31 October 2007

History's warning about the price of money

By Manuel Hinds and Benn Steil

Published: October 30 2007 02:00 | Last updated: October 30 2007 02:00

The Federal Reserve's dramatic 0.5 per cent interest rate cut on Sep-tember 18 was greeted with euphoria in the stock market, which soared 5 per cent in the two weeks that followed. This fact itself was hailed as vindication for a Fed that felt Jim Cramer's pain, and gave the world the cheaper dollars the market guru shrieked for in CNBC's (and YouTube's) most memorable "Mad Money" segment ever.

To those who worry about inflation, the Fed could point to crunching credit as a danger to growth, and ipso facto a force for disinflation. Waiting for the numbers to prove it would just be reckless dithering.

We have sympathy for Ben Bernanke, Fed chairman, and company. The job of a price fixer is never easy. What should money cost? For most of human history this was easy: once you fixed a conversion factor with gold, you just sat back and let the forces of supply and demand do their stuff. But since the collapse of the Bretton Woods currency regime (the last vestige of thousands of years of commodity money), discretion has been the watchword. Nine smart folks at the Fed board have taken over the job of deciding what the price of money should be. If the hagiography and hatred showered on Mr Bernanke's predecessor, Alan Greenspan, is any indication, that price should be wisely wiggled down to make jobs, up to prick bubbles and now, apparently, back down to offset losses on millions of bad credit decisions.

So, are our cheaper dollars now at the right price? In the coming months, all eyes will be on the consumer price index for the answer.

Unfortunately, there are circumstances in which excessive monetary creation can destabilise the economy while the rate of CPI inflation remains low. These tend to be present when the danger of monetary destabilisation is at its highest because people have lost faith in the ability of money to keep its value through time.

As one of the great monetary economists of the last century, Jacques Rueff, pointed out in the late 1960s, people react to the "growing insolvency" of a reserve currency, such as the dollar, by acquiring "gold, land, houses, corporate shares, paintings and other works of art having an intrinsic value because of their scarcity". Sounds familiar? Indeed, this is the story of our present decade, one in which alternatives to the dollar as a store of value have soared even while the CPI has remained subdued.

This phenomenon is well-known in developing countries, where asset booms combined with low CPI inflation have preceded monetary and financial crises. In Mexico, for example, share prices rose 12-fold between January 1989 and November 1994, while inflation fell from 35 per cent to 7 per cent. Inflation then soared as the Tequila crisis exploded.

Prices of shares and real estate more than doubled from 1993 to 1996 in Indonesia and South Korea while CPI inflation rates were declining. In May 1997, just weeks before the currencies collapsed, inflation was only 4.5 per cent in Indonesia and 3.8 per cent in South Korea.

The same symptoms have been visible in many other monetary crises in developing countries. They seem to be visible today in the US. Following the 2001 dotcom crash, resources flowed into real estate, foreign exchange and commodities, while CPI inflation remained modest. In 2007 the housing bubble finally burst, causing credit to crunch as the market struggled to out the owners of dud mortgages and -mortgage-linked contracts. The Fed reacted with cheaper dollars, which did precisely nothing in that regard. Credit risk fears remain unabated. But the market duly dumped dollars for harder assets, pushing the euro, shares, oil and gold to record dollar prices.

Gold, having been global money for the better part of 2,500 years, and therefore the commodity most sensitive to expectations of macroeconomic in-stability, provides the best measure of the extent of the rush towards -inflation-proof hard assets.

Between August 2001 and August 2007, the dollar price of gold soared 144 per cent, while the CPI rose only 17 per cent. The last time such a substantial and sustained appreciation of gold was observed was in the 1970s, on the heels of America's loose money policy and balance of payments deterioration in the 1960s and Rueff's warnings regarding "the precarious dominance of the dollar". There were two episodes, from 1971 to 1975 and from 1977 to 1980. In both, the increase in the price of gold and other commodities presaged substantial increases in CPI inflation as well as significant falls in the international value of the dollar.

The dollar sustained its role as the international standard of value because of good fortune on two fronts. First, the Fed under Paul Volcker hammered out inflationary expectations with a painful but necessary period of high interest rates. Second, there was no viable alternative.

It may not be so lucky this time. Today, not only does the euro wait in the wings as understudy, but gold banks have risen in tandem with the dollar's decline and offer the world a viable private alternative that has permanent intrinsic value.

As the Fed debates whether the world is truly crying out for even cheaper dollars, it would be wise to heed the lessons of monetary history.

Manuel Hinds is a former Salvadoran finance minister and author of Playing Monopoly with the Devil. Benn Steil is director of international economics at the Council on Foreign Relations and co-author of Financial Statecraft

30 October 2007

The Secrets of Intangible Wealth -- Education, dudes!

By Ronald Bailey
September 29, 2007

A Mexican migrant to the U.S. is five times more productive than one who stays home. Why is that?

The answer is not the obvious one: This country has more machinery or tools or natural resources. Instead, according to some remarkable but largely ignored research — by the World Bank, of all places — it is because the average American has access to over $418,000 in intangible wealth, while the stay-at-home Mexican’s intangible wealth is just $34,000.

But what is intangible wealth, and how on earth is it measured? And what does it mean for the world’s people — poor and rich? That’s where the story gets even more interesting.

Two years ago the World Bank’s environmental economics department set out to assess the relative contributions of various kinds of capital to economic development. Its study, “Where is the Wealth of Nations?: Measuring Capital for the 21st Century,” began by defining natural capital as the sum of nonrenewable resources (including oil, natural gas, coal and mineral resources), cropland, pasture land, forested areas and protected areas. Produced, or built, capital is what many of us think of when we think of capital: the sum of machinery, equipment, and structures (including infrastructure) and urban land.

But once the value of all these are added up, the economists found something big was still missing: the vast majority of world’s wealth! If one simply adds up the current value of a country’s natural resources and produced, or built, capital, there’s no way that can account for that country’s level of income.

The rest is the result of “intangible” factors — such as the trust among people in a society, an efficient judicial system, clear property rights and effective government. All this intangible capital also boosts the productivity of labor and results in higher total wealth. In fact, the World Bank finds, “Human capital and the value of institutions (as measured by rule of law) constitute the largest share of wealth in virtually all countries.”

Once one takes into account all of the world’s natural resources and produced capital, 80% of the wealth of rich countries and 60% of the wealth of poor countries is of this intangible type. The bottom line: “Rich countries are largely rich because of the skills of their populations and the quality of the institutions supporting economic activity.”

What the World Bank economists have brilliantly done is quantify the intangible value of education and social institutions. According to their regression analyses, for example, the rule of law explains 57% of countries’ intangible capital. Education accounts for 36%.

The rule-of-law index was devised using several hundred individual variables measuring perceptions of governance, drawn from 25 separate data sources constructed by 18 different organizations. The latter include civil society groups (Freedom House), political and business risk-rating agencies (Economist Intelligence Unit) and think tanks (International Budget Project Open Budget Index).

Switzerland scores 99.5 out of 100 on the rule-of-law index and the U.S. hits 91.8. By contrast, Nigeria’s score is a pitiful 5.8; Burundi’s 4.3; and Ethiopia’s 16.4. The members of the Organization for Economic Cooperation and Development — 30 wealthy developed countries — have an average score of 90, while sub-Saharan Africa’s is a dismal 28.

The natural wealth in rich countries like the U.S. is a tiny proportion of their overall wealth — typically 1% to 3% — yet they derive more value from what they have. Cropland, pastures and forests are more valuable in rich countries because they can be combined with other capital like machinery and strong property rights to produce more value. Machinery, buildings, roads and so forth account for 17% of the rich countries’ total wealth.

Overall, the average per capita wealth in the rich Organization for Economic Cooperation Development (OECD) countries is $440,000, consisting of $10,000 in natural capital, $76,000 in produced capital, and a whopping $354,000 in intangible capital. (Switzerland has the highest per capita wealth, at $648,000. The U.S. is fourth at $513,000.)

By comparison, the World Bank study finds that total wealth for the low income countries averages $7,216 per person. That consists of $2,075 in natural capital, $1,150 in produced capital and $3,991 in intangible capital. The countries with the lowest per capita wealth are Ethiopia ($1,965), Nigeria ($2,748), and Burundi ($2,859).

In fact, some countries are so badly run, that they actually have negative intangible capital. Through rampant corruption and failing school systems, Nigeria and the Democratic Republic of the Congo are destroying their intangible capital and ensuring that their people will be poorer in the future.

In the U.S., according to the World Bank study, natural capital is $15,000 per person, produced capital is $80,000 and intangible capital is $418,000. And thus, considering common measure used to compare countries, its annual purchasing power parity GDP per capita is $43,800. By contrast, oil-rich Mexico’s total natural capital per person is $8,500 ($6,000 due to oil), produced capital is $19,000 and intangible capita is $34,500 — a total of $62,000 per person. Yet its GDP per capita is $10,700. When a Mexican, or for that matter, a South Asian or African, walks across our border, they gain immediate access to intangible capital worth $418,000 per person. Who wouldn’t walk across the border in such circumstances?

The World Bank study bolsters the deep insights of the late development economist Peter Bauer. In his brilliant 1972 book “Dissent on Development,” Bauer wrote: “If all conditions for development other than capital are present, capital will soon be generated locally or will be available . . . from abroad. . . . If, however, the conditions for development are not present, then aid . . . will be necessarily unproductive and therefore ineffective. Thus, if the mainsprings of development are present, material progress will occur even without foreign aid. If they are absent, it will not occur even with aid.”

The World Bank’s pathbreaking “Where is the Wealth of Nations?” convincingly demonstrates that the “mainsprings of development” are the rule of law and a good school system. The big question that its researchers don’t answer is: How can the people of the developing world rid themselves of the kleptocrats who loot their countries and keep them poor?

29 October 2007

The Catastrophist View

Peter Schiff is laughing at me. I've just asked him to entertain the following notion: that we dodged a bullet during August's financial-market turmoil and, with the stock market bouncing right back from every dip, things might be okay. So why worry?

He stops laughing. “Why worry?” he asks. “Because we dodged a bullet but are about to step on a hand grenade.”

Sitting in a corner office of a nondescript building just off I-95 in Darien, Connecticut, Schiff, the president of brokerage Euro Pacific Capital, will spend the next hour spelling out a singularly pessimistic view of the American economy. And he will do so while exhibiting a curious juxtaposition unique to the bearish prognosticator: He speaks of disaster with a smile on his face. No, he's not happy about our impending doom. But he is happy that people are finally taking him seriously.

The Bottom Continues to Fall Out of the Housing Market

Manhattan's gravity-defying real estate aside, it's quite clear the nation is experiencing a genuine housing crisis. In August, pending home sales dropped 6.5 percent, and they currently sit at their lowest level since 2001. The National Association of Realtors conducted a recent survey that showed more than 10 percent of sales contracts fell through at the last moment in August, primarily owing to disappearing loan commitments from banks. The crisis will only deepen, when more borrowers see their adjustable-rate mortgages adjusted upward. There was a foreclosure filing for one of every 510 households in the country in August, the highest figure ever issued, and by one estimate, more than 1.7 million foreclosures will occur in the country by the end of 2008. That's not just subprime borrowers: According to the Federal Housing Finance Board, while nearly 35 percent of conventional mortgages in 2004 used ARMs, some 70.7 percent of jumbo loans—those above $333,700 (the jumbo threshold in 2004; it's now higher)—did too.

Hedge-fund veteran Rick Bookstaber, the author of A Demon of Our Own Design, spells out a potentially disastrous scenario that could unfold regardless of what the Fed does: Continued foreclosures result in a further drop in housing prices, which results in further foreclosures, which result in a further drop in housing prices. Even for those of us not selling, reduced home values result in a reduced sense of security, which results in reduced consumption, which results in a slowing economy, which … you get the point.

The Derivatives-Related Meltdown, Part II

Each time one of these write-downs has been announced, the market has had a curiously positive response, taking the news as a sign that the worst was over and the banks were cleaning up their books. But because these derivatives are linked to other debt, there's no reason to be certain that trouble won't bleed into other markets. Among other things, the liquidity crisis froze the market in structured investment vehicles (SIVs), a nifty bit of financial engineering that banks use to profit from the spread between short-term debt and long-term debt. No one yet knows how nasty these losses could turn out to be because SIVs are stashed, Enron style, off the books.

Consumers Run Out of Steam (and Take the Economy Down With Them)

The willingness of consumers to keep spending and piling on debt in the midst of a slowing real-estate market is hailed on Wall Street as an act of patriotism, which Schiff considers perverse. Imagine, he suggests, that you ran into a good friend and asked him how he was doing. His reply: “I took out a third mortgage, maxed out my credit cards, and emptied out my kids' college savings account so I could buy a bigger TV and a new car, and we're going to Greece on vacation over the holidays. Things are great!” Schiff lets the idea sink in and then finishes the thought: “And we're celebrating the fact that we're doing this as a nation?”

