recently resigned as chairman of Russia's Federal
Commission for the Securities Market. "It's not easy to enforce securities laws here because we don't
have the courts we need to prosecute violators."
Eager to forge alliances with businessmen who could one day prove to be Rockefellers or Gettys,
Goldman sought to develop close relations with Menatep. The bank was the financing arm in the empire
of Mikhail Khodorkovsky, a 35-year-old, tough-talking businessman who controlled one of the country's
biggest business networks, including Yukos and other big oil concerns. Goldman's calling card: a $200
million loan for Menatep.
Bankers who have had direct dealings with Khodorkovsky said that he used Menatep and Yukos to
wangle cash out of smaller companies in which Menatep had big equity stakes. Some of those subsidiary
companies are publicly listed, and they have minority shareholders who do not benefit from profits at
Yukos or Menatep. Yukos has also pledged much of its projected short-term earnings as collateral to go
on a huge borrowing binge, analysts said, raising serious doubts about the company's ability to pay its
debts.
Khodorkovsky, as well as Menatep and Yukos officials in Moscow, declined repeated interview
requests by telephone and fax. A lawyer for the company in Washington declined to comment, and was
unable to obtain a response from company representatives.
Yukos had approached several banks, including Morgan Stanley and Chase Manhattan, seeking a $500
million loan in the summer of 1997 -- some more than once -- but was repeatedly turned away. Then
Goldman entered the picture. Late last year, Goldman arranged for a group of banks, including Credit
Lyonnais and Merrill Lynch, to join in lending Yukos $500 million, with oil-export earnings used as
collateral, in advance of a proposed bond offering.
The banks had hoped to repackage the loan as a security and sell it to other investors. But as was often
the case in Russia, their ardor was not matched by market demand: Much of the loan remains on their
books, meaning that Yukos still owes them money. While Yukos missed a debt payment last spring,
putting the loan into technical default, Goldman says the payments are now current, and does not
consider it a loss.
Goldman's help in raising money for Yukos had a direct impact on some American companies. The Dart
Management Co., which oversees Russian investments of the Michigan industrialist Kenneth Dart, has
stakes in several formerly independent oil companies that Yukos now controls.
E. Michael Hunter, Dart's manager in Russia and a former banker, said Yukos routinely squeezed profits
out of its new subsidiaries by forcing them to sell oil to the parent company at below-market prices.
Yukos then resold the oil abroad at market prices and collected the profits at the expense of its
subsidiaries.
Hunter said he wrote letters to Goldman's chairman and chief executive, Jon Corzine, and the heads of
other banks in the lending syndicate detailing Yukos' business practices. He urged the banks not to
accept the disputed oil exports as collateral for the loan they made to Yukos. Hunter said his pleas were
rejected by the banking syndicate's lawyer.
"I think they are horribly bad at doing due diligence," Hunter said of Goldman and Yukos' other bankers.
"They were moved by greed, frankly. They preferred to hitch their horse to these guys rather than to face
the truth."
Goldman officials said that they believed that Yukos acted legally under Russian law, though the firm
declined to discuss the details of its relationship with the client.
The Investors: So Many New Bonds, So Little Confidence
ince the default in August, investors in Russian bonds have criticized Goldman and another top
adviser to Moscow, J.P. Morgan, for their work in issuing Russian bonds. Investors and some rival
bankers argue that bond issues underwritten by those two firms swamped an already-soggy bond market,
accelerating a loss of investor confidence.
By the spring of this year, Russia found it nearly impossible to issue any more ruble-denominated bonds
in its domestic market. After a flood of issues over three years that left Moscow struggling to pay
interest on tens of billions of dollars in borrowings, investors lost faith and declined to buy more
short-term Russian debt. The government was also having great difficulty collecting taxes. So, it sought
bankers who would help find new sources of foreign money. Before the summer, Russia had issued a
cumulative total of $4.3 billion in medium- and long-term dollar bonds overseas, and that market was
viewed as potentially much larger.
To the Russians, Goldman was the key. It underwrote a $1.25 billion issue of dollar-denominated bonds
known as Eurobonds in June -- the first new dollar bonds Russia managed to sell since the fall, before
Asia's turmoil spread. Goldman also arranged a $6.4 billion bond swap in July, which allowed
investors in Russia's short-term ruble debt to exchange their holdings for longer-term dollar bonds. This
offered at least temporary breathing space for the government.
Combined with a separate $2.5 billion Eurobond issue underwritten by J.P. Morgan and Deutsche Bank
in late June, the investment banks tripled the total supply of Russia's dollar bonds in just six weeks --
from $4.3 billion to nearly $15 billion -- despite growing investor squeamishness about emerging
markets.
Many bankers judge the merits of a bond or stock deal by whether prices rise or at least hold firm after
the issue is sold to investors. That's because clients do not want to see the market value of their
securities plummet, which makes it harder to raise money later. Russia's summer bond deals did not
pass that price test: while the new issues prompted a brief market rally, they soon tumbled.
J.P. Morgan's Russia Eurobond index gives the tally: the Russian benchmark bond price hovered above
$100 all year until the new issues began reaching the market in June. By late July, just before the giant
Goldman swap of ruble bonds for dollar bonds, the benchmark price had fallen to just above $80. But it
was soon after that Goldman bond swap, in late July, that the bottom fell out. The crash to about $50
directly preceded Russia's default.
