What's up guys and welcome back to wall street millennial on this channel, we cover everything related to stocks and investing today we're looking at the dark world of hedge funds and some of the most radical things they do to make money. The top hedge fund managers can amass fortunes of billions or even tens of billions of dollars. They use unconventional strategies which move around tens of billions of dollars of notional value. In some cases, these strategies can threaten to destabilize entire economies.

In today's video, we'll be looking at the legendary hedge fund manager, george soros and specifically how he profited to the tune of 1 billion pounds by breaking the bank of england, george soros was born into a jewish family. In hungary, a country he was barely able to escape during the nazi occupation in world war ii, he escaped to the united kingdom, where he attended the london school of economics majoring in philosophy he studied under the renowned philosopher, karl popper. Popper was a big proponent of the idea of reflexivity reflexivity is the idea that you can have two things that are both causes and effects of each other. Think of it like a self-fulfilling prophecy.

One example of this is a placebo drug, let's say you're in pain and need pain, medication. The doctor gives you a pill and it relieves your pain, even if it was just a sugar pill, there's a good chance that your brain would trick yourself into feeling pain relief, just because you thought it was a painkiller. Thus you have the chicken versus the egg problem. Did the pill cause your pain to go away or did the pain cause the pill to work unless you crush up the pill and look at it under a microscope? You have no way of knowing for sure self-fulfilling prophecies can also be observed in economics.

If people think that a bank will go bust, depositors will all try to withdraw their money at the same time causing a bankruptcy. Even if the bank would otherwise be completely healthy, soros thought they could apply the theory of reflexivity to the world of trading in financial markets. He believed that asset prices can themselves affect the future fundamental value of assets. For example, when home prices rise, homeowners automatically have greater wealth with homeowner balance sheets.

In a better position, banks feel comfortable relaxing their requirements and decreasing interest rates for new homes. This increases demand for homes, pushing prices up even further. The value of any asset depends on a wide range of economic conditions, which are affected heavily by investor sentiment in soros's view, it's a fool's errand to try to find the static, fair value of a given asset. Instead, he spent his time trying to identify and predict transit investor sentiment, which would drive asset prices going forward.

His theories differed greatly from the more traditional general equilibrium models that most investors subscribed to at the time. Whenever a new development takes place in the economy, asset prices should shift to a new equilibrium over time. Most economists and investors alike never consider that changes in asset prices could themselves cause changes in equilibrium. Throughout the 1950s and 60s he worked as a trader at investment banks in london and new york, slowly rising the ranks and building a name for himself in 1970.

He opened up his own hedge fund called soros fund management where he put his theories of reflexivity in financial markets to the test he later renamed it. The quantum fund his fund was almost immediately successful and by the late 80s he was managing over 400 million dollars. It appeared that his reflexivity theories were better at predicting asset prices than the older models, but the biggest test for soros's investment strategy was still yet to come. During the 1970s and early part of the 1980s high inflation rates were rampant across the united states and much of western europe in 1990, a man by the name of john major was the united kingdom's chancellor of the exchequer, a position similar to the secretary of the Treasury in the united states major remembered the painful experience that the uk had with inflation in the 1970s.

He wanted to put in place a policy to prevent anything similar ever happening again. At the time, germany was considered to be the most monetarily, prudent country in europe and perhaps the entire world because of their experience with hyperinflation during the weimar republic. German politicians are extremely inflation, diverse even to this day because of germany's aversion to excess inflation. The deutsche mark, which was a currency at the time, was very stable.

John major thought that by picking the pound to the deutsche mark at a fixed exchange rate, the uk could effectively import all the benefits of germany's low inflation in 1990. He convinced then prime minister margaret thatcher to establish a fixed exchange rate of 2.95 deutsche marks per pound soros crunched the numbers and found that the 2.95 fixed exchange rate was unsustainable in the early 1990s. Germany's inflation rate started to increase as a result of government expenditures associated with the reunification of east and west germany to combat the inflation. The german central bank increased interest rates sharply.

The swift action from the german monetary authorities successfully decreased inflation back down to acceptable levels in order to maintain the fixed currency peg, the uk would have to maintain the same inflation rate as germany importing this low inflation was the entire point of establishing the currency peg. In the first place to decrease the inflation rate, the bank of england would have to sharply increase its own interest rates, but there was a problem. The uk economy was not doing very well, their manufacturing sector was facing increasing competition from lower cost asian countries and worker productivity growth was also slowing down sharply. Raising interest rates would likely cause a painful recession with high unemployment in the early 1990s.

The uk's inflation rate was above that of germany, and the interest rate differential was not enough to compensate for this. Naturally, people started viewing german bonds as superior investments and they started selling their pounds to buy deutsche marks. The selling pressure would push the value of the pound below the 2.95 peg if the selling pressure was only temporary, it wouldn't have been a big deal. The bank of england had tens of billions of pounds worth of foreign currency reserves.

They can sell their foreign currencies in exchange for pounds, thus propping up the exchange rate. The uk government thought that the high inflation in the uk was only temporary. They had enough foreign currency reserves to maintain the exchange rate for many months. They could just wait it out and everything would be fine in the end.

But george soros knew that this couldn't be maintained. The fixed exchange rate made the pound overvalued compared to what the country's economic fundamentals could justify, but remember that soros was a believer in reflexivity. Just knowing that the pound was overvalued, wasn't enough to initiate a short position he needed to change. The trend of sentiment such as the fall in the pound is inevitable.