That the Rest of the World Decides They Don't Need Us and the Dollar Tumbles Hard

The dollar is falling, possibly collapsing, depending on whom you talk to. The greenback has sunk close to its lowest point in the post-1973 floating-exchange-rate era, so low that it's been overtaken by the Canadian dollar—affectionately known as the loonie—for the first time since 1976. How low will it go? When Alan Greenspan was asked by Lesley Stahl of 60 Minutes last month what currency he'd like to be paid in, his response was telling: “[The] key question … is, ‘In what currency do you wish to hold your assets?' And what I've done is I diversify.” Translation: He isn't betting on the dollar. And neither is the majority of Wall Street.

That We Don't See It Happening Because It's a Slow-Motion Train Wreck

4 phases of the US bust

A friend of mine who is a senior professional in one of the largest financial institutions in the world has sent me
privately – and confidentially - the following email messages. Like me, he predicted a year ago that this would be
the worst housing recession in US history and described a bust process that would go through 4 phases. Here is the way he is putting it:

It appears that we are now entering phase 2 on the timeline for the housing bust:

Phase 1: rising mortgage defaults, homes prices start falling, sale volumes falls, housing starts and permitsdecline.

Phase 2: home-builders' bankruptcies, housing starts and permits crash, substantial layoffs in construction and real estate-related fields (mortgage brokers, mortgage lenders, etc.).

Phase 3: substantial price declines in major metro areas, large rise in defaults of prime but low-equity mortgages.

Phase 4: large-scale government intervention to help households going bankrupt. This is a political phenomenon, so the timing and nature of this cannot be reliably forecast.

Evidence of financial distress and default among homebuilders in phase 2:

Public builders in trouble:

Levitt Corp (LEV): "Levitt home-building unit gets loan default notices"

Tousa (TOA): "A creditor group that owns more than $1 billion in senior notes and subordinated debt has hired law firm Akin Gump Strauss Hauer Feld to assess its rights in the event of a bankruptcy filing"

Plus many smaller, private builders in trouble or bankrupt:

"As countless builders and subcontractors go out of business or find themselves unable to pay their bills, Glover and his fellow repossession agents are snapping up the vehicles at the behest of lien holders such as Ford Motor."

Neumann Homes: "Crippled by the downturn in the housing market, Neumann Homes, one of Chicago's largest home-building companies, said Monday that it plans to file for bankruptcy."

Enterprise Construction (FL) files for bankruptcy

I fully agree with him with one caveat: we are not just at the beginning of phase 2 but most likely already at phase 3 as most of the aspects of phase 2 have already occurred by now and some elements of 3 are already on their way (home prices are falling sharply in some major metro areas, we are seeing the rise in defaults in near prime and prime mortgages and some near prime and prime lenders are in trouble). And we are getting close to phase 4 as over a dozen proposals to rescue 2 million plus households on the way to default and foreclosure are now being debated in

Next, this senior colleague sent me the following additional message - after my latest blog revisiting my predictions – on the macro impact of the worst housing bust in US history:

Follow-up to your blognote today... I think you deserve credit for your bold forecast, violating the rule of never predict both an event and a date.

Even more interesting is that the current view has not substantially changed from that of a year ago. The evidence is now overwhelming and consensus admits what they denied last year: that we will experience at least a severe
housing downturn -- in price action unlike anything since the 1930's, probably also in rates of foreclosure.

But consensus opinion remains unshaken that there will be only minor macro effects. This seems extraordinary to me. A 70 year record decline in what is perhaps the largest private asset class, the collateral for the majority of
household debt, whose leverage is at an all-time record high. A downturn - perhaps crash - in the construction and real estate industries (18% of 2005 total metropolitan area GDP).

Perhaps the most astonishing aspect of this event is the refusal to recognize the possible dimensions, the impact,of what is coming.

Indeed, the soft landing consensus is increasingly delusional in believing that the biggest housing recession in US history will not have severe macro effect. Most of the consensus now recognizes that, after the spurt in growth in Q3 (probably a little above 3%) the economy is now rapidly decelerating and Q4 will be weak: for example one of the most bullish houses – JP Morgan – is now forecasting a Q4 growth of only 1%, fully in the growth recession territory (Bloomberg consensus for Q4 is an optimistic 1.8%). But this consensus next goes to assume and predict that Q4 will be the bottom of the US growth slowdown and that economic growth will recovery in soft landing territory (2.5%).

What is the basis for this alleged 2008 growth recovery? Mostly wishful thinking as the economic and financial shocks leading to falling demand (a worsening housing bust; anemic capex spending; slowdown in commercial real estate demand; sharp private consumption slowdown) and weak supply (weakening ISM; slowing down employment; glut of supply of new and existing homes, auto/motorvehicles, consumer durables; a capacity overhang; an excess inventory buildup) will fully persist into 2008. Indeed, as David Rosenberg, the chief US economist for Merrill Lynch put it in his most recent report:

"We think a miracle is needed to avoid recession. With domestic demand growth struggling to stay above a 1% run-rate, if we manage to avoid a recession with another huge down-leg in homebuilding activity and home prices, we
think it will be a miracle."

A miracle to avoid a recession! Indeed it seems that many of the soft landing optimists are now in wishful thinking mode, if not hoping for a miracle. As Ed Leamer showed in his Jackson Hole paper, six of the last eight housing recessions have ended up in a economy-wide recession; and this housing recession will end up being more severe than
all of the former eight ones. The only two exceptions of a housing recession not leading to economy-wide ones were those during the Korean War and the Vietnam war when a massive fiscal stimulus rescued the economy. What we spent –
or waste – on Iraq is not sufficient to get that fiscal stimulus; we would need another equivalent of $200 billion fiscal stimulus to do the job. A war with Iran is such an option: but a war in Iran would lead to an overnight doubling of oil prices to $200 per barrel plus and would lead to a certain U.S. and global recession.

Home prices will have to fall by 20% to bring back home affordability to semi- normal levels; or mortgage rates would have to fall by 200bps to get the same result. Chances of the latter happening are zippo as long rates went up
after the Fed eased on September 18th. So the adjustment will occur via a painful and deflationary 20% fall in home prices that will trigger an economy wide recession as any mainstream macro-econometric model shocked with a 20% fall
in home prices shows.

No wonder that Mishkin – in his Jackson Hole paper – went through a benchmark scenario where home prices fall by 20%; do you think that Bernanke had not read Mishkin's paper before the Jackson Hole meeting? And the implication of
the Mishkin paper was that the Fed needed to start with a 200bps Fed Funds cut to try to attempt to counter this home price shock alone; even that would not be enough as long rates and mortgage rates are likely to fall less than otherwise hoped by the Fed.

So no surprise that Marty Feldstein urged at Jackson Hole the Fed to cut rates right away – to start with – by 100bps. But, at best, the FOMC will give us another 25bps as a Halloween Treat on Wednesday, not the 200bps implied by the Mishkin analysis. So, what the Fed does is – again – too little too late. The consensus among the independent academic luminaries at Jackson Hole (Feldstein, Leamer, Shiller, and even implicitly, Mishkin) was that this was the worst housing bust ever and that the macro effects would be severe with a high risk of a recession. So why is the
Wall Street consensus and the Fed not getting it?

What does the macro econometric model used by the Fed imply if you shock it with the worst US housing recession, 20%fall in home prices, collapsing HEW, a severe liquidity and credit crunch, a rise in investors' risk aversion and
uncertainty, and oil at $90? Would someone at the Fed let us know? And - based on that model - which cut in the Fed Funds rate it will take to avoid a recession? Hopefully someone at the Fed may have that answer and provide it to
the public.

24 October 2007

The Blow up artist - Niederhoffer

Can Victor Niederhoffer survive another market crisis?
by John Cassidy

Niederhoffer’s approach is eclectic. His funds, a friend says, appeal “to people like him: self-made people who have a maverick streak.”

“Practical Speculation” On a wall opposite Victor Niederhoffer’s desk is a large painting of the Essex, a Nantucket whaling ship that sank in the South Pacific in 1820, after being attacked by a giant sperm whale, and that later served as the inspiration for “Moby-Dick.” The Essex’s captain, George Pollard, Jr., survived, and persuaded his financial backers to give him another ship, but he sailed it for little more than a year before it foundered on a coral reef. Pollard was ruined, and he ended his days as a night watchman. The painting, which Niederhoffer, a sixty-three-year-old hedge-fund manager, acquired after losing all his clients’ money—and a good deal of his own—in the Thai stock market crash of 1997, serves as an admonition against the incaution to which he, a notorious risktaker, is prone, and as a reminder of the precariousness of his success.

Niederhoffer has been a professional investor for nearly three decades, during which he has made and lost several fortunes—typically by relying on methods that other traders consider reckless or unorthodox or both. In the nineteen-seventies, he wrote one of the first software programs to identify profitable trades. In the early eighties, he went into business with George Soros, then arguably the world’s most successful investor. A few years later, when prominent money managers were based almost exclusively in Manhattan, Niederhoffer moved his home and his trading room to Connecticut, to a twenty-thousand-square-foot neo-Tudor mansion crammed with books, manuscripts, silver jewelry, art work, and a collection of seashells. The walls of his vast living room, which has a ceiling about thirty feet high, are covered with more than two dozen paintings, many depicting industrial landscapes or Western shoot-’em-ups, and the floor is occupied by, among other objects, a large painted pony, a black-spotted wooden hound carrying three quail on its back, a seated pig, and two miniature black bears. Niederhoffer’s home is also frequently occupied by various of his children. (He has six daughters and an infant son, from two marriages and an extramarital relationship.)

After the 1997 Asian financial crisis, Niederhoffer was forced out of business for several years. Then, in his late fifties, he made a dramatic recovery. He founded three new hedge funds and launched a Web site, DailySpeculations.com, where he posts his idiosyncratic insights into the stock market—“What can we learn from shelled species about the markets?” he wrote in May—as well as opinions about sports, politics, and culture (“ ‘The Fantasticks,’ currently running as a revival on Broadway, is the perfect musical”). He has mentored dozens of successful traders, many of whom regard him as a guru. “Before I joined Victor, I used to trade for a Wall Street firm,” James Lackey, a self-employed Florida investor who placed trades for Niederhoffer from 2002 to 2006, told me. “But I quickly realized that I didn’t know very much. What he taught me was how to approach the market as a whole, and how to analyze it scientifically. He was just amazing at seeing what was happening and showing us how to make money.”

Niederhoffer, a former national squash champion who is considered one of the most talented Americans to have played the game, relishes the acclaim, but he knows that in his field circumstances can change quickly. By the end of August, his funds were in trouble, and on Wall Street rumors circulated that he would soon be out of business again. Niederhoffer had been worried all summer, but he tried to project a wry, self-deprecating humor. “If an event like 1997 occurred again, my dependents would be up the creek, and I would be a night watchman somewhere, just like Captain Pollard,” he said to me when I visited him at his home one morning in June. “In America, they give you a second chance but not a third.”

Tall and trim (he still looks like an athlete), with closely cropped white hair, olive skin, and a long, expressive face, Niederhoffer speaks softly, with a strong Brooklyn accent. He was wearing a yellow shirt, pink trousers, and white socks, but no shoes—he maintains a “no shoes” rule in the office, to reduce noise—and was sitting behind his desk, which is dominated by two Bloomberg screens, in a large room over the garage which he shares with his partner, Steve Wisdom, and several members of his company, Manchester Trading. (The trading operation fits into two rooms; the other one is over the kitchen.) In one hand, he was holding a telephone receiver, and his light-blue eyes were fixed on the computer screens. “The market’s way down today,” he said by way of greeting. Turning back to the telephone and addressing his broker at the Chicago Mercantile Exchange, he asked, “Can you repeat those quotes, please?” After a few seconds, he said, “I’ll sell two hundred red March at five hundred and ten. I’ll sell two hundred blue March at eleven ten.”

The Chicago Merc is a futures market, where people trade contracts that give them the right to purchase a particular commodity at a specified date in the future. Originally, the items traded on the exchange were physical commodities, such as eggs, butter, and pigs, and its main customers were farmers and food companies. In recent decades, futures trading has become more abstract; professional speculators now use the exchange to place bets on the prices of financial securities, such as stocks, bonds, and currencies—a development that Niederhoffer, a former math prodigy who has a Ph.D. in economics, has exploited. He likes to be at his desk well before the Chicago market opens, especially on days when he has big positions riding overnight. He is mainly a short-term operator—he bets on how prices will move in the subsequent few minutes, hours, or days—and most of his knowledge of current events comes from Bloomberg. (He doesn’t read newspapers or watch television.) When he arrives at his office, he turns on his computer and reads about developments in the Asian and European markets, which often foreshadow the day’s action in the United States.

At the end of the previous week, the yield on ten-year Treasury bonds had surged to almost five per cent, prompting Niederhoffer to turn uncharacteristically bearish on stocks. Once the bond yield reached five per cent, he had reasoned, some investors would move their money from stocks to bonds, which would depress stock prices. Accordingly, he had sold short more than a billion dollars’ worth of stock futures. (Selling short, a common tactic among speculators, involves selling something you don’t own with the intention of buying it back later, at a cheaper price. If the price of the security falls while you are “short,” you make a profit; if the price rises, you lose money.)

