"VimpelCom was an American type of entrepreneurial success story that took place in Russia with Russians," says James H. Friedland, an analyst with Arnhold and S. Bleichroeder Inc. in New York.

VimpelCom sales quickly climbed to $100.9 million by the end of 1995, producing a profit of $27.6 million, and its distinctive "Bee Line" brand won 52 percent of the cellular telephone market in Moscow.

In late 1996, VimpelCom became the first post-Soviet Russian company to be listed on the New York Stock Exchange. VimpelCom executives touted their shares in a month-long roadshow through 23 cities in the United States and Europe. Donaldson, Lufkin & Jenrette Securities Corp. underwrote the offering and on Oct. 9 – a month before the listing – it reinforced investor enthusiasm with a report by its own chief international economist. The report, written for institutional investors, was headlined, "Russia: The Bear Moves Toward Stability." The listing was launched at $20.50 a share and raised $110.8 million.

"We made a quality breakthrough," said Valery Goldin, a VimpelCom vice president. The money gave the fledgling firm much needed capital for expansion. Among its projects – expand a fiber-optic network and create a PCS (personal communication system) network, the latest generation technology.

VimpelCom wasn't the only one making a breakthrough. Its public offering in New York came at about the same time Gazprom, the giant state-run natural gas monopoly, floated its first shares overseas and the Russian government issued its first batch of Eurobonds. The next year, the entire Russian stock market soared, producing the best return of any of the world's booming markets in 1997.

In that stunning year for Russian markets, the Russian economy grew by a modest half of 1 percent, the first increase since the 1991 breakup of the Soviet Union.

"What brought people here was revenues," said Dmitri Ponomarev, president of the Russian Trading System, the main over-the-counter stock exchange. "They all heard we were growing. Up and up, every day, every month. Especially after Yeltsin won the elections, everyone was hoping that it would grow again and that the reforms would be deeper."

McGinnis said that in 1995 he bought a stake in Lukoil, a major Russian oil company that was partially privatized. "Its reserves were more than Exxon or Royal Dutch/Shell," he said. "You could buy a future eighth sister for pennies on the dollar." Within two years, the value of the stake had grown 20-fold, and McGinnis sold out, making millions for his investors.

"It was clear skies as far as the eye can see," recalled James Fenkner, equity strategist for Troika Dialog, a leading brokerage fund in Moscow. "And towards the end, everyone was after everything. All you had to do is say a Russian word, and if the Russian word had 'share' attached to it, you could sell it."

But beneath the veneer of success, Russia had serious problems.

VimpelCom was not a typical company. Most of the stock market was dominated by lumbering state enterprises left over from Soviet days. Many foreign fund managers favored these "dinosaurs" – which had been regional or national monopolies under the Soviet system – because they were "liquid," that is big enough to be sold and bought easily. Fenkner, who was earlier at CentreInvest Securities, wrote a report saying that oil and gas companies made up 91 percent of the market capitalization. Next came banks with 5 percent, metals with 3 percent and vehicle manufacturers with 1 percent.

But the dinosaurs had not really changed much. "There was an ownership change, but there wasn't any corporate governance change," said an international banker who has advised the Russian government.

McGinnis recalls meeting officials from Unified Energy Systems, the national holding company for electric utilities. "They marched in a couple of Communist stiffs," he said. "It was pretty amusing. They were leery of answering anything past their names. They wanted to sell us power out of St. Petersburg. They had no idea what a liability was." But, he added, "we figured we'd help them figure it out."

Foreign investment dollars as well as ruble operating profits mostly went to feather the nests of the well-connected Russian managers and owners rather than into equipment that would make the firms more efficient. Valuable assets were sold off cheaply to the new Russian oligarchs. Fenkner said overseas investors did not realize that "the people at the top of Russian business are not the same type you find at General Motors. Their experience and motivation is that building a business is kind of a secondary item to building one's fortune."

Many Russian companies were opaque to outside investors, who could not figure out how companies were run or what their business plans were, if any. Many investors simply guessed at what companies were worth based on oil in the ground or kilowatts generated.

"People looked at kilowatts per line. They could say ... this company is trading in Russia at 2 cents, the company in Brazil at $5 and in the United States at $50. So the 2-cent thing, if they [the Russian company managers] get it right, with the resources behind it, over 10, 15 or 20 years it looks pretty sexy. And people took the risk," a Moscow-based Western fund manager said.

Insider trading was common. So were techniques such as "front-running," in which local brokers would ride the rise in a stock price created when a customer placed a large order.

What was largely missing in Russia was foreign direct investment. Those investors were put off because property and shareholder rights were not protected, taxes were confiscatory and the rule of law did not exist. Coercion and contract killings frightened off potential investment partners.