The good thing about currencies is that they are far less volatile than stocks because of this they're considered less risky, and you can take out a lot more leverage on a currency position, and this is exactly what soros did. He started short selling billions of pounds. The position ultimately reached a notional value of 10 billion pounds, making it bigger than the equity of his entire fund. The reason for the large size of the position was twofold.

Firstly, he was confident in the position and wanted to profit big time on it, but perhaps, more importantly, was how other market participants would view his trades whenever someone puts a large order to short billions of pounds at a time. Other currency speculators will take note of this unusual activity. They don't know who is making the short position, but they do know that it has to be some sort of sophisticated hedge fund that can support a multi-billion pound position and remember the bank of england is the one propping up the exchange rate every time. Someone short sells a pound.

The bank of england has to be the counterparty, exchanging them for other currencies. The bank of england has a limited supply of foreign currencies. If enough investors started shorting pounds. The bank of england will eventually run out of money and be forced to abandon the fixed exchange rate.

When this happens, the value of the pound will tank making billions in profits for the short sellers. Other hedge fund managers, including paul tudor jones, took note of the situation. They also started shorting pounds. They all wanted to get a piece of the profits when the bank of england inevitably runs out of cash.

By placing such large trades soros had successfully shifted the market sentiment under his theory of reflexivity. The fact that all these hedge fund managers think the pound will crash is enough to make the pound actually crash. The moment of truth came on wednesday september 16th 1992, which would later be referred to as black ones. A by this point, so many hedge funds had jumped onto the bandwagon that they were shorting 2 billion pounds per hour collectively.

The bank of england would run out of reserves in a matter of days. John major, who had recently become prime minister, desperately wanted to maintain a deutsche mark. Peg, he told norman lamont, who is the chancellor of exchequer to increase interest rates. Raising rates would make british bonds more attractive to foreign investors and thus increase buying pressure for the pound.

Norman lamont announced a plan to raise the country's benchmark interest rate from 10 to 12 percent and then even further to 15. Remember that increasing the interest rate would almost certainly cause a recession. This would increase unemployment and likely doomed. The ruling conservative party in the next election cycle norman was probably bluffing.

He thought that temporarily increasing interest rates would reverse the bearish sentiment on the pound and force the short sellers to cover. Once this happens, they could quickly decrease the interest rate back down to 10 percent and avoid a major recession soros and the other hedge funds called norman's bluff. They didn't believe that the uk government would really be willing to plunge the economy into recession. Just to maintain the exchange rate, the speculators ended up being correct.

The uk was forced to abolish the fixed exchange rate and let the currency trade freely. Here's a clip of norman lamont explaining what happened on that fateful day. Well, i think the most vivid memory i have is just when we put interest rates up from 10 to 12 percent, how it had absolutely zero effect - and i remember just looking at the computer and seeing an absolutely straight line. The currency hadn't moved at all and i felt just like a surgeon looking at a heart graph of a patient and realize the patient was dead.

Without the support of the bank of england, the pound fell about 20 from 2.9 deutsche marks to 2.4, while 20 doesn't sound like all that much. This is a huge move for a currency and because the hedge funds used leverage, they were able to multiply. This percentage return many times over the biggest winner was george soros. His quantum fund made 1 billion pounds of profit, which is equivalent to about 3 billion us dollars today, adjusting for inflation.

After the event, soros was vilified by many in the media, as the man who broke the bank of england, when hedge funds make billions speculating on currencies, this money has to come from somewhere. In this case, it came from the uk government which lost an estimated 3.14 billion pounds. This equates to about 160 us dollars per citizen, adjusted for inflation. Part of the reason it was so controversial was precisely because of soros's reflexivity theory.

Not only did he predict the currency movements, his trade itself was a catalyst for the crash nobel prize-winning economist, paul krugman wrote quote there really are investors who not only move money in anticipation of a currency crisis, but actually do their best to trigger that crisis for Fun and profit these new actors on the scene do not yet have a standard name. My proposed term is soroy, unquote with soroy, obviously referencing george soros, but while the uk government did hold the bag in the short term, the exchange rate peg with the deutsche mark was unsustainable and probably would have collapsed on its own anyway, when the uk pegged its Currency to the deutsche mark, this effectively meant they had to adopt the same interest rate policy as germany, but because the two economies have different characteristics and business cycles. This leads to an inefficient and ultimately untenable system and to make matters worse. The exchange rate of 2.95 that we chose to peg at was way too high.

The artificially high exchange rate made british exports less competitive on the global stage. This combined with increasing competition from rapidly developing asian nations, severely hampered their manufacturing sector when the country finally allowed the currency to depreciate demand for british exports increase and they experienced strong economic growth for the remainder of the decade. While soros's theories of reflexivity were novel at the time, they've gained more widespread acceptance in recent years, for example, soros breaking the bank of england mirrors the gamestop short squeeze from early 2021. In a lot of ways, the short sellers had a limited ability to maintain their position as the stock price went up.

This put them in a similar situation to the bank of england in 1992.. Retail investors knew that if enough of them started buying shares, they could force the short sellers to capitulate. Gamestop's share price could not be determined by an equilibrium, but instead as a self-fulfilling prophecy, created by a large group of individual investors, alright guys that wraps it up. For this video, what do you think about george soros breaking the bank of england? Do you think the gamestop saga has any similarities? Let us know in the comments section below, as always.

Thank you so much for watching and we'll see in the next one wall. Street millennial signing out.