Even by Niederhoffer’s generous standards, going short a billion dollars of stock futures was a large bet, but it worked out well. Not long after the markets reopened on Monday, the bond yield climbed to five per cent, and stocks and stock futures tumbled. On Wednesday, the morning of my visit, shortly after the opening bell sounded on Wall Street, Niederhoffer repurchased the futures he had sold, making more than five million dollars.

He didn’t look pleased, though. During the morning, stocks had continued to fall, and he knew that if he had waited he could have made an even bigger profit. He says that in twenty-eight years as a professional investor he hasn’t had a single truly satisfactory trading day. At eleven o’clock, the Dow Jones Industrial Average had slipped about a hundred points and the S. & P. 500 Index was down about thirteen points. Niederhoffer stared morosely at his Bloomberg screens. “The score doesn’t look good,” he muttered. The screens were tracking the movements of various stock-market indices in Europe and Latin America, but I noticed that they weren’t displaying any American prices. Niederhoffer used to invest heavily overseas, but since his 1997 misadventure in Thai stocks he has confined his trading to the United States. He explained that when the U.S. market was falling he preferred to track the DAX, a German stock index that generally moves in synch with the American market. “You can see how much you are losing, but it doesn’t hurt as much as watching the S. & P.,” he said.

Before long, Niederhoffer cheered up a bit. “There have been three big down opens in a row, which is unusual,” he said. “The market doesn’t like to do the same things repeatedly.” He turned to Alex Castaldo, a thin, bespectacled fifty-three-year-old Italian who has a degree in electrical engineering from M.I.T. and a Ph.D. in finance from CUNY, and asked him to compile some data. “Doc,” he said to Castaldo, “what does the market do when it opens down a lot three days in a row?” A few minutes later, Castaldo handed Niederhoffer a computer printout, which showed that since the start of 2003 there had been just ten occasions on which, for three consecutive days, the S. & P. 500 had fallen sharply in the first hour and a half of trading. On eight of those occasions, stocks had bounced back, with the average market rise by the end of the following trading day amounting to three tenths of one per cent. For a trader like Niederhoffer, who uses leverage—borrowed money—to scale up his bets, the ability to predict even relatively small changes in the market can pay off handsomely.

The software that Niederhoffer uses to identify stock-price patterns is a version of the code that he wrote thirty years ago. Many hedge funds and Wall Street banks now rely on such programs to spot potentially lucrative market fluctuations and place orders automatically—a practice known as “black box” investing—but Niederhoffer is scornful of this method. Although markets sometimes move in predictable ways, he says, the patterns change constantly, and reliance on mathematical algorithms can be disastrous. At Manchester Trading, Niederhoffer or Wisdom reviews each trade before it is placed.

In this instance, Niederhoffer expected the market to rebound, but he decided to hold off on buying. Morgan Stanley had just issued a notice advising its clients to reduce their stock holdings. “Plus, the Fed has been making bearish noises,” Niederhoffer said. A few minutes earlier, the Dow had dropped below thirteen thousand five hundred. Castaldo went over to Niederhoffer’s Bloomberg and called up some U.S. stock charts. Niederhoffer, looking at the falling lines, announced, “It’s gone down two per cent—that’s enough.” Then he turned to Owen Wilson, a young Englishman who has worked for him for a couple of years. Holding a phone to his ear, Wilson shouted out quotes from the Chicago Merc. “Buy a hundred and fifty at eighteen seventy-five,” Niederhoffer said. Wilson placed the trades and called out more numbers. Again, Niederhoffer told him to buy. Within a few minutes, Wilson had purchased tens of millions of dollars’ worth of stock futures.

Niederhoffer received his first lessons in finance as a child growing up in Brighton Beach. He learned to bet on stoopball, paddleball, and checkers, which he played with other local kids, and with adults who went by nicknames such as Bitter Irving, Bookie, and Nervous Phil. His father, Artie, a New York City cop who spent twenty years on the force before becoming a professor of sociology at John Jay College of Criminal Justice, tried unsuccessfully to dissuade him from gambling. “Everything was a money game,” Niederhoffer told me. “My father hated it, but I loved to win a nickel or a dime.” With the encouragement of his uncle Howie, who was in high school, he also placed wagers on professional sports. In October, 1951, on Yom Kippur, Howie and Victor, who was eight, sneaked out of synagogue and bet eight hundred dollars on the Brooklyn Dodgers, who were playing the New York Giants in a pennant-decider. When Bobby Thomson hit his famous home run, defeating the Dodgers, Howie and Victor were devastated. (The knowledge that only two of the lost dollars were Niederhoffer’s did little to console him.)

Niederhoffer says that as far back as the Middle Ages his ancestors were money changers. At the end of the nineteenth century, his paternal great-grandparents moved from Austria to the Lower East Side, where several of their seven sons sold fruit from a horse and cart. Niederhoffer’s grandfather Martie, who had a good head for figures, became an accountant. In the boom years of the nineteen-twenties, Martie borrowed money and invested it in real estate and stocks, assembling a portfolio that made him nearly a millionaire. The stock-market crash of October, 1929, destroyed most of his wealth; two years later, the market dived again, wiping out what he had left.

Martie, who spoke Yiddish and pidgin Spanish, got a job as a translator in a Brooklyn courthouse. But he retained an interest in the stock market, and in 1954 he financed Victor’s first equity investment: a hundred shares of the Benguet Mining Company, which was trading at fifty cents. For several years, the stock hardly moved. Then, in just a few months, it doubled in value. On Martie’s advice, Victor sold his shares, and made a profit of fifty dollars. During the next thirty-six months, the stock’s value increased to thirty dollars a share. “I have repeated the mistake of grabbing at small profits and selling at a targeted round number over and over in my speculative career,” he wrote in “The Education of a Speculator,” a memoir that he published in 1997. “I believe many others make this same error.”

At the age of six, Niederhoffer says, he was such an accomplished paddle-tennis player that he had to spot his opponents fifteen points a game. At thirteen, he defeated a seventeen-year-old to win the New York City junior singles tennis championship. (In school, his competitiveness elicited mixed reactions. At the end of his last year at P.S. 225, his sixth-grade teacher wrote, “Although a little trying at times, you were the spark the class needed this year. You have a keen mind; learn to curb your inclinations to demonstrate superiority.”) At Abraham Lincoln High School on Ocean Parkway, Niederhoffer was the president of his class, the captain of the tennis team, the star of the math team, a pianist in the orchestra, a clarinettist in the band, the sports editor of the newspaper, and a frequent contributor to Vanguard, the school magazine. In an article that appeared in the June, 1958, issue, Niederhoffer warned that automation “will require a complete reorientation” in the attitudes of trade unions. Five months later, displaying a view of government intervention that he would later renounce, he argued that “federal aid to education is imperative if equality of educational opportunity in our democracy is to have real meaning.”

Niederhoffer’s father, whom he idolized, encouraged his athletic and intellectual pursuits, and his mother, Elaine, who was descended from a long line of rabbis, pressed him and his younger brother and sister—now, respectively, a commodity-fund adviser and a psychiatric social worker—to succeed. “My mother was never content,” Niederhoffer told me. “She pushed us to be No. 1.” In January, 1960, at his mother’s urging, he applied to Harvard. In a letter of recommendation, his academic adviser and tennis coach, Milton Hecht, wrote, “Victor ranks among the first in intellectual achievement and promise in comparison with the thousands of students I have taught in the last thirty years.” Harvard awarded him a partial scholarship, as did Columbia and the University of Pennsylvania. Niederhoffer chose Harvard, where he majored in economics.

Niederhoffer spent less time in the classroom than he did on the squash court. Until he moved to Cambridge, he had never played squash—or squash racquets, as it was then called—but the physical demands of the game appealed to him. He borrowed every book on squash at the Widener Library, and took some with him to the practice court, where he opened them on the floor and repeatedly copied the moves they described. In 1962, as an eighteen-year-old sophomore, Niederhoffer won the junior championship of the National Intercollegiate Squash Racquets Association. A year later, he won the Harry Cowles tournament, a prestigious competition for amateurs. “He has good size, quickness, and a skillful touch,” his Harvard coach, Jack Barnaby, told the News and Views of Harvard Sports, a campus publication, in January, 1963. “But a lot of players have those attributes. What he has beyond that is one of the most competitive characters I’ve ever seen. He makes you feel like you are watching a person of Ty Cobb’s cut in action again.”

In the 1963-64 season, Niederhoffer, now a senior, was captain of the Harvard squash team, which went undefeated. He also won the individual national collegiate title, and his aggressive playing style attracted the attention of a reporter at Sports Illustrated, who wrote, “Niederhoffer thinks he is unbeatable and clamors loudly for justice when his shots go awry. Consequently, on those rare occasions when he loses a tournament, squash lovers are delighted.” The reporter quoted Niederhoffer’s freshman coach, Corey Wynn, who recalled his former student’s penchant for “handballing it”—physically blocking his opponents from reaching the ball, a tactic that was frowned upon in New England. Niederhoffer’s mother read the article and consulted a Fifth Avenue law firm, Cohn & Glickstein, about suing Sports Illustrated for libel. (On the firm’s advice, she decided not to file a suit.)

In February, 1966, Niederhoffer won the U.S. national amateur championship, the culmination of a series of important victories. Sports Illustrated and Time sent reporters to these events, and Niederhoffer wasn’t pleased with the coverage. First, he wrote to Time, denying its claim that during the national championship he had offered odds of two-to-one against himself. An editor replied, defending the magazine’s reporting as having been based on “reliable sources.” Unsatisfied, Niederhoffer wrote another letter, to a senior executive at Time-Life, the parent company of both Time and Sports Illustrated, complaining that the articles had “created the impression that I was a poor boy from Brooklyn who had adjusted badly to the rigors of a social sport.”

An aura of class and ethnic prejudice pervaded press accounts of Niederhoffer’s achievements; he was widely viewed as an ill-mannered upstart from the wrong side of the East River. The Times Magazine noted that he was “built wrong for a squash player: not lithe and wiry, or even tall and gracefully powerful. He is shaped rather like a block—fairly broad in the shoulders, no waist, thick shapeless legs—and his color is sallow, the deep oyster sallow of a New York street creature.” In Chicago, where Niederhoffer moved in 1964, to attend graduate school, he couldn’t find a squash club that would admit him. He was so offended that for several years he gave up the game.

After he returned to the court, in 1972, he won the national amateur championship four years running, an unprecedented feat. In January, 1975, in Mexico City, he won the North American Open, a major professional tournament, defeating the legendary Pakistani player Sharif Khan in four games. Afterward, Niederhoffer wasn’t very gracious. “Khan had a fatal plan—a lack of real toughness,” he told Sports Illustrated. “He’s been winning so long he doesn’t know anymore what it is to play a battle to the death.”

Shortly after noon, a housekeeper’s voice announced over an intercom, “Victor’s lunch is ready. Does he want it?” “No,” Niederhoffer replied. “I can’t eat lunch with the market like this.” He looked at his screens. “Europe got killed,” he said to nobody in particular. He was still irked by Morgan Stanley’s bearish notice to clients. “If the big brokerage houses are going to make money from commissions, they have to get people selling as well as buying,” he said dismissively. Unlike most Wall Street firms, Manchester Trading doesn’t have a television in its trading room, partly because Niederhoffer doesn’t want to be distracted but also because he can’t abide doom-mongering market commentators, like Alan Abelson, a columnist for Barron’s, the financial weekly, and Robert Prechter, Jr., the publisher of the Elliot Wave Theorist. “These people have been bearish since Dow 700,” Niederhoffer said angrily. “When the market is going up, they can’t get a hearing. But when the market falls they get invited back on. They say it’s like 1997, or 1987, or 2002. How about 1907? That was a bad year. Interest rates went up; the market went down by nearly fifty per cent.”

Just after one o’clock, the market hit a new low for the day, with the Dow down about a hundred and twenty-five points, and the S. & P. 500 down about fourteen points. It is a strange feature of financial markets that time occasionally seems to speed up. On quiet days, when prices aren’t moving much, traders monitor their positions, read the papers, and chat with each other, and it can seem as though an eternity passes before the closing bell sounds. But when the market becomes volatile every move brings with it a fresh opportunity for profit or loss, and each minute can fly by. The mathematician Benoît Mandelbrot, who pioneered the application of chaos theory to financial markets, refers to this phenomenon as the “multifractal nature of trading time.”

Niederhoffer turned to Castaldo. “This day is far from over,” he said. “Doc, what happens when the market is down twelve points at one o’clock and it has been down significantly the previous two days?” A few minutes later, Castaldo handed him another computer printout. “Most of the time, these computer analyses don’t work, but it gives you an anchor,” Niederhoffer said as he scanned the sheet. “My checkers teacher said even a bad system is better than no system at all.” The data showed that the last time trading seemed to follow the current pattern was between November, 2000, and September, 2002, when there had been eight such three-day periods. In most of these instances, the market had rebounded strongly during the subsequent seventy-two hours. Niederhoffer looked at Owen Wilson. “I’ll buy another fifty at eleven-fifty,” he said.

