The Quants: How a New Breed of Math Whizzes Conquered Wall Street and Nearly Destroyed It (31 page)

Brown had no intention of becoming an academic, however. His experience trading options had given him a taste for the real thing. After years playing poker and blackjack in backroom card parlors around the country, he heard the siren song of the world’s biggest casino: Wall Street. After graduating in 1982, he moved to New York. His first job was helping to manage the pension plans of large corporations for Prudential Insurance Company of America. A few years later, he took a job as head of mortgage research at Lepercq, de Neuflize & Co., a boutique investment advisor in New York.

With each move, Brown delved more deeply into quantdom. At the time, quants were seen as second-class citizens at most trading firms, computer nerds who didn’t have the balls to take the kinds of risks that yielded the real money. Brown got sick of seeing the same
rich kids he’d suckered at Harvard lord it over the quants in trading-floor games such as Liar’s Poker. That’s when he decided to bust up Liar’s Poker with quant wizardry.

At Lepercq he picked up a new quant skill: the dark art of securitization. Securitization was a hot new business on Wall Street in the mid-1980s. Bankers would purchase loans such as mortgages from thrifts or commercial banks and bundle them up into securities (hence the name). They would slice those securities into tranches and sell off the pieces to investors such as pension funds and insurance companies. Brown quickly learned how to carve up mortgages into slices with all the dexterity of a professional chef.

Prior to the securitization boom, home loans were largely the province of community-based lenders who lived and died by the time-honored business of borrowing cheap and lending at higher rates. A loan was made by the bank and stayed with the bank until it was paid off. Think Jimmy Stewart and the Bailey Building & Loan Association of the Frank Capra classic
It’s a Wonderful Life
. It was such a stolid business that local bankers lived by what some called the “rule of threes”: borrow money at 3 percent, lend it to home buyers at three points higher, and be on the golf course by three.

But as baby boomers started buying new homes in the 1970s, Wall Street noticed an opportunity. Many savings and loans didn’t have enough capital to satisfy the demand for new loans, especially in Sunbelt states such as California and Florida. Rust Belt thrifts, meanwhile, had too much capital and too little demand. A Salomon bond trader named Bob Dall saw an opening to bring the two together through the financial alchemy of securitization. Salomon would be the middleman, shifting stagnant assets from the Rust Belt to the Sunbelt, plucking out a portion of the money for itself along the way. To trade the newly created bonds, he turned to Lewis Ranieri, a thirty-year-old trader from Brooklyn working on the bank’s utility bond desk.

Over the next few years, Ranieri and colleagues fanned out across the United States, wooing bankers and lawmakers to their bold vision. Mortgage loans made by local banks and thrifts were purchased by Salomon, repackaged into tradable bonds, and sold around the globe. And everybody was happy. Homeowners had access to loans, often at
a cheaper interest rate, since there was more demand for the loans from Wall Street. The S&Ls no longer had to worry about borrowers defaulting, because the default risk had been shifted to investors. The banks gobbled up a tidy chunk of middleman fees. And investors could get custom-made, relatively low-risk assets. It was quant heaven.

The Salomon wizards didn’t stop there. Like car salesmen always looking to lure buyers and increase share with shiny new models, they began to concoct something called collateralized mortgage obligations, or CMOs, bondlike certificates built from different tranches of a pool of mortgage-backed securities. (A mortgage-backed security is a bunch of loans sliced into tranches; a CMO is a bunch of those tranches sliced into even more tranches.) The first CMO deal had four tranches worth about $20 million. The tranches were divided into various levels of quality and maturity that spit out different interest payments—as always, greater risk resulting in greater reward. An ancillary benefit, for the banks at least, was that investors who bought these CMOs took on the risk if the underlying loans defaulted or if borrowers refinanced their loans in the event interest rates shifted lower.

That’s where quants such as Brown entered the scene. As Ranieri once said, “Mortgages are math.” With the rising levels of complexity, all those tricky tranches (there would soon be CMOs with a hundred tranches, each one carrying a somewhat different mix of risk and reward), the devil was in figuring out how to price the assets. The quants pulled out their calculators, cracked open their calculus books, and came up with solutions.