"Joint ventures were a joke," recalled the Moscow-based Western fund manager, who asked not to be identified. "They were all collapsing. ... The property laws, contractual obligations – no one really trusted the Russians."

Stocks seemed to have the virtue of being easy to escape.

Escape was a constant theme. Much of the foreign currency flowing into Russia was leaving just as quickly by the back door, as Russians spent money on foreign goods or vacations, opened foreign bank accounts or converted their spare rubles into dollars. Russians flocked to resorts in Florida and along the Mediterranean. Restaurants in Cannes began printing menus in Russian.

Much of that money was kept out of the country to evade confiscatory taxes; many taxes left over from Soviet days threatened to swallow up the entire profits of some firms. Not coincidentally, Russia was struggling with a growing budget deficit. Unable or unwilling to collect taxes, the Russian government squandered chances to raise revenues through its practice of selling valuable state assets to small groups of privileged individuals at modest prices.

To cover the shortfall of revenues, it borrowed money by issuing bonds in growing amounts. In 1997, Russia borrowed $36.6 billion from abroad, tapping foreign money to cover three-quarters of its budget deficit. Of that amount, $12 billion was raised by selling short-term, ruble-denominated Russian treasury bonds, known as GKOs, to foreigners. About $19 billion was short-term borrowing from foreign commercial banks.

The situation was unsustainable, given the lack of control over government spending, which more and more had to be devoted to paying off the interest on the bonds. "It was like a pyramid scheme," said an international banker who has advised the Russian government. "It was like a cat chasing its tail of increasing debt."

None of that bothered investors.

For a while, Russia's GKO bonds were hugely profitable for investors. In the spring before Yeltsin's reelection in 1996, the annualized yields on the bonds shot up to more than 150 percent because of jitters over the election outcome. Those bold enough to buy at those levels could profit handsomely.

The returns were so good on the GKOs, Russian banks put their funds into the bonds rather than make loans to businesses. The Russian banking system thus failed to fulfill its main function in a market economy – marshaling the savings of households and companies to finance productive capital investment in the incipient private sector.

After Yeltsin's election, the government relaxed regulations on purchases of GKOs by foreigners. McGinnis was just one of the big buyers. Other major buyers included many of the world's premier financial institutions such as Chase Manhattan Corp., the Swiss bank UBS, Credit Suisse First Boston, Republic Bank and others. As inflation fell and foreign demand for GKOs rose, yields declined, hitting a low of 16 percent in the fall of 1997. For a while, that only helped drive the stock market higher as foreign investors looked for steep returns.

On Oct. 6, 1997, the Russian Trading System main index peaked at 571, making it the hottest emerging market in the world.

Shock Waves

In Moscow, the importance of the Asia crisis still wasn't appreciated. Anatoly Chubais, the veteran reformer who was then a deputy prime minister, said the Asian events might put off Russian economic growth by six months. He was mistaken. Russia was now part of the global economy, and investors in emerging markets, which included Russia, grew cautious. Encouraged by the IMF to defend the value of the ruble, Russia's central bank spent a quarter of its gross international reserves to maintain currency stability. It doubled refinancing interest rates.

Asia's economic slowdown also meant a dampening of demand for oil, coming just when members of the Organization of Petroleum Exporting Countries were vying to increase production. As a result, oil prices plunged, shrinking Russian foreign exchange earnings and swelling the budget deficit.

Instead of taking decisive measures to deal with the crisis, Russia went into political gridlock. First, in late 1997, a vicious public mudslinging campaign broke out among the leading business tycoons and reformers in the government over a telecommunications privatization. Second, in March 1998, Yeltsin abruptly fired his prime minister, Viktor Chernomyrdin, unleashing months of political conflict and uncertainty.

Political paralysis exacerbated Russia's fundamental flaws. The budget deficit grew as the weakened government failed to raise enough taxes or cut spending, which meant it had to keep borrowing. Moreover, Russia remained hostile to foreign direct investment. A hastily arranged auction for a large state oil company, Rosneft, was postponed when no one bid for it.

On April Fool's Day 1998, IMF Managing Director Michel Camdessus, in a speech to the U.S.-Russia Business Council, complained that "cozy relationships" with the government were allowing businesses to avoid paying taxes and compared Russia's system to the "crony capitalism" of South Korea. "The continued large fiscal deficit leaves Russia highly vulnerable to swings in market sentiment," he said.

But most investors weren't listening. One emerging market analyst who left a job at one investment bank to go to another, said, "If markets are going up, there are big bonuses and everybody is happy. If you're a Cassandra, you could deter money from coming in. People don't want to hear that kind of thing. They don't want to hear the bad news."

In the U.S. banking business, there is a concept known as "too big to fail." It applies to a handful of banks so big that most investors expect that the U.S. government would bail them out to prevent a broad financial panic even though the U.S. government has no legal obligation to come to the banks' rescue.