Niederhoffer’s investment philosophy is based on a belief that over the long term the market goes up, but over the short term it constantly reverses itself. In his books—his second, “Practical Speculation,” was published in 2003—he compares the behavior of investors to that of herds of rampaging elephants that retrace their steps over and over. He refers to this pattern as a “LoBagola,” after Bata LoBagola, the author of “LoBagola: An African Savage’s Own Story,” a book published in 1930 describing the customs and wildlife of West Africa. After the book appeared, LoBagola was revealed to be an African-American vaudeville entertainer from Baltimore, the son of a former slave. In a 2004 post on DailySpeculations.com, Niederhoffer wrote, “Regrettably LoBagola was an American con man. . . . Nevertheless, I claim that despite his imposture, the moves back and forth in big markets often follow a LoBagola, and even though, nay especially because, LoBagola was an impostor his name should be given to major moves which would seem to follow a symmetry up and down.”

Niederhoffer doesn’t claim to be able to say what the Dow or the S. & P. 500 will do next week or next month, but he believes that over shorter periods—hours or days—there are sometimes predictable patterns that can be exploited. In “The Education of a Speculator,” he devotes an entire chapter to this notion, comparing the market’s movements to some of his favorite pieces of classical music, and juxtaposing pages of sheet music with stock charts. “When the markets are moving in my favor in a nice, gentle way—never below my initial price—I often think of the ‘Trout Quintet,’ ” he writes. “Another frequent work I hear in the market is Haydn’s Symphony No. 94. . . . Right after lunch, or before a holiday, the markets have a tendency to meander up and down in a five-point range above and below the opening. The pattern is similar to the twinkling C-major fifths of Haydn’s symphony.”

In the early eighties, when he was making a presentation to potential clients, Niederhoffer sometimes took along Robert Schrade, a friend who was a classical pianist. After Niederhoffer talked about his methods, Schrade would demonstrate the rhythms of the market on the piano. This double act didn’t always impress investors. “CalPERS”—the California Public Employees’ Retirement System—“is not going to be interested in investing with Victor, nor is the Harvard endowment,” Paul DeRosa, a partner at the hedge fund Mt. Lucas who has known Niederhoffer since the late seventies, said to me. “Your basic, buttoned-down endowment, advised by professional consultants, wouldn’t touch him with a ten-foot pole. His is a fund that is going to appeal to people like him: self-made people who have a maverick streak.”

A few months ago, after visiting a Redwood forest in Northern California, Niederhoffer became fascinated by the ecology of trees. He bought several books on the subject and posted an article on his Web site applying what he had learned about trees to the stock market:

Lesson Two: The forest thrives and benefits after many seemingly disastrous events. Fires clear the underbrush. Dead trees still standing provide cover for much flora and fauna. Trees contain so much water that there is still much biomass left when they die, and they contain the nutrients and moisture that other plants or fungi need for survival. This situation is called a biological legacy by the scientists, but is just known as a gift by the laymen.

The number of, the amount of time in between, and the extent of watershed declines that the market has witnessed in the last year, as well as the resilience of the market to these declines, is a good measure of the health of a system. It is often good for future growth, to see decimated parts of the market landscape, such as the U.S. real-estate sector, which has currently taken it on the chin, or the Saudi Arabian market, which is down 75%.

After he wrote the article, Niederhoffer gave the books he had read to one of his employees, Charles Pennington, a former professor of physics, and asked him to develop precise numerical analogies between the life cycles of forests and those of corporations, in the hope that the exercise might suggest some profitable investments. Niederhoffer’s employees are used to such requests. “Things sometimes work that you wouldn’t believe, and things don’t work that you would expect to work,” Steve Wisdom said to me after we had left Niederhoffer at his desk and gone downstairs to eat lunch in his formal dining room. (The dining room is next to the library, where Niederhoffer keeps his collection of rare books and manuscripts, including a first edition of Adam Smith’s “Wealth of Nations” and a copy of David Ricardo’s “Principles of Political Economy and Taxation” which has margin notes by Thomas Malthus.)

Wisdom, a clean-cut man of forty-six, met Niederhoffer twenty-five years ago, in New York City, when Wisdom was a philosophy major at Harvard and the chairman of the university’s Libertarian Club. “We hit it off, and that was that,” Wisdom recalled. After graduating, in 1983, Wisdom worked for Niederhoffer for fourteen years, until Niederhoffer’s business collapsed, in 1997. He returned in 2003, largely, he told me, because of Niederhoffer’s willingness to try new ideas. “Everyone has computers; everyone has Ukrainian math Ph.D.s,” Wisdom said. “There are people chopping at the data every which way. Making money is not easy, and it requires a lot of creativity. Victor always says, ‘Suppose I didn’t know anything. Suppose I’d never traded this instrument before. What would I think?’ ”

Manchester Trading’s three hedge funds are relatively small by current standards. At the end of June, the funds’ collective value was about three hundred and fifty million dollars, of which about half belonged to Niederhoffer and Wisdom. In 2003 and 2004, the funds increased in value by more than forty per cent each year, and in 2005 the value of the largest fund, Matador, rose fifty-six per cent—a performance that earned Niederhoffer an industry award. Last year, his funds were flat. But in the first six months of 2007 they were up again, by between thirty and forty per cent.

Niederhoffer acknowledges that his aggressive investing style and his reliance on borrowed money increase the volatility of his returns and the likelihood that he will suffer a calamity. In May, 2006, Matador lost about thirty per cent of its value, and in February of this year it suffered another big fall. Many hedge funds claim that they can generate high returns with little risk. Niederhoffer tells friends who want to invest money with him that it is too risky. (Most of his clients are multimillionaires and financial institutions.) “The idea that you can make a lot of wealth in a steady, unspectacular fashion, with no great gyrations, is a canard,” he said to me. “If you are going to try and make forty or fifty per cent a year, tremendous variations are inevitable.”

At three o’clock, when Wisdom and I went back upstairs, Niederhoffer was outside playing tennis with one of his traders, Duncan Coker. Soon, however, he returned, sitting down at his desk in a T-shirt, tennis shorts, and sneakers, ignoring the no-shoes rule. “The market’s supposed to go up from three until the close,” he said. “Let’s see if it does.” While Wisdom and I were having lunch, the Dow had stabilized and Niederhoffer had sold some of the stock futures he had purchased earlier in the day. “The worst mistake in this business is to be in over your head,” he said. “I was long about seventy-five million dollars. In addition to that, I had my regular option position. So I took the opportunity to reduce my exposure.”

In addition to speculating on short-term market movements, Niederhoffer frequently sells financial contracts, called “put options,” which, in the event of a steep fall in the market, would oblige him to pay out large sums of money. The buyers of these options are usually other investors seeking to hedge their positions, and in a sense Niederhoffer acts like an insurance company: in return for a premium—the price of the option—he agrees to bear the risk of a market crash. Often, this is a good business; but whenever the market enters a volatile period he is in peril. (“He is his own worst enemy,” Nassim Taleb, the author and derivatives trader, says of Niederhoffer. “One of the most brilliant men I have ever met, and he wastes his time selling options—something nobody can have any skill in—and it leaves him vulnerable to blowing up.”)

As 4 P.M.—the close of trading—approached, the Dow was again down, by about a hundred and twenty points. Niederhoffer didn’t seem particularly discouraged, though. He thought that he discerned a LoBagola pattern. “It’s going to be very bullish for tomorrow,” he said. “It will be the first one-hundred-point drop in sixteen hundred points. I’m going to buy some more futures.”

Niederhoffer’s theories about market behavior date to his college years. In 1964, when he was a senior at Harvard, he wrote a thesis on stock-market patterns. At the time, the so-called “efficient market hypothesis,” which states that stock prices move randomly and therefore can’t be predicted, was coming into vogue. Niederhoffer, citing data on trading volumes and subsequent price movements, claimed to have found evidence that contradicted the random model. His argument didn’t fully convince his adviser, the economist Robert Dorfman, but it helped earn him admission to the University of Chicago Graduate School of Business, where he enrolled in September, 1964.

At Chicago, Niederhoffer wrote several research papers arguing that it was possible to detect predictable movements in the stock market. He uncovered evidence, for example, that the market tended to do worse on Mondays than on Fridays. Several members of the faculty had helped to develop the efficient market hypothesis, and Niederhoffer’s relationships with his professors were often contentious. At one seminar, he later recalled, “I criticized all those who had concluded that markets were random, including most of the professors in the room, as being too heavy-handed in their testing methods to uncover the structure of price variations. Further, I cautioned them that their failure to disprove a hypothesis that no structure existed was methodologically inadequate to support a conclusion that prices were random. When I put it in the vernacular, ‘You can’t prove a negative,’ pandemonium broke loose.”

Niederhoffer was an early proponent of what is now called behavioral economics, and his unorthodox theories made him something of an academic celebrity. In 1969, he was hired at Berkeley as an assistant professor, and several hundred students signed up for his course on finance. Three years later, enrollment had dropped precipitately. “I wasn’t too good at it, frankly,” he told me. “I was not a very good teacher, and I had my own ideas about things. I was earning nine thousand dollars a year. I was playing squash, doing research, dabbling in business. It was all too much.”

Niederhoffer had also married—Gail Herman, a graduate of Bryn Mawr whom he met at the wedding of a Harvard friend, the economist Richard Zeckhauser. In the early seventies, Gail and Niederhoffer, who had decided to leave academe, moved to New York, where he started an investment-banking firm that sought out small, family-owned companies and helped sell them to bigger, public companies. The venture proved so successful that before long Niederhoffer and a partner, Dan Grossman, started buying and operating businesses themselves. Among the firms they acquired were American Almond, a Brooklyn company that provided almond paste to bakeries, and Tech Com Inc., a Florida defense contractor that built navigation equipment for planes and ships. “I would run the companies. Victor would visit them every two years or so, and cause havoc,” Grossman, a lawyer by training, recalled recently. “He’d say something like ‘What this company needs is sales. No more research, no more secretarial duties—I want you all out there selling things.’ Then he’d leave, and I’d say, ‘Don’t take any notice of what he said. That’s just Victor being Victor.’ ”

By the late seventies, Niederhoffer and Gail had two daughters: Galt, who was named after Francis Galton, the Victorian polymath who helped to develop regression analysis and coined the term “eugenics”; and Katie. In 1981, Niederhoffer and Gail separated, and he began dating his assistant, Susan Cole, whom he married in 1991. They have four daughters: Rand, Victoria, Artemis, and Kira. The mother of Niederhoffer’s son, Aubrey, who is one and a half, is Laurel Kenner, a former editor at Bloomberg whom he met in 1999. “My personal life is more complicated than Rupert Murdoch’s,” Niederhoffer joked to me. (Murdoch has six children from three marriages.)

Niederhoffer began investing seriously in the stock market when Galt and Katie were young. In 1979, using money he had saved, he started trading more or less full time and opened an office in midtown. “I got lucky,” he told me. “In eighteen months, I ran fifty thousand dollars up to twenty million dollars. I had an idea that there was going to be inflation, so I kept selling Treasury bonds and buying gold and silver. For a long time, it worked very well. Then one day I was playing racquetball in Staten Island with a guy who subsequently became the U.S. champion. After the first game, I called the office to see where the market was. The price of gold had fallen from eight hundred and fifty dollars to six hundred dollars in an hour. My net worth had gone down to ten million dollars.

“That was where my Brighton Beach training came in,” Niederhoffer went on. “I’d seen a lot of gamblers die broke. My father used to say I’d end up on the Bowery, like the other gamblers. I’d say, ‘Dad, I’ve got a system.’ He’d say, ‘Baloney. Those guys on the Bowery had more statistics and systems than you’ve got.’ I took what he said seriously. I told my assistant, who later became my second wife, ‘If I ever lose more than half my stake, close out all my positions. Don’t let me trade anymore.’ I went back to my match. During the second game, she sold everything. By then, my ten million dollars had dwindled to five million, but at least I got out with that much.”

Wall Street in the late seventies was much less technologically sophisticated than it is today. “If you could solve two equations in two unknowns, you were a high-tech person,” Paul DeRosa recalled. “Someone with Victor’s quantitative skills was a rare bird. In the early years, that gave him a big advantage.” In 1981, George Soros, who was by then a wealthy investor but who was having a bad year, heard about Niederhoffer’s reputed ability to predict short-term market movements and arranged to meet him at his office. Soros left the meeting impressed, and gave Niederhoffer some money to manage. The men shared an intellectual fascination with markets, and they became close, talking on the phone nearly every day, and playing tennis or chess several times a week. “My father had just passed away,” Niederhoffer recalled. “George was struggling. He needed a ledge to give him some purchase. I provided that.”

