A Hedge Fund Meltdown

Refco's willingness to make accommodations to its best customers was part of the reason for its success, and it may have played a role in its undoing.

'The Worst Situation Imaginable'

On Oct. 27, 1997, 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 Refco told him that prior arrangements were no longer in force because of uncertainty over how their authorities would calculate their own liquidity.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 because of 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 on to 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 we'd both be better off, but they had their own agenda to make sure the thing didn't snowball," Niederhoffer says. "It was the worst situation imaginable."

Niederhoffer's business was wiped out, but he says it was never clear what became of his positions. In addition to his options on futures, there were numerous other assets, including up to 10 million shares in two private companies that would go on a few years later to have successful initial public offerings. One of them is now worth $3.7 billion. Depending on how the options positions were marked to market, he figures Refco ended up with anywhere from a sizable gain to a $40 million loss.