A version of that philosophy applied to Russia. Investors thought it was too great a nuclear power to fail.

So, even early this year, the exuberance had not worn off. VimpelCom stock rose to $59.43¾ a share on May 6, and Securities and Exchange Commission filings show that investors at or near those lofty prices included mutual funds managed by Fidelity Investments Inc., INVESCO (NY) Asset Management Inc., Morgan Stanley, Oppenheimer & Co., AIM Advisors Inc. and others. The yields on Russian treasury bonds actually declined from 50 percent in late January to about 25 percent at the end of March, an indication that investors were willing to take Russian risk for less reward.

Like many hedge fund managers, McGinnis, who had rolled his Lukoil profits into GKOs, held fast to his Russian bond investments. He leveraged two of his funds at 2.1 times his investors' equity. A third fund, in which he borrowed 140 percent of his investors' equity, was devoted entirely to Russia. More than half of each fund was invested in Russian government bonds, mostly GKOs. According to bankruptcy filings in September, McGinnis was able to finance those investments with loans from blue chip firms like Bank of America, Credit Suisse First Boston Corp., Lehman Brothers Inc., Merrill Lynch & Co. and, the biggest, Citibank, which loaned him more than $150 million.

In June, Goldman Sachs & Co. put together a $1.25 billion Eurobond offering for Russia. It was oversubscribed.

"Russia was the ultimate moral hazard," said Robert Hormats, vice chairman of Goldman Sachs International. "The general view was that it was too big or too nuclear to fail, that the West would put money in as far as the eye can see. It gave foreign investors a feeling of complacency."

Still, the yields on GKOs started rising steeply in late spring as global markets began to doubt whether Russia could continue to roll over outstanding bonds. As the GKOs came due each week, the lack of confidence among investors meant that the government had to pay ever high yields.

In July, the IMF agreed on a new package of $22.6 billion in loans that Chubais and others hoped would stabilize Russian markets by beefing up the central bank's reserves. Unaware of confidence crumbling beneath them, Chubais and IMF deputy director Stanley Fischer immediately went on vacations.

But their evaluation of market psychology was wrong. Once the deal was made and the first $4.8 billion tranche of cash was injected into Russia by the IMF, investors ran for the exits. Instead of stabilizing the markets, the IMF loan gave both Russian and foreign investors a means to escape from them by providing a fresh supply of dollars. The money quickly disappeared.

"We ourselves were sure that we could break out of the situation with this package," Chubais said recently. "I was mistaken. ... It's necessary to admit that we, overall, didn't understand completely the scale of the processes we were dealing with."

After that, panic set in. The government, with $12 billion in foreign exchange reserves left, would not be able to meet its commitments. Pressure mounted on the Russian ruble, as Russians and foreigners hoarded dollars and shunned rubles.

On Aug. 17, the government's resolve cracked. It announced a unilateral default on GKOs and let the value of the ruble, which had been fixed within a narrow band, go into free fall.

The Aftermath

"The money went in with the hope and expectation that the Russians would change for their own good," he said. "The reason people got hurt was that the Russians didn't have to do what they did."

Lots of people got hurt. Even the funds run by the hedge fund titan George Soros lost $2 billion on their Russian investment. Ordinary investors, too, were stung as emerging market mutual funds plunged. Western commercial banks wrote off billions of dollars of investments in Russian treasury bonds and loans to ailing hedge funds.

The Russian default and devaluation shattered confidence not only in Russia but in all emerging markets, and ultimately rattled markets in the United States and Europe. Having ignored massive risks in Asia and Russia, investors fled from smaller risks in Brazil, Europe and the United States. Credit tightened, banks unveiled losses and eventually Federal Reserve Chairman Alan Greenspan shaved interest rates to keep U.S. growth from slowing.

Back in Russia, the situation was worse. Russian companies – even the small number of solid ones – were being strangled by a lack of credit, a slowdown in business and an inability to attract foreign investment from a financial community that had been badly burned. Volume on the Russian stock exchange for all shares dwindled to a piddling $2 million a day.

VimpelCom's American-listed stock plunged to less than $5 a share, less than 9 percent of its peak price. The company was suddenly struggling to keep its subscriber base from shrinking. Crimped for cash and credit, it has slashed its capital spending plans for next year.

Recently the company has tacked a line onto its "Be Happy" marketing slogan. The new line: "Don't Worry."

One year after the Russian stock market index peaked at 571, it crashed to an all-time low of 37.

McGinnis still likes many of the Russian companies he bought and sold, but with a new note of realism. He enthuses about the plans one utility company had to build a long-distance power line and sell electricity to the Chinese.

"I think it's a project that will eventually happen," he said, "but maybe not in my lifetime."