In fact, some investors in Russian dollar bonds complain that the deals contributed to the default: With
the international bond market collapsing along with the domestic one, the Russian government saw
another of its channels for raising money blocked, perhaps concluding that it had little left to lose by
defaulting.
Steve Merrell, a manager for the IDS Global Bond Fund and an active investor in Russian dollar bonds,
said that underwriters torpedoed the market with the deluge of new issues, undercutting prices.
"In hindsight there was no plan," Merrell said. "Just take as much money as the market will give and
hope it holds together."
A senior J.P. Morgan banker responsible for the firm's business in the Russian region said that his
institution acted with good faith in Russia and that the firm considered the June bond deal it underwrote
to be a success.
Likewise, Michael Sherwood, head of Goldman's emerging-markets syndicate desk in London, argued
that Goldman's June bond deal was well received by investors, selling out in less than an hour and
raising much-needed money for Russia at a tough time.
The July debt swap, he said, fell short of Goldman's goal of relieving Russia's domestic debt burden,
though he said that it was the right thing to do. The reason the swap failed, he said, was because it was
too small, not too large. If investors had opted to swap more of their short-term ruble debt for long-term
dollar bonds, the deal might have allowed Russia to continue to pay interest on all its debt, avoiding
default. He said he suspected that investors might have chosen not to participate in Goldman's swap
because they had a false sense of confidence that Russia would continue to honor its high-interest ruble
debt, a favorite source of income for speculative hedge funds. Many also may have hoped that the
International Monetary Fund would pump enough money into Russia to insure that it did not fail.
Whatever the merits for Russia, the deals were good for Goldman. The firm earned fees of about $56
million for arranging the July debt swap alone, rival bankers say, though they add that that fee is
standard in the industry for the work performed.
Part of the proceeds Russia raised from the June bond issue also went to pay off Goldman's half-share of
$500 million in short-term financing known as a bridge loan to the Russian government late last year.
That loan, Goldman officials acknowledge, was made to put its name at the front of the list of banks
jostling to be named advisers and underwriters for the government. Goldman officials said they had an
agreement with the government to have the loan repaid as soon as Russia raised money through a foreign
bond offering. Goldman was the underwriter for the first such offering made after the loan was extended.
Rival bankers and investors say the bridge loan raises the question of a conflict of interest because
Goldman, with nearly 4 percent of its partners' capital tied up in that one loan, was highly motivated to
market the June bond deal -- and make sure that it was big enough for Russia to pay Goldman back.
Goldman itself at that time was preparing to issue shares to the public, a move that would require the
private partnership to open its books to scrutiny for the first time in its 130-year history. A large bridge
loan to the Russian government, unsecured by collateral and made at a time of considerable turmoil in
emerging markets worldwide, would have raised a red flag for brokerage firm analysts and credit rating
agencies, which view that kind of lending as high risk.
Goldman also had a great deal of its own capital at stake in the second bond deal, but managed to take it
off the table well before the August default. The firm said that it sought to generate momentum for the
July debt swap by buying ruble-denominated securities in the days leading up to the swap for the
purpose of including them in the swap transaction -- a standard, though somewhat risky, underwriting
activity, not altogether unlike a publisher snapping up books from stores to try to get the title on the
best-seller list. After the swap was completed, that left Goldman with a store of newly minted Russian
dollar bonds valued at about $550 million. Goldman disclosed in financial documents that it had the
right to participate in the swap offering in this way.
But the story has another twist: Even as Goldman proclaimed publicly as recently as its elegant House
of Unions party that it was in Russia for the long term, the firm appears to have had limited faith in the
country's financial future. Goldman confirms that its trading position on Russian debt went from "quite
long" in the days around the swap to "flat" or even "short" by August, meaning that it substantially
trimmed its $550 million holdings of Russian bonds or even had trading positions that would have
benefited from a fall in prices of those bonds.
Goldman officials declined to talk in detail about the trading the firm does on its own account. But
officials said the international dollar bond market was large, accommodating large buy and sell orders
each day, and that Goldman was an active trader in that market. The firm, these officials said, frequently
buys large blocks of bonds and sells them to investors when it thinks the price is right, a practice they
describe as a routine part of Goldman's core business.
Rival bankers agree that Goldman would not have been wise to invest lots of money in Russian dollar
bonds at such a volatile time -- though other firms do often keep a store of bonds in which they are
dealers to facilitate trading. But several bankers who followed the transaction noted that Goldman
accumulated its holdings of Russian bonds specifically to create momentum for its swap deal, then
quickly sold the bonds when the deal was done, a sequence that Goldman does not deny. Goldman
officials said that market demand for Russian dollar bonds was still strong when it trimmed its position.
But other bankers said Goldman's heavy selling almost certainly worsened the sharp drop in Russian
dollar bond prices in the days following the debt swap.
Moreover, by quickly selling off its own holdings just after it led investors to purchase the same
securities suggests that it was worried more about the firm's own money than the long-term interests of
its client, the Russian government, these bankers say.
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