By the mid-eighties, Niederhoffer was managing many of Soros’s investments in bonds and commodities, which were worth hundreds of millions of dollars. On Tuesday, October 20, 1987, a day after the Dow dropped five hundred and eight points, Niederhoffer and Soros played tennis, as usual. Both men had lost a lot of money in the crash, and Niederhoffer had trouble concentrating; Soros, however, was calm. Don’t worry, he told Niederhoffer, the market will reopen tomorrow, and there will be plenty of opportunities to make back our losses.

Over the next several years, Niederhoffer’s funds yielded an annual average return of about thirty per cent, which put them near the top of the industry. In 1994, Business Week named him the best commodities-fund manager in the country. A year later, he started two new hedge funds: Niederhoffer Investments and Niederhoffer International Markets. For a while, he hardly slept. During the day, he traded stocks and currencies in Europe and the United States, and at night he bought and sold Japanese yen. He also invested in emerging markets, making successful plays in Turkish bonds and Mexican stocks.

Toward the end of 1996, another profitable year for him, Niederhoffer decided that he wanted to invest in Southeast Asia, which was widely seen as a growing market. He dispatched an old friend, Steven (Bo) Keeley, to the region. Keeley, a veterinarian who spent six months of the year living in the California desert without a telephone or electric power, had trekked in dozens of countries. On one trip, while paddling down the Amazon, he had contracted malaria, briefly gone blind, and been comatose for a week. Keeley believed that assessing a developing country’s economic prospects involved not only meeting with the C.E.O.s of leading companies but studying the lengths of discarded cigarettes—the theory being that the wealthier people are, the longer their butts—and the state of the brothels. After a couple of months in Asia, he reported to Niederhoffer that the brothels in Bangkok had recently become much cleaner and safer, and that Thailand was an excellent place to invest. During the previous decade, the Thai economy had grown at an annual rate of almost ten per cent; its interest rates were among the lowest of any country in the region; and its stocks were cheap because they had fallen sharply earlier in the year. In the spring of 1997, Niederhoffer invested several hundred million dollars in Thailand. Instead of buying stocks in some of the country’s biggest companies, he entered into complicated deals with Wall Street firms to buy futures contracts that were tied to the value of Thai stocks. The margin requirements for futures purchases are much lower than those for stock purchases, so he was able to put up a relatively modest amount of cash, while using borrowed money to accumulate substantial holdings.

His timing was atrocious. In May and June, a wave of selling swept through the Asian financial markets, and Thailand was especially hard hit. Many overseas investors tried to repatriate their money, and the Thai government started to run out of foreign-exchange reserves. On July 2nd, it was forced to abandon what amounted to a fixed exchange rate between the baht and the dollar, which had been in place for more than a decade. The Thai currency collapsed, and so did the stock market. The value of many of Niederhoffer’s Thai holdings dropped by more than ninety per cent. His lenders demanded that he put up more collateral. In order to meet their demands, he was forced to sell many of his profitable investments, which left his funds severely depleted. “We were like someone who is immune-deficient,” Steve Wisdom recalled. “We had lost so much money that we had no resistance left to other maladies.”

Apart from his Thai holdings, Niederhoffer’s most substantial investments were in the American futures markets. At first, the U.S. market weathered the Asian crisis pretty well, but in the fall of 1997 it became more volatile. On October 27, 1997, the Dow fell by more than five hundred points, and, for the first time in recent history, the market closed early. Amid widespread panic, Niederhoffer fielded calls from lenders. Some, including Refco, a large commodities broker, demanded that he give them more money to support his options positions. Niederhoffer was unable to come up with the cash, and the next morning Refco liquidated his portfolio.

“It was a very poor decision on my part to invest in Thailand,” Niederhoffer told me. “I had no scientific basis for investing there. In the U.S. market, there is evidence that it is a good time to invest after a big fall. In Thailand, there was no such statistical evidence. It was purely a qualitative idea. I’d seen Soros do that a lot of times and make a lot of money, but it didn’t work for me. Previously, I had had two or three qualitative ideas that made money—Turkish bonds, Mexican stocks—and it lured me into a false sense of security.”

We were sitting on a bench outside a building in the East Fifties, where Laurel Kenner lives and Niederhoffer stays when he visits. He was drinking a bottle of organic lemonade. I asked him whether hubris had contributed to his downfall. “Yeah, I’d say,” he replied. “In those days, we always wanted to be No. 1 in the ratings. There was a Canadian firm, Friedberg—they were having a good year, and we wanted to keep up with them. It was always nip and tuck between us and them.” Niederhoffer was silent for a moment. Then he spoke quickly: “You asked for reasons—I could name another ten. We had no stops. We picked the wrong country to invest in. We were too illiquid. We had too big a percentage of the market, and we didn’t have the ability to get out of our positions. We were too financially vulnerable to the brokers. I didn’t take account of the fact that I could be squeezed and that customers could withdraw their money. But mainly I didn’t have a proper foundation for my investment there. I had no knowledge of the country. I’d never even visited the country. All I had done was finance a trip by Bo Keeley to the brothels there.’’

After his funds folded, Niederhoffer fell into a deep depression. His eldest daughter, Galt, a film producer and novelist who is thirty-one and lives in Manhattan, recalls coaxing him to Long Island for a walk on a beach, where he knelt on the sand like a zombie. “It wasn’t just depression,” she said. “It was self-hatred and hopelessness. He felt like he had let people down. It was so shameful. This was a guy who grew up in a modest house, the son of a cop. Imagine what it would be like to create all of those things for your family and then to lose them.”

Niederhoffer had managed to retain some of his assets. He mortgaged his house in Connecticut and sold a collection of trophy and presentation silver and some of his rare books, which enabled him to pay off his creditors. He used this period of enforced inactivity to reconsider his approach to investing and to retool his pattern-recognition software. After about six months, using several hundred thousand dollars of his own money, he started trading again. “I had no brokerage account—no broker would do business with me under ordinary terms,” he said. “No customers would open a new account with me.” In 1999 and 2000 he did well, and in 2002 he started Matador, an offshore hedge fund. Its biggest investor was Octane, a hedge fund based in Switzerland, whose chief investment officer, Mustafa Zaidi, is an old friend of Niederhoffer’s.

At the beginning, Matador had less than ten million dollars to invest. In its second year, the fund had a return of forty-one per cent, and Niederhoffer’s renewed success helped him attract more money, including some from former clients who had lost their investments in 1997. (For these investors, he waived the hefty fees that hedge funds normally charge.) Eventually, he had enough cash to open two more funds. In February, 2003, Niederhoffer published “Practical Speculation,” a manual for serious investors, which he co-wrote with Laurel Kenner, whom he had been dating for several years. That year, he separated from his wife, Susan, and in 2004 he and Kenner launched DailySpeculations.com, which they dedicated to “the scientific method, free markets, deflating ballyhoo, creating value, and laughter.”

The Web site has since evolved into an informal social-networking site for speculators and aspiring speculators. “I met a lot of my friends through the site,” James Lackey, the trader who once worked with Niederhoffer and who posts regularly on the site, said. “Victor is like the hub where the wheels of speculation turn. He’s the center of so many of our relationships—we call him the Chairman. He’s the guy who keeps everyone in line.”

In April, 2006, Niederhoffer attended a dinner at the St. Regis Hotel, where MARHedge, a company that published a newsletter for the hedge-fund industry, presented him with an award as the top manager in the commodity-fund category. “What I’m proudest of is that we’ve made several hundred million dollars after fees,” Niederhoffer said to me in July.” “We’ve returned a lot more money to our investors than they have invested.”

As Niederhoffer and his funds prospered, it appeared to many of his old friends and colleagues that he had finally become a master speculator. “It is impossible to go through what Victor went through without it altering what you do,” Paul DeRosa told me in July. “It made him more conscious of risk, more attuned to it. It was an expensive education, but the important thing is that it wasn’t wasted.” Irving Redel, a former gold and silver trader and chairman of the New York Commodities Exchange, who was a mentor to Niederhoffer in his Wall Street days, said, “To be a great trader you need discipline. You have to have certain strategies that you follow, but you also have to have the flexibility to know when it is going wrong. And you have to know to never go beyond what you can afford to lose.” I asked Redel whether Niederhoffer has these qualities. He replied, “He does now.”

On the first Thursday of every month, Niederhoffer hosts a meeting of libertarians at the General Society of Mechanics and Tradesmen, on West Forty-fourth Street. One Thursday evening in early June, about seventy people were gathered in the society’s library, listening to an elderly woman in a white hat, who stood at a lectern talking enthusiastically about Christopher Hitchens’s book “God Is Not Great.” A middle-aged man with a beard spoke next, urging the others to accompany him on a walking tour he hosted called Ayn Rand’s New York, in which he visited local buildings where Rand had lived and held objectivist salons, as well as sites—the Waldorf-Astoria, Grand Central Terminal—that served as inspirations for places in her novel “Atlas Shrugged.”

The meetings are open to the public, and Niederhoffer, who was sitting on a table at the back of the room, swinging his legs, encourages each person to speak. He calls these sessions the New York City Junto, after the discussion group that Benjamin Franklin founded in Philadelphia in 1727, which held meetings for thirty years and eventually became the American Philosophical Society. Niederhoffer’s Junto is more casual, but he takes libertarianism seriously, considering it to be a natural complement to speculating. As a statement on his Web site puts it, “Victor Niederhoffer believes the purpose of life is the pursuit of happiness and achievement, and that the voluntary transactions that flow naturally out of an enterprise system are the key to material and personal freedom, and peace.” In an op-ed article that he published in the Wall Street Journal in 1989, he argued that speculators serve several important economic functions. When a good becomes scarce, he said, speculators bid up prices, which encourages firms to produce more and consumers to buy less, and helps to restore balance to the market. “I am proud to be a speculator,” Niederhoffer wrote. “I am proud that my humble attempts to predict Tuesday’s prices on Monday are an indispensable component of our society. By buying low and selling high, I create harmony and freedom.”

The guest speaker at the meeting was Thomas DiLorenzo, an economics professor at Loyola College, in Maryland, and the author of fourteen books, including “How Capitalism Saved America: The Untold History of Our Country from the Pilgrims to the Present.” DiLorenzo’s subject was the filmmaker and liberal gadfly Michael Moore. Not having seen Moore’s latest movie, “Sicko,” DiLorenzo was at something of a disadvantage, but he expressed outrage at Moore’s failure, in his previous films, to recognize the importance of competition, the virtues of sweatshops, and the depredations of socialism. At one point, Niederhoffer interrupted him and asked, “What are the general principles?” DiLorenzo replied, “Markets work and government-run monopolies don’t.”

At least one member of the audience, a gray-haired man, seemed to think that this was going a bit too far. He cited the Federal Home Loan Banks, an agency that makes mortgages more readily available, and the National Park Service. Don’t you agree that the government does some things well? the man asked. “No,” DiLorenzo replied. “The government has screwed up the national parks. I think capitalism would do a much better job with land.”

Shortly after ten o’clock, Niederhoffer ended the meeting. I was eager to speak to him about the stock market, which had fallen by almost two hundred points that day. “I can’t talk about it,” he said when I approached him. “It’s too painful. I might be able to review it in a few days.” He walked across the room to greet Kenner and Aubrey. He put his son on his shoulders and disappeared onto Forty-fourth Street.

On May 3, 2006, the day that Aubrey was born, Niederhoffer’s wife, Susan, filed for divorce. As his spouse and the legal owner of many of his assets, which he had transferred to her in 1997, she had claim to much of his fortune. For months, the couple’s lawyers argued. Then, in February, Niederhoffer persuaded Susan to drop the divorce proceedings. In return, he agreed to leave Kenner at the end of 2007 and return to her. Then he informed Kenner of the plan.

For now, Niederhoffer shuttles between the women. From Sunday to Tuesday, he and Susan share the house in Connecticut. (Three of their four daughters have left home; the youngest, Kira, attends boarding school.) He spends the rest of the week in Manhattan, with Kenner and Aubrey. “He’s emotionally involved with both of those women right now,” Galt said to me. “He never really leaves women. Wives become extended-family members, like in-laws, or honorary members of the harem. They tolerate it because he’s a flawed genius and a man. They take the good with the bad. It’s all I’ve ever known. All I’ve ever known is we are weird.”

I was having lunch with Galt at a French restaurant near her apartment in Chelsea. Although Aubrey’s birth had been a shock to the family, she went on, her father sees his other children regularly, and he is on good terms with his first wife, Gail—Galt’s mother—who divides her time between New York and Texas. “We’ve become kind of like this very functional dysfunctional family,” Galt said. “To most people, it is completely abnormal, and yet we’ve come to have this somewhat wholesome, happy dynamic. All of the girls are close. My mother and Susan have grown very close.” Recently, Galt added, she, Gail, Susan, and all her sisters except Artemis, who was away, got together to celebrate the third birthday of her daughter, Magnolia. Laurel was not at the party. “Laurel is another story,” Galt said. “Susan and Laurel are not close. There’s nothing happy about that.”

