Joseph Kahn and Timothy L. O'Brien of The New York Times report on how Wall Street's Goldman, Sachs & Co. advised the Kremlin f and escaped the Russian economic bloodbath.
The 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 toasts were raised to U.S.-Russian ties. The talk was about what mattered to Goldman and its 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, and 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 Eurobonds. A few weeks later, it arranged a complex deal in which short-term treasury bills, or GKOs, were exchanged for longer-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 GKOs that Goldman had sold, earning tens of millions of dollars in fees in the process, now hold nearly worthless paper. Goldman itself, however, escaped the blood bath: 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 here as constructive and attributed the country's troubles to problems that had little to do with investment banking.
But the troubled debt swap Goldman oversaw and the skillful way it protected 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 f including Russian officials, analysts and some investment bankers who worked in Russia f Wall Street players 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.
Investment bankers helped the Russian government borrow billions from foreign investors before it could reliably pay them back. As Russia built a roaring bond market, it 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 U.S. Federal Reserve and an occasional adviser to Russian government officials. "You just do the deal and get out."
Papering Over the Danger Signs
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 warning signs about Russia f corporate corruption, failure to pay loans on time, gross accounting irregularities and tax evasion. Others say they were lulled into complacence by a presumption of international backing f in other words, taxpayer-funded bailouts f 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."
Easy Foreign Money
From November 1996, when J.P Morgan and SBC-Warburg jointly marketed Russia's first international bond since the days of the tsar, 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 even marginal clients.
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 underlaid 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 accepted Irkutskenergo's terms. SBC-Warburg, the Swiss-British investment bank, eventually won the company's nod to underwrite the bond.
There was 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.
And there were more exotic investment opportunities. 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 and one of the biggest sellers of Russian debt derivatives to foreign investors. Those and other deals brought CS First Boston big profits in 1996 and 1997 but this year, the bank was caught heavily exposed by Russia's default. Analysts predict CS First Boston losses of from $500 million to $2 billion this year.
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 f and so, by the way, a man with much influence over when and whether the IMF organizes its Russia bailouts f 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 f and opened its checkbook. Goldman made temporary 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.
Critics in the investment community say the practice created a false confidence in Russia that easy foreign money could always be counted on. Goldman officials countered that they were not eager to make such loans, but that in some cases they considered it the price of making business contacts.
Courting an Oligarch
Eager to forge alliances with businessmen who could one day prove to be Rockefellers or Gettys, Goldman sought to develop close relations with the oligarchs, businessmen who control most of the country's big industries. A few such businessmen bought up Russia's oil companies, metals companies and other natural resource giants for fire-sale prices via rigged privatization auctions.
Goldman in particular set its sights on 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 f some more than once f 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.
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 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.
Swamped in Soggy Debt
Since 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 revenue-hungry government 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 f 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.
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 f from $4.3 billion to nearly $15 billion.
While the new issues prompted a brief market rally, they soon tumbled in value. J.P. Morgan's Russia Eurobond index gives the tally: the Russian bench mark 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 bench mark 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 bond 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 f and perhaps concluded that it had little left to lose by defaulting.
A senior J.P. Morgan banker 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, failed 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 f 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 treasury bills, 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 such a fee is standard.
Part of the proceeds Russia raised from the June bond issue 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 f 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.
Goldman also had a great deal of its own capital at stake in the July debt swap it had orchestrated f but managed to take it off the table well before the August default. Goldman said that it sought to generate momentum for the debt swap by spending its own money to buy up the short-term debt on offer f a standard, if risky, underwriting practice, not 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.
But the story has another twist: Even as Goldman proclaimed publicly at 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 f meaning that it substantially trimmed its $550 million holdings of Russian bonds.
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, these bankers say, Goldman's speed in ditching securities it had just led investors to purchase suggests that the company was worried more about its own money than the long-term interests of its client, the Russian government.