The Quants: How a New Breed of Math Whizzes Conquered Wall Street and Nearly Destroyed It (17 page)

Thorp was familiar with Scholes, Merton, and Meriwether—but he hesitated. The academics didn’t have enough real-world experience, he thought. Thorp had also heard that Meriwether was something of a high roller. He decided to take a pass.

For a while, it looked like Thorp had made the wrong call. LTCM earned 28 percent in 1994 and 43 percent the following year. In 1996, the fund earned 41 percent, followed by a 17 percent gain in 1997. Indeed, the fund’s partners grew so confident that at the end of 1997 they decided to return $3 billion in capital to investors. That meant more of the gains from LTCM’s trades would go to the partners themselves, many of whom were plowing a great deal of their personal wealth into the fund. It was the equivalent of taking all of one’s chips, shoving them into the pot, and announcing, “All in.”

Meriwether and his merry band of quants had been so successful, first at Salomon Brothers and then at LTCM, that bond trading desks across Wall Street, from Goldman Sachs to Lehman Brothers to Bear Stearns, were doing their level best to imitate their strategies. That ultimately spelled doom for LTCM, known by many as Salomon North.

The first blow was a mere mosquito bite that LTCM barely felt.
Salomon Brothers’ fixed-income arbitrage desk had been ordered to shut down by its new masters, Travelers Group, which didn’t like the risk they were taking on. As Salomon began to unwind its positions—often the very same positions held by LTCM—Meriwether’s arbitrage trades started to sour. It set off a cascade as computer models at firms with similar positions, alerted to trouble, spat out more sell orders.

By August 1998, the liquidation of relative-value trades across Wall Street had caused severe pain to LTCM’s positions. Still, the fund’s partners had little clue that disaster was around the corner. They believed in their models. Indeed, the models were telling them that the trades were more attractive than ever. They assumed that other arbitrageurs in the market—Fama’s piranhas—would swoop in and gobble up the free lunch. But in the late summer of 1998, the piranhas were nowhere to be found.

The fatal blow came on August 17, when the Russian government defaulted on its debt. It was a catastrophe for LTCM. The unthinkable move by Russia shook global markets to their core, triggering, in the parlance of Wall Street, a “flight to liquidity.”

Investors, fearful of some kind of financial collapse, piled out of anything perceived as risky—emerging-market stocks, currencies, junk bonds, whatever didn’t pass the smell test—and snatched up the safest, most liquid assets. And the safest, most liquid assets in the world are recently issued, on-the-run U.S. Treasury bonds.

The trouble was, LTCM had a massive short bet against those on-the-run Treasuries because of its ingenious relative-value trades.

The off-the-run/on-the-run Treasury trade was crushed. Investors were loading up on newly minted Treasuries, the ones LTCM had shorted, and selling more seasoned bonds. They were willing to pay the extra toll for the liquidity the fresher Treasuries provided. It was a kind of market that didn’t exist in the quantitative models created by LTCM’s Nobel Prize winners.

As Roger Lowenstein wrote in his chronicle of LTCM’s collapse,
When Genius Failed:
“Despite the ballyhooed growth in derivatives, there was no liquidity in credit markets. There never is when everyone wants out at the same time. This is what the models had missed. When losses mount, leveraged investors such as Long-Term are forced to sell,
lest their losses overwhelm them. When a firm has to sell in a market without buyers, prices run to the extremes beyond the bell curve.”

Prices for everything from stocks to currencies to bonds held by LTCM moved in a bizarre fashion that defied logic. LTCM had relied on complex hedging strategies, massive hairballs of derivatives, and risk management tools such as VAR to allow it to leverage up to the maximum amount possible. By carefully hedging its holdings, LTCM could reduce its capital, otherwise known as equity. That freed up cash to make other bets. As Myron Scholes explained before the disaster struck: “I like to think of equity as an all-purpose risk cushion. The more I have, the less risk I have, because I can’t get hurt. On the other hand, if I have systematic hedging—a more targeted approach—that’s interesting because there’s a trade-off: it’s costly to hedge, but it’s also costly to use equity.”