Last year, Galt published a novel, “A Taxonomy of Barnacles,” which she described to me as “an effort to exorcise my demons about living in a family that was different from everybody else’s.” The novel features an eccentric and domineering businessman who has six daughters and desperately wants a male heir. Eventually, he acquires one in surprising circumstances. Shortly after the book came out, Niederhoffer took Galt to lunch at the Four Seasons and told her that her book had been prescient. “Oh, my God, you have a love child!” Galt blurted out. “No,” Niederhoffer said. “I have a son.” A few months later, Aubrey was born.

Kenner, who is fifty-three, told me that she is unhappy about Niederhoffer’s arrangement with her. “Obviously, there is a lot of anger there,” she said. “But it is not just me. There is a baby involved.” I expressed surprise that her relationship with Niederhoffer remained cordial. “We had eight great years,” she replied. “He gave me so much. I am immeasurably better off on so many levels through meeting Victor. He was the best lover I ever had—not just in sexual terms. We wrote a book together. He is a great, romantic, gentle person.”

Niederhoffer declined to discuss his relationship with Susan. As for Kenner, he said, “We’ve had a very fine collaboration and had much pleasure and happiness together, and we have a wonderful son. We’re parents, and we still have mutual respect and admiration for each other.” He went on, “We didn’t have in mind the ultimate outcome, but we created a fantastic legacy—the baby, the books, and the articles.”

On Tuesday, July 17th, the Dow rose above fourteen thousand for the first time. The economy was growing, the long-term interest rate had dropped back to five per cent, and the volatile trading days of early summer seemed largely to have been forgotten. After the market closed, however, Bear Stearns announced that two of its hedge funds, which had investments in securities tied to subprime mortgages, had lost almost all their value. Problems in the subprime market spilled into money markets that banks and other financial institutions rely on to finance their daily activities; several more hedge funds went under; and commentators began to speak of a looming “credit crunch.” Stock markets around the world experienced wild fluctuations.

On Tuesday, July 24th, the Dow fell two hundred and twenty-six points. Two days later, it dropped three hundred and eleven points. Commentators on CNBC were making ominous pronouncements. I sent Niederhoffer an e-mail, saying that I hoped he had been well positioned for the market’s correction. He replied in three words: “I was not.” On Friday, July 27th, the Dow fell another two hundred points, closing four per cent down for the week. The markets were still volatile a week later, when Niederhoffer came into Manhattan for his monthly libertarian meeting. After it ended, we went across the street to a restaurant, where he ordered a cappuccino. He looked pale and haggard, and years older. For several minutes, we sat in silence. Then, in a low voice, he said, “Things have changed totally since we last spoke. The situation is fundamentally different. It is critical.” Kenner and Aubrey joined us, but Niederhoffer hardly seemed to notice them. “We are fighting for survival night and day,” he said when I pressed him for details. “I was caught wrong-footed in the market turbulence. I’m not as smart as I thought I was.”

The previous week, the Chicago Mercantile Exchange, in response to the turmoil in the market, had raised its margin requirements on futures traders, a move that was potentially devastating for Niederhoffer, who had hundreds of millions of dollars in options. He had more money in reserve than he had had in 1997, but he was worried. “It’s a matter of redeploying resources,” he said. “Also, in trying to be courageous in response to the crisis, I put up a lot of my own capital. You remember the story of the Essex and Captain Pollard? We are like a tiny fishing boat off the coast of Alaska that has been caught in the biggest waves in a hundred years.”

Talking about his predicament seemed to improve Niederhoffer’s mood a little. He ate some sorbet and played with Aubrey. Then he said, “Now I have to go home and work.” Kenner got up to leave, straightening her dress and inadvertently exposing a thigh. “Do that again,” Niederhoffer commanded. “Do what?” Kenner asked. “Lift it up,” he said. “It can keep a man afloat.” They both laughed.

During the next two weeks, I tried repeatedly to talk to Niederhoffer. Part of the reason for his reticence was that he feared a leak. Hedge funds depend on access to borrowed money. If lenders learn that a fund is in trouble, they might decide to stop giving it money—which can have disastrous consequences for the fund. On July 30th, Sowood Capital Management, a Boston-based fund, announced that the assets under its management had lost more than fifty per cent of their value in a few weeks, and the fund closed shortly afterward. By mid-August, two funds operated by Goldman Sachs had lost about a third of the value they’d had at the beginning of the year. Goldman decided to invest two billion dollars of its own money in one of the funds, Global Equity Opportunities, and it persuaded several wealthy investors to put up another billion dollars on favorable terms.

The spectacle of one of Wall Street’s most profitable firms being forced to shore up one of its flagship funds suggested some of the pressures that Niederhoffer was confronting. In today’s interconnected financial markets, there is no such thing as an isolated incident. When a dramatic event occurs in one sector, the effects are felt in others. The Goldman funds were computer-driven funds, and their software programs had failed to predict the size and speed of movements in the stock market. Prices had got “way out of whack,” David Viniar, Goldman’s chief financial officer, complained. “We were seeing things that were twenty-five standard-deviation moves several days in a row.”

Like Niederhoffer’s funds, the Goldman funds were heavily leveraged. For every hundred dollars of capital that the Global Equity Opportunities fund owned, it had borrowed about six hundred dollars. When a fund is leveraged six to one, a five-per-cent fall in the value of its portfolio becomes a thirty-per-cent loss in capital. “Leverage is a double-edged sword,” Richard Bernstein, an analyst at Merrill Lynch, wrote in a note to clients a few days before Goldman announced its efforts to prop up the Global Opportunities fund. “It enhances returns on the upside, but also makes underperformance more rapid and severe.”

Of course, Niederhoffer was aware of these dangers. But, between the middle of 2003 and the start of this year, the financial markets had been mostly calm. Stock prices had gone up, and, atypically, they had done so in a fairly straight line, with only two significant reversals, in May, 2006, and in February, 2007. From Niederhoffer’s perspective, the decline in market volatility was a welcome development, because it made his options trading much less risky. With prices steady or rising, he was less likely to be caught on the wrong end of a big market move. As the quiet times continued, many investors were lulled into believing that a less volatile era had begun. Alan Greenspan, who was the chairman of the Fed until February, 2006, helped to feed this illusion by talking about how financial innovations, such as the development of asset-backed securities, had spread risks more widely, making the market less vulnerable to shocks.

The crisis in the subprime-mortgage market changed all this. In the stock market, volatility was more pronounced than it had been for years. Even on days when the Dow closed just a few points down, prices lurched around. On Friday, August 10th, the Dow fell more than two hundred points before recovering at the close. On Thursday, August 16th, it fell almost three hundred and fifty points before closing down just fourteen points. A measure of market turbulence which many traders watch closely is the Chicago Board Options Exchange Volatility Index, known as the VIX. Between January, 2003, and January, 2007, the VIX fell from more than thirty to about ten. By the end of July, it had surged above twenty, and on August 16th, the day before the Fed cut the discount rate, it hit thirty-seven.

The surge in volatility prompted the Chicago Merc to raise its margin requirements for options on S. & P. 500 Index futures twice, first from two per cent to three per cent, and then from three per cent to four per cent. Niederhoffer was asked to double the amount of capital supporting his positions, and he found it difficult to raise the necessary cash. Some of his investments had lost a lot of their value, and the value of others was difficult to determine. There were so many moving parts in his portfolio that he wasn’t sure where he stood. When a trader can’t meet his margin requirements, he is at the mercy of his creditors. As Niederhoffer’s financial situation deteriorated, ADM Investor Services, a Chicago-based brokerage firm that caters to futures traders, ordered him to liquidate some of his options positions. Working late into the night, Niederhoffer berated himself for leaving himself so exposed. Referring to the margin calls, he said to one acquaintance, “I shouldn’t have been in the position where it could have had such an impact.” Despite the lessons of 1997, and the precautions he had taken, he was again in over his head.

Every August, Niederhoffer throws a big party in New York City, to which he invites dozens of regular contributors to his Web site as well as some of his friends. This year, there were about seventy-five guests. Most were New Yorkers, but some had come from as far away as England. For three days, Niederhoffer entertained them at his expense. On Friday, he organized a trip to the New York Botanical Garden and to a Mets game. On Saturday, he hosted a beach outing at Coney Island and a dinner at Delmonico’s, near Wall Street. On Sunday, he provided a picnic brunch in Central Park’s Conservatory Garden.

As the crisis in the market spread, Niederhoffer had briefly considered cancelling the party, but he decided that to do so would have alerted people to his troubles. At three o’clock on Saturday afternoon, I saw him in the crowd on the boardwalk at Coney Island, across from the Cyclone roller coaster. As usual, he wasn’t difficult to spot: he was wearing yellow trousers and a yellow T-shirt that said “Chief Speculator” on the back. On the beach, his staff had set up a blue canopy, and about a dozen people had gathered underneath it, taking shelter from the sun.

Niederhoffer had Aubrey on his shoulders, and he seemed to be in a better mood than when I had last seen him. He makes frequent visits to Coney Island and Brighton Beach; the house he lived in as a boy was about half a mile east of where we were standing. “We are going on the Wonder Wheel,” Niederhoffer said, gesturing over his shoulder at the slowly turning Ferris wheel, which dates to 1920. While he was gone, I spoke with two of his guests, a young Liberian M.B.A. student who said that he had recently posted an article on DailySpeculations.com about gambling on thoroughbred racing, and an older Frenchman who traded stocks at a Wall Street firm. The atmosphere was friendly and relaxed. None of the guests mentioned Niederhoffer’s financial predicament.

At 6 P.M., the party reconvened at Delmonico’s, which Niederhoffer had reserved for the evening. After cocktails in the dark-panelled bar, his guests entered the ornate dining room, where a Broadway tap dancer and a family of Hawaiian singers performed. I was seated next to Laurel Kenner and Aubrey, but didn’t see much of Niederhoffer, who was wearing a lilac jacket and spent most of the evening table-hopping. After dessert was served, he stood up to speak.

“This is a historic gathering,” he said, swaying slowly back and forth. “We are here in the middle of one of the greatest turmoils in Wall Street history. I am sure that many of you are keen to know how we are doing. Well, I can tell you that it has been very difficult. The battle has been joined, and it is still to be determined who the victor is. I always say that when you are in the middle of one of these situations it is better to say nothing. If you say you are doing badly, it gives ammunition to your enemies. If you say you are doing well, you are tempting fate. . . . We will see what happens and who wins the final point.”

Later in August, after the Federal Reserve cut the discount rate—the rate at which it lends to banks—the markets calmed down; but Niederhoffer’s woes continued. In September, he was forced to close two of his funds, including his flagship, Matador, which had declined in value by more than seventy-five per cent. After cashing out many of his investments, Niederhoffer repaid his lenders and returned what money was leftover to his clients. He laid off several employees and consulted with his lawyers. Meanwhile, rumors circulated on the Internet that, for the second time in a decade, his funds had “blown up.”

Had he been able to wait a little longer before liquidating his trades, his funds might have recouped most of the losses. After the Federal Reserve cut interest rates again, on September 18th, the stock market rallied further and volatility decreased. Still, Niederhoffer sounded philosophical. “The market was not as liquid as I anticipated,” he said. “The movements in volatility were greater than I had anticipated. We were prepared for many different contingencies, but this kind of one we were not prepared for.” Niederhoffer was still trading for his own account, and for some remaining clients. “My basic ideas about the creative power of the market, buying in panics, buying on weakness—I don’t think what has happened has anything to do with that stuff,” he said. “I am going to keep going, for better or worse.” ♦

20 October 2007

Iran pricing crude in euro's upsets Paulson --- G7

We reaffirmed our commitment to vigorously counter money laundering, terrorist and proliferation financing in order to promote economic development and safeguard the integrity of the global financial system. We discussed ways to deal with Iran's pursuit of a nuclear capability and ballistic missiles, the regime's vast financial support to lethal terrorist groups, and the deceptive financial tactics employed by Iran to evade sanctions and mask illicit transactions. We welcomed the recent statement by the Financial Action Task Force highlighting the significant threat Iran's illicit conduct poses to the international financial system.

War with Iran in works

The Secret History of the Impending War with Iran That the White House Doesn't Want You to Know
Two former high-ranking policy experts from the Bush Administration say the U.S. has been gearing up for a war with Iran for years, despite claiming otherwise. It'll be Iraq all over again.

In the years after 9/11, Flynt Leverett and Hillary Mann worked at the highest levels of the Bush administration as Middle East policy experts for the National Security Council. Mann conducted secret negotiations with Iran. Leverett traveled with Colin Powell and advised Condoleezza Rice. They each played crucial roles in formulating policy for the region leading up to the war in Iraq. But when they left the White House, they left with a growing sense of alarm -- not only was the Bush administration headed straight for war with Iran, it had been set on this course for years. That was what people didn't realize. It was just like Iraq, when the White House was so eager for war it couldn't wait for the UN inspectors to leave. The steps have been many and steady and all in the same direction. And now things are getting much worse. We are getting closer and closer to the tripline, they say.