With the math whizzes at the helm, it was a relatively safe business, give or take the odd, predictable blowup every few years. Brown ran Lepercq’s securitization business with a steady hand. The bank had tight relationships with local bankers throughout the country. If Brown had questions about a loan he was packaging, he could call up the banker directly and ask about it. “Sure, I just drove by that house the other day, he’s putting in a new garage,” the banker might say.

But in the late 1980s, Lepercq’s business was overwhelmed when Salomon massively ramped up its mortgage securitization business.
Salomon poured billions into the business, bidding for every loan it could get its hands on. A single deal by Salomon could match the entire year’s product at Lepercq. Small dealers such as Lepercq couldn’t compete. Salomon didn’t just offer better deals for loans to the bankers Brown was dealing with—Salomon bought the bank. And it didn’t stop at home mortgages. Securitization was the flavor of the financial future, and the future belonged to whoever controlled the supply.

Salomon was soon securitizing every kind of loan known to man: credit cards, car purchases, student loans, junk bonds. As profits kept increasing, so did its appetite and capacity for risk. In the 1990s, it started securitizing riskier loans to borderline borrowers who as a class came to be known as subprime.

Wall Street’s securitization wizards also made use of a relatively new accounting trick called “off-balance-sheet accounting.” Banks created trusts or shell companies in offshore tax havens such as the Cayman Islands or Dublin. The trusts would buy loans, stick them in a “warehouse,” and package them up like Christmas presents with bows on top (all through the cybermagic of electronic transfers). The bank didn’t need to set aside much capital on its balance sheet, since it didn’t own the loans. It was simply acting as middleman, shuffling assets between buyers and sellers in the frictionless ether of securitization.

The system was extremely profitable due to all the sweet, sweet fees. Guys such as Aaron Brown either jumped on board or moved on to other things.

Brown moved on. Several top firms offered him jobs after he left Lepercq, but he turned them down, eager to get away from the Wall Street rat race. He started teaching finance and accounting courses at Fordham University and Yeshiva University in Manhattan while keeping his hand in the game by taking the odd consulting job. Consulting at J. P. Morgan, he helped design a revolutionary risk management system for a group that eventually became an independent company called RiskMetrics, a top risk management shop.

Securitization, meanwhile, took off like a freight train in the early 1990s after the savings and loan crisis, when the federal Resolution Trust Corporation took over defaulted savings and loans that once
held more than $400 billion of assets. The RTC bundled up the high-yielding, risky loans and sold them in just a few years, whetting the investors’ appetites for more.

In 1998, Brown took a consulting job with Rabobank, a staid Dutch firm that had started dabbling in credit derivatives. He was introduced to the exciting world of credit default swaps and created a number of trading systems for the new derivatives. It was still the Wild West of the swap market, and there was lots of low-hanging fruit to be had with creative trading.

Credit default swaps may sound fiendishly complex, but they’re actually relatively simple instruments. Imagine a family—call it the Bonds family—moves into a beautiful new home worth $1 million recently built in your neighborhood. The local bank has given the Bondses a mortgage. Trouble is, the bank has too many loans on its books and would like to get some of them off its balance sheet. The bank approaches you and your neighbors and asks whether you would be interested in providing insurance against the chance that the Bonds family may one day default.

Of course, the bank will pay you a fee, but nothing extravagant. Mr. and Mrs. Bonds are hardworking. The economy is in solid shape. You think it’s a good bet. The bank starts paying you $10,000 a year. If Mr. and Mrs. Bonds default, you owe $1 million. But as long as Mr. and Mrs. Bonds keep paying their mortgage, everything is fine. It’s almost like free money. In essence, you’ve bought a credit default swap on Mr. and Mrs. Bonds’s house.

One day you notice that Mr. Bonds didn’t drive to work in the morning. Later you find out that he’s lost his job. Suddenly you’re worried that you may be on the hook for $1 million. But wait: another neighbor, who thinks he knows the family better than you, is confident that Mr. Bonds will get his job back soon. He’s willing to take over the responsibility for that debt—for a price, of course. He wants $20,000 a year to insure the Bondses’ mortgage. That’s bad news for you, since you have to pay an extra $10,000 a year—but you think it’s worth it because you really don’t want to pay for that $1 million mortgage.