With a razor-thin capital cushion, LTCM’s assets evaporated into thin air. By the end of August the fund had lost $1.9 billion, 44 percent of its capital. The plunge in capital caused its leverage ratio to spike to an estimated 100 to 1 or more. In desperation, LTCM appealed to deep-pocketed investors such as Warren Buffett and George Soros. Buffett nearly purchased LTCM’s portfolio, but technicalities nixed the deal at the last minute. Soros, however, wouldn’t touch it. LTCM’s quantitative approach to investing was the antithesis of the trade-by-the-gut style that Soros was famous for. According to Soros: “The increasing skill in measuring risk and modeling risk led to the neglect of uncertainty at LTCM, and the result is you could use a lot more leverage than you should if you recognize uncertainty. LTCM used leverage far above what should have been the case. They didn’t recognize that the model is flawed and it neglected this thick tail in the bell curve.”

The wind-down of the fund was brutal, involving a massive bailout by a consortium of fourteen U.S. and European banks organized by the Federal Reserve. Many of the partners who had invested their life savings in the fund suffered massive personal losses.

As painful as the financial cost was, it was an even more humiliating fall for a group of intelligent investors who had ridden atop the financial universe for years and lorded it over their dumber, slower, less quantitatively gifted rivals. What’s more, their cavalier use of
leverage nearly shattered the global financial system, hurting everyday investors who were increasingly counting on their 401(k)s to carry them through retirement.

LTCM’s fall didn’t just tarnish the reputation of its high-profile partners. It also gave a black eye to an ascendant force on Wall Street: the quants. Long-Term’s high-powered models, its space-age risk management systems as advanced as NASA’s mission control, had failed in spectacular fashion—just like that other quant concoction, portfolio insurance. The quants had two strikes against them. Strike three would come a decade later, starting in August 2007.

Ironically, the
collapse of LTCM proved to be one of the best things that ever happened to Boaz Weinstein. As markets around the world descended into chaos and investors dove for safety in liquid markets, the credit derivatives business caught fire. Aside from Deutsche Bank and J. P. Morgan, other banking titans started to leap into the game: Citigroup, Bear Stearns, Credit Suisse, Lehman Brothers, UBS, the Royal Bank of Scotland, and eventually Goldman Sachs, Merrill Lynch, Morgan Stanley, and many others, lured by the lucrative fees for brokering the deals, as well as the ability to unload unwanted risk from their balance sheets. Banks and hedge funds sought to protect themselves from the mounting turmoil by lapping up as much insurance as they could get on bonds they owned. Others, including American International Group, the insurance behemoth—specifically its hard-charging London unit full of quants who specialized in derivatives, AIG Financial Products—were more than willing to provide that insurance.

Another boom came in the form of a new breed of hedge funds such as Citadel—or Citadel copycats—that specialized in convertible-bond arbitrage. Traditionally, just as Ed Thorp had discovered in the 1960s, the strategy involved hedging corporate bond positions with stock. Now, with credit default swaps, there was an even better way to hedge.

Suddenly, those exotic derivatives that Weinstein had been juggling were getting passed around like baseball cards. By late 2000, nearly $1 trillion worth of credit default swaps had been created. Few
knew more about how they worked than the baby-faced card-counting chess whiz at Deutsche Bank. In a flash, thanks in part to Russia’s default and LTCM’s collapse, Weinstein went from being a bit player to a rising star at the center of the action, putting him on the fast track to becoming one of the hottest, highest-paid, and most powerful credit traders on Wall Street.

Ona
spring afternoon in 1985, a young mortgage trader named Aaron Brown strode confidently onto the trading floor of Kidder, Peabody & Co.’s Manhattan headquarters at 20 Exchange Place. Brown checked his watch. It was two o’clock, the time Kidder’s bond traders gathered nearly every day for the Game. Brown loved the Game. And he was out to destroy it.

This is going to be good
, Brown thought as Kidder’s traders gathered around. It was a moment he’d been planning for months.