"The hard-liners are upping the pressure on the State Department," says Leverett. "They're basically saying, 'You've been trying to engage Iran for more than a year now and what do you have to show for it? They keep building more centrifuges, they're sending this IED stuff over into Iraq that's killing American soldiers, the human-rights internal political situation has gotten more repressive -- what the hell do you have to show for this engagement strategy?' "

But the engagement strategy was never serious and was designed to fail, they say. Over the last year, Rice has begun saying she would talk to "anybody, anywhere, anytime," but not to the Iranians unless they stopped enriching uranium first. That's not a serious approach to diplomacy, Mann says. Diplomacy is about talking to your enemies. That's how wars are averted. You work up to the big things. And when U.S. ambassador to Iraq Ryan Crocker had his much-publicized meeting with his Iranian counterpart in Baghdad this spring, he didn't even have permission from the White House to schedule a second meeting.

The most ominous new development is the Bush administration's push to name the Iranian Revolutionary Guards a terrorist organization.

"The U.S. has designated any number of states over the years as state sponsors of terrorism," says Leverett. "But here for the first time the U.S. is saying that part of a government is itself a terrorist organization."

This is what Leverett and Mann fear will happen: The diplomatic effort in the United Nations will fail when it becomes clear that Russia's and China's geopolitical ambitions will not accommodate the inconvenience of energy sanctions against Iran. Without any meaningful incentive from the U.S. to be friendly, Iran will keep meddling in Iraq and installing nuclear centrifuges. This will trigger a response from the hard-liners in the White House, who feel that it is their moral duty to deal with Iran before the Democrats take over American foreign policy. "If you get all those elements coming together, say in the first half of '08," says Leverett, "what is this president going to do? I think there is a serious risk he would decide to order an attack on the Iranian nuclear installations and probably a wider target zone."

This would result in a dramatic increase in attacks on U.S. forces in Iraq, attacks by proxy forces like Hezbollah, and an unknown reaction from the wobbly states of Afghanistan and Pakistan, where millions admire Iran's resistance to the Great Satan. "As disastrous as Iraq has been," says Mann, "an attack on Iran could engulf America in a war with the entire Muslim world."

Mann and Leverett believe that none of this had to be.

Flynt Lawrence Leverett grew up in Fort Worth and went to Texas Christian University. He spent the first nine years of his government career as a CIA analyst specializing in the Middle East. He voted for George Bush in 2000. On the day the assassins of Al Qaeda flew two hijacked airplanes into the World Trade Center, Colin Powell summoned him to help plan the response. Five months later, Leverett landed a plum post on the National Security Council. When Condoleezza Rice discussed the Middle East with President Bush and Donald Rumsfeld, Leverett was the man standing behind her taking notes and whispering in her ear.

Today, he sits on the back deck of a house tucked into the curve of a leafy suburban street in McLean, Virginia, a forty-nine-year-old white American man wearing khakis and a white dress shirt and wire-rimmed glasses. Mann sits next to him, also wearing khakis. She's thirty-nine but looks much younger, with straight brown hair and a tomboy's open face. The polish on her toenails is pink. If you saw her around McLean, you wouldn't hesitate:

Soccer mom. Classic soccer mom.

But with degrees from Brandeis and Harvard Law and stints at Tel Aviv University and the powerful Israeli lobby known as AIPAC, she has even better right-wing credentials than her husband.

As they talk, eating grapes out of a bowl, lawn mowers hum and birds chirp. The floor is littered with toy trucks and rubber animals left behind by the youngest of their four children. But the tranquillity is misleading. When Mann and Leverett went public with the inside story behind the impending disaster with Iran, the White House dismissed them. Then it imposed prior restraint on them, an extraordinary episode of government censorship. Finally, it threatened them.

Now they are afraid of the White House, and watching what they say. But still, they feel they have to speak out.

Like so many things these days, this story began on the morning of September 11, 2001. On Forty-fifth Street in Manhattan, Mann had just been evacuated from the offices of the U.S. mission to the United Nations and was walking home to her apartment on Thirty-eighth Street -- walking south, toward the giant plume of smoke. When her cell phone rang, she picked it up immediately because her sister worked at the World Trade Center and she was frantic for word. But it wasn't her sister, it was a senior Iranian diplomat. To protect him from reprisals from the Iranian government, she doesn't want to name him, but she describes him as a cultured man in his fifties with salt-and-pepper hair. Since early spring, they had been meeting secretly in a small conference room at the UN.

"Are you all right?" he asked.

Yes, she said, she was fine.

The attack was a terrible tragedy, he said, doubtless the work of Al Qaeda.

"I hope that we can still work together," he said.

That same day, in Washington, on the seventh floor of the State Department building, a security guard opened the door of Leverett's office and told him they were evacuating the building. Leverett was Powell's specialist on terrorist states like Syria and Libya, so he knew the world was about to go through a dramatic change. As he joined the people milling on the sidewalk, his mind was already racing.

Then he got a call summoning him back to Foggy Bottom. At the entrance to a specially fortified office, he showed his badge to the guards and passed into a windowless conference room. There were about a dozen people there, Powell's top foreign-policy planners. Powell told them that their first job was to make plans to capture or kill Osama bin Laden. The second job was to rally allies. That meant detailed strategies for approaching other nations -- in some cases, Powell could make the approach, in others the president would have to make the call. Then Powell left them to work through the night.

At 5:30 a.m. on September 12, they walked the list to the office of the deputy secretary of state, Richard Armitage. Powell took it straight to the White House.

Mann and Leverett didn't know each other then, but they were already traveling down parallel tracks. Months before September 11, Mann had been negotiating with the Iranian diplomat at the UN. After the attacks, the meetings continued, sometimes alone and sometimes with their Russian counterpart sitting in. Soon they traded the conference room for the Delegates' Lounge, an airy two-story bar with ashtrays for all the foreigners who were used to smoking indoors. One day, up on the second floor where the windows overlooked the East River, the diplomat told her that Iran was ready to cooperate unconditionally, a phrase that had seismic diplomatic implications. Unconditional talks are what the U.S. had been demanding as a precondition to any official diplomatic contact between the U.S. and Iran. And it would be the first chance since the Islamic revolution for any kind of rapprochement. "It was revolutionary," Mann says. "It could have changed the world."

A few weeks later, after signing on to Condoleezza Rice's staff as the new Iran expert in the National Security Council, Mann flew to Europe with Ryan Crocker -- then a deputy assistant secretary of state -- to hold talks with a team of Iranian diplomats. Meeting in a light-filled conference room at the old UN building in Geneva, they hammered out plans for Iranian help in the war against the Taliban. The Iranians agreed to provide assistance if any American was shot down near their territory, agreed to let the U.S. send food in through their border, and even agreed to restrain some "really bad Afghanis," like a rabidly anti-American warlord named Gulbuddin Hekmatyar, quietly putting him under house arrest in Tehran. These were significant concessions. At the same time, special envoy James Dobbins was having very public and warm discussions in Bonn with the Iranian deputy foreign minister as they worked together to set up a new government for Afghanistan. And the Iranians seemed eager to help in more tactical ways as well. They had intimate knowledge of Taliban strategic capabilities and they wanted to share it with the Americans.

One day during the U.S. bombing campaign, Mann and her Iranian counterparts were sitting around the wooden conference table speculating about the future Afghani constitution. Suddenly the Iranian who knew so much about intelligence matters started pounding on the table. "Enough of that!" he shouted, unfurling a map of Afghanistan. Here was a place the Americans needed to bomb. And here, and here, he angrily jabbed his finger at the map.

Leverett spent those days in his office at the State Department building, watching the revolution in the Middle East and coming up with plans on how to capture the lightning. Suddenly countries like Syria and Libya and Sudan and Iran were coming forward with offers of help, which raised a vital question -- should they stay on the same enemies list as North Korea and Iraq, or could there be a new slot for "friendly" sponsors of terror?

As a CIA analyst, Leverett had come to the view that Middle Eastern terrorism was more tactical than religious. Syria wanted the Golan Heights back and didn't have the military strength to put up a serious fight against Israel, so it relied on "asymmetrical methods." Accepting this idea meant that nations like Syria weren't locked in a fanatic mind-set, that they could evolve to use new methods, so Leverett told Powell to seize the moment and draw up a "road map" to peace for the problem countries of the Middle East -- expel your terrorist groups and stop trying to develop weapons of mass destruction, and we will take you off the sponsors-of-terrorism list and start a new era of cooperation.

That December, just after the triumph over Afghanistan, Powell took the idea to the White House. The occasion was the regular "deputies meeting" at the Situation Room. Gathered around the table were the deputy secretary of state, the deputy secretary of defense, the deputy director of the CIA, a representative from Vice-President Cheney's office, and also the deputy national security advisor, Stephen Hadley.

Hadley hated the idea. So did the representatives from Rumsfeld and Cheney. They thought that it was a reward for bad behavior, that the sponsors of terrorism should stop just because it's the right thing to do.

After the meeting, Hadley wrote up a brief memo that came to be known as Hadley's Rules:

If a state like Syria or Iran offers specific assistance, we will take it without offering anything in return. We will accept it without strings or promises. We won't try to build on it.

Leverett thought that was simply nutty. To strike postures of moral purity, they were throwing away a chance for real progress. But just a few days later, Condoleezza Rice called him into her office, warming him up with talk of how classical music shaped their childhoods. As he told her about the year he spent studying classical piano at the Liszt Academy in Budapest, Leverett felt a real connection. Then she said she was looking for someone to take the job of senior director of Mideast affairs at the National Security Council, someone who would take a real leadership role on the Palestinian issue. Big changes were coming in 2002.

He repeated his firm belief that the White House had to draw up a road map with real solutions to the division of Jerusalem and the problem of refugees, something with final borders. That was the only remedy to the crisis in the Middle East.

Just after the New Year, Rice called and offered him the job.

The bowl of grapes is empty and the plate of cheese moves to the center of the table. Leverett's teenage son comes in with questions about a teacher. Periodically, Mann interrupts herself. "This is off the record," she says. "This is going to have to be on background."

She's not allowed to talk about confidential documents or intelligence matters, but the topic of her negotiations with the Iranians is especially touchy.

"As far as they're concerned, the whole idea that there were talks is something I shouldn't even be talking about," she says.

All ranks and ranking are out. "They don't want there to be anything about the level of the talks or who was involved."

"They won't even let us say something like 'senior' or 'important,' 'high-ranking,' or 'high-level,' " Leverett says.

But the important thing is that the Iranians agreed to talk unconditionally, Mann says. "They specifically told me time and again that they were doing this because they understood the impact of this attack on the U.S., and they thought that if they helped us unconditionally, that would be the way to change the dynamic for the first time in twenty-five years."

She believed them.

But while Leverett was still moving into the Old Executive Office Building next to the White House, Mann was wrapped up in the crisis over a ship called the Karin A that left Iran loaded with fifty tons of weapons. According to the Israeli navy, which intercepted the Karin A in the Red Sea, it was headed for the PLO. In staff meetings at the White House, Mann argued for caution. The Iranian government probably didn't even know about the arms shipments. It was issuing official denials in the most passionate way, even sending its deputy foreign minister onto Fox News to say "categorically" that "all segments of the Iranian government" had nothing to do with the arms shipment, which meant the "total government, not simply President Khatami's administration."

Bush waited. Three weeks later, it was time for his 2002 State of the Union address. Mann spent the morning in a meeting with Condoleezza Rice and the new president of Afghanistan, Hamid Karzai, who kept asking Rice for an expanded international peacekeeping force. Rice kept saying that the Afghans would have to solve their own problems. Then they went off to join the president's motorcade and Mann headed back to her office to watch the speech on TV.

That was the speech in which Bush linked Iran to Iraq and North Korea with a memorable phrase:

"States like these, and their terrorist allies, constitute an axis of evil, arming to threaten the peace of the world."

The Iranians had been engaging in high-level diplomacy with the American government for more than a year, so the phrase was shocking and profound.

After that, the Iranian diplomats skipped the monthly meeting in Geneva. But they came again in March. And so did Mann. "They said they had put their necks out to talk to us and they were taking big risks with their careers and their families and their lives," Mann says.

The secret negotiations with Iran continued, every month for another year.

Leverett plunged right into a dramatic new peace proposal floated by Crown Prince Abdullah of Saudi Arabia. Calling for "full normalization" in exchange for "full withdrawal" from the occupied territories, Abdullah promised to rally all the Arab nations to a final settlement with Israel. In his brand-new third-floor office at the Old Executive Office Building, a tiny room with a very high ceiling, Leverett began hammering out the details with Abdullah's foreign-policy advisor, Adel Al-Jubeir. When Ariel Sharon said that a return to the '67 borders was unacceptable, Al-Jubeir said the Saudis didn't want to be in the "real estate business" -- if the Palestinians agreed to border modifications, the Saudis could hardly refuse them. Al-Jubeir believed he had something that might actually work.

But the White House wasn't interested. Sharon already rejected it, Rice told Leverett.

At the Arab League meeting, Abdullah got every Arab state to sign his proposal in a unanimous vote.

The White House still wasn't interested.