Welcome to the world of credit default swaps trading.

Many CDS traders, such as Weinstein, weren’t really in the game
to protect themselves against a loss on a bond or mortgage. Often these investors never actually held the debt in the first place. Instead, they were gambling on the
perception
of whether a company would default or not.

If all of this weren’t strange enough, things became truly surreal when the world of credit default swaps met the world of securitization. Brown had watched, with some horror, as banks started to bundle securitized loans into a product they called a collateralized debt obligation, or CDO. CDOs were similar to the CMOs (collateralized mortgage obligations) Brown had encountered in the 1980s. But they were more diverse and could be used to package any kind of debt, from mortgages to student loans to credit card debt. Some CDOs were made up of other pieces of CDOs, a Frankenstein-like beast known as CDO-squared. (Eventually there were even CDOs of CDOs of CDOs.)

Just when things seemingly couldn’t get stranger, CDOs underwent a completely new twist when a team of J. P. Morgan quants created one of the most bizarre and ultimately destructive financial products ever designed: the “synthetic” CDO.

In the mid-1990s, a New York group of J. P. Morgan financial engineers began thinking about how to solve a problem that plagued the bank: a huge inventory of loans on the bank’s balance sheet that was earning paltry returns. Because the bank was limited in how many loans it could make due to capital reserve requirements, those loans were holding it back. What if there was a way to make the risk of the loans disappear?

Enter the credit default swap. The bank came up with the novel idea of creating a synthetic CDO using swaps. The swaps were tied to the loans that had been sitting on J. P. Morgan’s balance sheet, repackaged into a CDO. Investors, instead of buying an actual bundle of bonds—getting the yield on the bonds, but also assuming the risk of default—were instead agreeing to
insure
a bundle of bonds, getting paid by a premium to do so.

Imagine, in other words, thousands of swaps tied to bundles of mortgages (or other kinds of loans such as corporate and credit card debt) such as those owned by Mr. and Mrs. Bonds.

By selling slices of synthetic CDOs to investors, J. P. Morgan offloaded the risk of the debt it held on its balance sheet. Since the bank was essentially insuring the loans, it didn’t need to worry anymore about the risk the loan holder would default. With that—presto change-o—the bank could use more capital to make more loans … and book more fees.

It was brilliant, on paper. In December 1997, J. P. Morgan’s New York derivatives desk unveiled its masterpiece of financial engineering. It was called Bistro, short for Broad Index Secured Trust Offering. Bistro was a high-powered vacuum cleaner for a bank’s credit exposure, an industrialized risk management tool. The first Bistro deal allowed J. P. Morgan to unload nearly $1 billion in credit risk from its balance sheet on a portfolio of $10 billion in loans. The bank retained a certain part of the synthetic CDO in the form of a high-grade “super-senior” tranche, which had been deemed so safe that there was virtually no chance that it would ever see losses. This fizzing concoction would play a critical role in the credit meltdown of 2007 and 2008.

As time went on, more and more credit default swaps, or tranches of them, spread through the financial system. Traders such as Boaz Weinstein scooped them up like racetrack gamblers betting on which horse would finish last. In certain ways, the whole increasingly complex derivatives fantasia harkened back to the block-trading desk at Morgan Stanley in the early 1980s when Gerry Bamberger came up with the idea of statistical arbitrage: an idea that started off as a risk management tool had turned into a casino. But Bamberger’s creation was kid stuff compared to the industrial-strength mathematical nightmare cooked up in the quant labs of J. P. Morgan. Complexity built upon complexity. Soon it went viral.

In 1998, the Russian government defaulted on its bonds and Long-Term Capital Management collapsed. The resulting chaos helped to turbocharge the credit derivatives industry (helping set the stage for the rise of Boaz Weinstein). Everyone wanted a piece of these arcane swaps, since they provided a form of protection against the risk of default. J. P. Morgan pumped new products into the system as it Bistro’d up its balance sheet. Other banks quickly followed suit.
A robust secondary market for credit default swaps sprang up in which traders such as Weinstein made bets on whether they were mis-priced.