As with
any evolutionary change in history, there’s no single shining moment that marks the quants’ ascent to the summit of Wall Street’s pyramid. But the quants certainly established a base camp the day Brown and his like-minded friends beat Liar’s Poker.

At the time, the quants were known as rocket scientists, since
many came from research hotbeds such as Bell Labs, where cell phones were invented, or Los Alamos National Laboratory, birthplace of the atomic bomb. Wall Street’s gut traders eventually proved to be no match for such explosive brainpower.

Michael Lewis’s Wall Street classic,
Liar’s Poker
, exemplified and exposed the old-school Big Swinging Dick trader of the 1980s, the age of Gordon Gekko’s “greed is good.” Lewis Ranieri, the mortgage-bond trader made famous in the book, made huge bets based on his burger-fueled gut. Michael Milken of Drexel Burhman for a time ruled the Street, financing ballsy leveraged buyouts with billions in junk bonds. Nothing could be more different from the cerebral, computerized universe of the quants.

Those two worlds collided when Aaron Brown strode onto Kidder’s trading floor. As an up-and-coming mortgage trader at a rival New York firm, Brown was an interloper at Kidder. And he was hard to miss. A tall bear of a man with a rugged brown beard, Brown stood out even in a crowd of roughneck bond traders.

As Brown watched, a group of Kidder traders gathered in a circle, each with a fresh $20 bill clutched in his palm. They were playing a Wall Street version of the game of chicken, using the serial numbers on the bills to bluff each other into submission. The rules were simple. The first trader in the circle called out some small number, such as four 2s. It was a bet that the serial numbers of all of the twenties in the circle collectively contained at least four 2s—a pretty safe bet, since each serial number has eight digits.

The next trader in the circle, moving left, had a choice. He could up the ante—four of a higher number (in this case, higher than 2) or five or more of any number—or he could call. If he called and there were, in fact, four 2s among the serial numbers, he would have to pay everyone in the circle $100 each (or whatever sum was agreed upon when the game began).

This was meant to continue until someone called. Usually the bets would rise steadily, to something on the order of twelve 9s or thirteen 5s. Then, when the next man—and in the 1980s they were almost always men—called, it would be time to check the twenties to see if the last trader who bet was correct. Say the last bet was twelve 9s. If
the bills did in fact have twelve 9s, the trader who called would have to pay everyone. If the bills didn’t have twelve 9s, the trader who made the bet paid up.

In Lewis’s book, the game involved Salomon chairman John Gutfreund and the firm’s star bond trader John Meriwether, future founder of the doomed hedge fund LTCM. One day, Gutfreund challenged Meriwether to play a $1 million hand of Liar’s Poker. Meriwether shot back: “If we’re going to play for those kind of numbers, I’d rather play for real money. Ten million dollars. No tears.” Gutfreund’s response as he backed away from Meriwether’s bluff: “You’re crazy.”

Top traders such as Meriwether dominated Liar’s Poker. There was a pecking order in the game that gave an advantage to players who made the earliest guesses, and the top traders always somehow managed to be first in line. Obviously no one would challenge a call of four 2s. But as the game moved toward the end of the line, things got a lot more risky. And the poor schleps at the end of the line were usually the quants, the big-brained rocket scientists. Like Aaron Brown.

The quants were deploying all the firepower of quantum physics, differential calculus, and advanced geometry to try to subdue the rebellious forces of the market. But in the 1980s, they were at best second-class citizens on investment banks’ trading floors. The kings of Wall Street were the trade-by-the-gut swashbucklers who relied more on experience and intuition than on number crunching.

The quants were not happy about the situation. They especially didn’t like being victimized on a daily basis by soft-brained Big Swinging Dicks playing Liar’s Poker, a game that was almost purely determined by probabilities and statistics. Quant stuff.

Brown fumed over the trader-dominated system’s abuse of the quants. He knew about odds and betting systems. As a teenager he’d haunted the backroom poker games in Seattle and had sat at more than one high-stakes table in Las Vegas, going head-to-head with some of the smartest cardsharps in the country. And he had his pride. So Brown set about beating Liar’s Poker.