Then violence in the Palestinian territories began to increase, climaxing in an Israeli siege of Arafat's compound. In April, Leverett accompanied Colin Powell on a tour that took them from Morocco to Egypt and Jordan and Lebanon and finally Israel. Twice they crossed the Israeli-army lines to visit Arafat under siege. Powell seemed to think he had authorization from the White House to explore what everyone was calling "political horizons," the safely vague shorthand for a peaceful future, so on the final day Leverett holed up in a suite at the David Citadel Hotel in Jerusalem with a group of senior American officials -- the U. . ambassador to Israel, the U. S. consul general to Jerusalem, assistant secretary of state for Near Eastern affairs Bill Burns -- trying to hammer out Powell's last speech.

Then the phone rang. It was Stephen Hadley on the phone from the White House. "Tell Powell he is not authorized to talk about a political horizon," he said. "Those are formal instructions."

"This is a bad idea," Leverett remembers saying. "It's bad policy and it's also humiliating for Powell, who has been talking to heads of state about this very issue for the last ten days."

"It doesn't matter," Hadley said. "There's too much resistance from Rumsfeld and the VP. Those are the instructions."

So Leverett went back into the suite and asked Powell to step aside.

Powell was furious, Leverett remembers. "What is it they're afraid of?" he demanded. "Who the hell are they afraid of?"

"I don't know sir," Leverett said.

In the spring, Crown Prince Abdullah flew to Texas to meet Bush at his ranch. The way Leverett remembers the story, Abdullah sat down and told Bush he was going to ask a direct question and wanted a direct answer. Are you going to do anything about the Palestinian issue? If you tell me no, if it's too difficult, if you're not going to give it that kind of priority, just tell me. I will understand and I will never say anything critical of you or your leadership in public, but I'm going to need to make my own judgments and my own decisions about Saudi interests.

Bush tried to stall, saying he understood his concerns and would see what he could do.

Abdullah stood up. "That's it. This meeting is over."

No Arab leader had ever spoken to Bush like that before, Leverett says. But Saudi Arabia was a key ally in the war on terror, vital to the continued U.S. oil supply, so Bush and Rice and Powell excused themselves into another room for a quick huddle.

When he came back, Bush gave Abdullah his word that he would deal seriously with the Palestinian issue.

"Okay," Abdullah said. "The president of the United States has given me his word."

So the meeting continued, ending with a famous series of photographs of Bush and Abdullah riding around the ranch in Bush's pickup.

In a meeting at the White House a few days later, Leverett saw Powell shaking his head over Abdullah's threat. He called it "the near-death experience."

Bush rolled his eyes. "We sure don't want to go through anything like that again."

Then the king of Jordan came to Washington to see Bush. There had to be a road map for peace in Palestine, the king said. Despite the previous experience with Abdullah in Crawford, Bush seemed taken by surprise, Leverett remembers, but he listened and said that the idea of a road map seemed pretty reasonable.

So suddenly they were working on a road map. For moderate Arab states, the hope of a two-state solution would offer some political cover before Washington embarked on any invasion of Iraq. In a meeting with the king of Jordan, Leverett made a personal promise that it would be out by the end of 2002.

But nothing happened. In Cheney's and Rumsfeld's offices, opposition came from men like John Hannah, Doug Feith, and Scooter Libby. In Rice's office, there was Elliott Abrams. Again they said that negotiation was just a reward for bad behavior. First the Palestinians had to reject terrorism and practice democracy.

Finally, it was a bitter-cold day just after Thanksgiving and Leverett was on a family trip to the Washington Zoo, standing in front of the giraffe enclosure. The White House patched through a call from the foreign minister of Jordan, Marwan Muasher, who said that Rice had just told him the road map was off. "Do you have any idea how this has pulled the rug out from under us, from under me?" Muasher said. "I'm the one that has to go into Arab League meetings and get beat up and say, 'No, there's going to be a plan out by the end of the year.' How can we ever trust you again?"

On Monday, Leverett went straight to Rice's office for an explanation. She told him that Ariel Sharon had called early elections in Israel and asked Bush to shelve any Palestinian plan. This time Leverett couldn't hide his exasperation. "You told the whole world you were going to put this out before Christmas," he said. "Because one Israeli politician told you it's going to make things politically difficult for him, you don't put it out? Do you realize how hard that makes things for all our Arab partners?"

Rice sat impassively behind her broad desk. "If we put the road map out," she said, "it will interfere with Israeli elections."

"You are interfering with Israeli elections, just in another way."

"Flynt, the decision has already been made," Rice said.

There was also an awkward scene with the secretary of defense. They were in the Situation Room and Leverett was sitting behind Rice taking notes when suddenly Rumsfeld addressed him directly. "Why are you laughing? Did I say something funny?"

The room went silent, and Rumsfeld asked it again.

"Why are you laughing? Did I say something funny?"

"I'm sorry Mr. Secretary, I don't think I know what you're talking about."

"It looks to me like you were laughing," Rumsfeld said.

"No sir. I'm sorry if I gave that impression. I was just listening to the meeting and taking notes. Didn't mean to disturb you."

The meeting continued, message received.

By that time, Leverett and Mann had met and fallen in love. They got married in February 2003, went to Florida on their honeymoon, and got back just in time for the Shock and Awe bombing campaign. Leverett quit his NSC job in disgust. Mann rotated back to the State Department.

Then came the moment that would lead to an extraordinary battle with the Bush administration. It was an average morning in April, about four weeks into the war. Mann picked up her daily folder and sat down at her desk, glancing at a fax cover page. The fax was from the Swiss ambassador to Iran, which wasn't unusual -- since the U.S. had no formal relationship with Iran, the Swiss ambassador represented American interests there and often faxed over updates on what he was doing. This time he'd met with Sa-deq Kharrazi, a well-connected Iranian who was the nephew of the foreign minister and son-in-law to the supreme leader. Amazingly, Kharrazi had presented the ambassador with a detailed proposal for peace in the Middle East, approved at the highest levels in Tehran.

A two-page summary was attached. Scanning it, Mann was startled by one dramatic concession after another -- "decisive action" against all terrorists in Iran, an end of support for Hamas and the Islamic Jihad, a promise to cease its nuclear program, and also an agreement to recognize Israel.

This was huge. Mann sat down and drafted a quick memo to her boss, Richard Haass. It was important to send a swift and positive response.

Then she heard that the White House had already made up its mind -- it was going to ignore the offer. Its only response was to lodge a formal complaint with the Swiss government about their ambassador's meddling.

A few days after that, a terrorist attack in Saudi Arabia killed thirty-four people, including eight Americans, and an intelligence report said the bombers had been in phone contact with Al Qaeda members in Iran. Although it was unknown whether Tehran had anything to do with the bombing or if the terrorists were hiding out in the lawless areas near the border, Rumsfeld set the tone for the administration's response at his next press conference. "There's no question but that there have been and are today senior Al Qaeda leaders in Iran, and they are busy."

Colin Powell saw Mann's memo. A couple weeks later he approached her at a State Department reception and said, "It was a very good memo. I couldn't sell it at the White House."

In response to questions from Esquire, Colin Powell called Leverett "very able" and confirms much of what he says. Leverett's account of the clash between Bush and Crown Prince Abdullah was accurate, he said. "It was a very serious moment and no one wanted to see if the Saudis were bluffing." The same goes for the story about his speech in Israel in 2002. "I had major problems with the White House on what I wanted to say."

On the subject of the peace offer, though, Powell was defensive. "I talked to all of my key assistants since Flynt started talking about an Iranian grand bargain, but none of us recall seeing this initiative as a grand bargain."

On the general subject of negotiations with Iran, he responded with pointed politesse. "We talked to the Iranians quietly up until 2003. The president chose not to continue that channel."

That is putting it mildly. In May of 2003, when the U.S. was still in the triumphant "mission accomplished" phase of the Iraq war, word started filtering out of the White House about an aggressive new Iran policy that would include efforts to destabilize the Iranian government and even to promote a popular uprising. In his first public statement on Iran policy since leaving the NSC, Leverett told The Washington Post he thought the White House was making a dangerous mistake. "What it means is we will end up with an Iran that has nuclear weapons and no dialogue with the United States."

In the years that followed, he spoke out in dozens of newspaper editorials and a book, all making variations on the same argument -- America's approach to rogue nations was all sticks and no carrots, all economic sanctions and threats of war without any dialogue. "To bring about real change," he argued, "we must also offer concrete benefits." Of course states like Iran and Syria messed around in Iraq, he said. Iran was supporting the Iraqi opposition when the U.S. was still supporting Saddam Hussein. It was insane to expect them to stop when the goal of a Shiite Iraq was finally in reach. The only way to solve the underlying issues was to offer Iran a "grand bargain" that would recognize the legitimacy of Iran's government and its right to a role in the region.

But that was an unthinkable thought. The White House ignored him. Democrats ignored him. The Brookings Institution declined to renew his contract.

Then he started talking about the peace offer. By then it was 2006 and the war wasn't going well and suddenly people started to respond: You mean Iran isn't evil? They helped fight the Taliban? They wanted to make peace? He summed it all up in a long paper for a Washington think tank that happened to be scheduled for publication last November, a vulnerable time for the White House, just after the Democrats swept the midterm elections and the Iraq Study Group released its report calling for negotiations with Syria and Iran. When he submitted the paper to the CIA for a routine review, they told him the CIA had no problem with it but someone from the NSC called to complain. "You shouldn't have cleared this without letting the White House take a look at it," the official said.

Leverett told them he wasn't going to let White House operatives judge his criticisms of White House operatives and distilled his argument into an op-ed piece for The New York Times. This time he shared a byline with his wife, who had experienced the peace offer up close. They submitted their first draft to the CIA and the State Department on a Sunday in early December, expecting to hear back the next day.

The next morning, Leverett gave a blistering talk on Bush's Iran policy to the influential conservatives at the Cato Institute. The speech was carried live on C-SPAN. Later that day, he flew to New York and made the same arguments at a private dinner with the UN ambassadors of Russia and Britain. He was starting to have an impact.

By Tuesday, he still hadn't heard from the CIA review board.

They called on Wednesday and told him that there was nothing classified in the piece as far as the agency was concerned, but someone in the West Wing wasn't happy with it and would be redacting large sections.

"You're the clearing agency," Leverett said. "You're the people named in my agreement."

They said their hands were tied.

After consulting a lawyer, Leverett and Mann and a researcher worked through the night to assemble a list of public sources where the blacked-out material had already been published. They also took out one line that might have been based on a classified document.

But the White House wouldn't budge. It was a First Amendment showdown.

On Thursday, Leverett and Mann decided to publish the piece with large sections of type blacked out, 168 words in all. Since the piece had been rendered pretty much incomprehensible, they included a list of public sources. "To make sense of our op-ed article, readers will have to look up the citations themselves."

As they tell their story, Mann rushes off to pick up one of their sons from a play date and Leverett takes over, telling what happened over the following months:

Bush sent a second carrier group to the Persian Gulf.

U.S. troops started to arrest Iranians living in Baghdad, accusing them of working with insurgents.

Bush accused Iran of "providing material support" for attacks on U.S. forces, a formulation that suggested a legal justification for a preemptive attack.

Senator Jim Webb of Virginia pushed through an amendment requiring Bush to get congressional authorization for an attack.

Colin Powell broke his long silence with a pointed warning. "You can't negotiate when you tell the other side, 'Give us what a negotiation would produce before the negotiations start.' "

Even Henry Kissinger started giving interviews on the need to "exhaust every possibility to come to an understanding with Iran."

From inside the White House, Leverett was hearing a scary scenario: The Russians were scheduled to ship fuel rods to the Iranian nuclear reactor in Bushehr, which meant the reactor would become operational by this November, at which point it would be impossible to bomb -- the fallout alone would turn the city into an urban Chernobyl. The White House was seriously considering a preemptive attack when the Russians cooled things down by saying Iran hadn't paid its bills, so they would hold back the Bushehr fuel rods for a while.

That put things into a summer lull. But by August, tensions were rising again. U.S. troops in Baghdad arrested an official delegation of Iranian energy experts, leading them out of a hotel in blindfolds and handcuffs. Then Iran said that it had paid its bills and that the Russians were ready to deliver the Bushehr shipment. In Time magazine, former CIA officer and author Robert Baer quoted a highly placed White House official:

"IEDs are a casus belli for this administration. There will be an attack on Iran."

Mann steps back out on the deck and starts collecting the scattered toys to prepare the house for a dinner party, the typical modern American mother multitasking her way through a busy day. "The reason I have to be so careful now is that I'm legally on notice and they will prosecute things that I say or do," she says, picking up a plastic truck.

"Because of that one article?"


Outside, it's getting warmer. There's a heavy haze and floating bugs and for a moment it feels a bit ominous, a gathering silence, one of those moments when giant pods start to sprout in local basements.

"We're tired," Mann says. "Nobody listens."

It seems inconceivable to her that once again a war could be coming, and once again no one is listening. Another pair of lawn mowers joins the chorus and the spell breaks. A cab pulls in the driveway. The caterer comes to prepare for the dinner guests.

Find this article at: http://www.esquire.com/features/iranbriefing1107