The Quants: How a New Breed of Math Whizzes Conquered Wall Street and Nearly Destroyed It (42 page)

BOOK: The Quants: How a New Breed of Math Whizzes Conquered Wall Street and Nearly Destroyed It
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Sunday afternoon, he took a car from his home in Montclair, New Jersey, to JFK Airport. All along the way he was checking his BlackBerry, looking for news or emails from his colleagues at Lehman. At the airport, as he was checking into the terminal, he sent one last email to Ravi: “Do you want me to go to this conference?”

Just as Rothman was about to go through security, he got a response. “Cancel the trip.”

Rothman’s first emotion was relief. Then it hit him: Lehman was dying. Numb with the realization of what had happened, he took a cab back home to Montclair and immediately hopped in his wife’s station wagon, leaving his ’96 Honda Civic behind. He needed the extra room, he thought. For boxes.

Nearly every Lehman employee who could make it streamed toward the bank’s New York office that night. Ranks of cameras and news teams lined Seventh Avenue. Rumors were flying around that the bank would shut its doors at midnight. There was no time to lose.

Inside the bank, there was relative calm. Employees were busy packing up their belongings. It was a surreal scene, like a wake. Another rumor came down: the computer systems were going to shut down. Everyone started sending emails, saying their goodbyes, attaching email addresses where they could be reached in the future, “It’s been great to work with all of you,” et cetera. Rothman sent his own email, picked up his belongings, and carried them out to his wife’s station wagon.

Monday morning
, chaos gripped Wall Street. Lehman had declared bankruptcy. Merrill Lynch had disappeared into Bank of America. American International Group, the world’s largest insurer, teetered on the edge of collapse.

Outside Lehman’s office, hordes of cameramen perched like vultures, pouncing on any bedraggled, box-laden Lehman employee scurrying from the building. Satellite dishes stacked atop vans lined the
western verge of Seventh Avenue at the feet of Lehman’s spotlit skyscraper. Mutating pixels of images and colors slithered robotically across the bank’s twenty-first-century façade, a triple-deck stack of massive digital screens. A bulky man in a blue suit and candy-striped tie, bald with a bushy white mustache—a beat cop dressed for a funeral—protected the doors to the besieged building.

A man in a scruffy white jacket and green cap shuffled back and forth in front of the building’s entrance, eyes shooting toward the turnstiles. “The capitalist order has collapsed,” he shouted, waving a fist as cameramen snapped the idle shot. “The whole scam is falling apart.” Security men quickly shooed him away.

In the executive suite on the thirty-first floor, Dick Fuld looked down upon the spectacle below. His global banking empire lay in ruins beneath his feet. To protect himself from fuming employees, Fuld, who’d taken home a $71 million paycheck in 2007, had staffed up on extra bodyguards. A garish painting of Fuld, perched on the sidewalk outside the building, was covered in angry messages scrawled in marker, pen, pencil. “Greed took them down,” read one. Another: “Dick, my kids thank you.”

Credit markets were frozen as trading began. Investors were struggling to make sense of Lehman’s collapse and the black cloud hanging over AIG. Later that Monday, rating agencies slashed AIG’s credit. Since AIG had relied on its triple-A rating to insure a number of financial assets, including billions in subprime bonds, the change pushed it toward the edge of insolvency. Rather than let AIG fail, the U.S. government stepped in with a massive bailout.

A unit of AIG, called AIG Financial Products, was behind the blowup. Known as AIG-FP, the unit had gobbled up $400 billion of credit default swaps, many of which were tied to subprime loans. AIG-FP’s headquarters were in London, where it could sidestep tricky U.S. banking laws. It had a AAA rating, which made its business attractive to nearly every investor imaginable, from hedge funds to highly regulated pension funds. The sterling rating also allowed it to sell products cheaper than many competitors.

AIG-FP had sold insurance on billions of dollars of debt securities tied to asset-backed CDOs packed with everything from corporate
loans to subprime mortgages to auto loans to credit-card receivables. Since AIG-FP had such a high credit rating, it didn’t have to post a dime of collateral on the deals. It could just sit back and collect fees. It was a form of infinite leverage based on AIG’s good name. The collateral was the soul and body of AIG itself.

The models that gauged the risk of those positions were constructed by Gary Gorton, a quant who also taught at Yale University. The models were replete with estimates about the likelihood that the bonds AIG was insuring would default. But defaults didn’t torch AIG-FP’s balance sheet: AIG-FP was killed by margin calls. If the value of the underlying asset insured by the swaps declined for whatever reason, the protection provider—AIG-FP—would have to put up more collateral, since the risk of default was higher. Those collateral calls started to soar in the summer of 2007. Goldman Sachs, for instance, had demanded an extra $8 billion to $9 billion in collateral from AIG-FP.

It was a case of model failure on a massive scale. AIG had rolled the dice on a model and had crapped out.

Meanwhile, the hasty exodus of Lehman employees that Sunday night had proven premature. The following week, Barclays purchased Lehman’s investment banking and capital markets units, which included Rothman’s group. But the damage had been done, and regulators were scrambling to contain it.

On Thursday, September 18, Fed chairman Ben Bernanke, Treasury secretary Hank Paulson, and a select group of about sixteen top legislators, including New York senator Chuck Schumer, Arizona senator Harry Reid, and Connecticut senator Chris Dodd, gathered around a polished conference table in the offices of House Speaker Nancy Pelosi. Bernanke began to talk. The credit markets had frozen, he explained, likening the financial system to the arteries of a patient whose blood had stopped flowing.

“That patient has had a heart attack and may die,” Bernanke said in a somber tone to the dead-quiet room. “We could have a depression if we don’t act quickly and decisively.”

Bernanke spoke for about fifteen minutes, outlining a looming financial Armageddon that could destroy the global economy. The
Money Grid was collapsing. The elected officials who had been faced with terrorist attacks and war were stunned. The loquacious Chuck Schumer was speechless. Chris Dodd, whose state pulled in billions from hedge fund taxes, turned talcum white.

The infusion of cash came quickly. The government stepped in with an $85 billion bailout of AIG, which soared to about $175 billion within six months. In the following weeks, the Treasury Department, led by Hank Paulson, former CEO of Goldman Sachs, unveiled a plan to pump $700 billion into the financial system to jolt the dying patient back to life. But no one knew if it would be enough.

Andy Lo’s Doomsday Clock was nearing midnight.

Alan Greenspan
sat in the hot glare of ranks of TV cameras on Capitol Hill, sweating. On October 23, 2008, the former chairman of the Federal Reserve faced rows of angry congressmen demanding answers about the cause of a credit crisis ravaging the U.S. economy. For more than a year, Greenspan had argued time and again that he wasn’t to blame for the meltdown. Several weeks earlier, President George W. Bush had signed a $700 billion government bailout plan for a financial industry devastated by the housing market’s collapse.

In July, Bush had delivered a blunt diagnosis for the troubles in the financial system. “Wall Street got drunk,” Bush said at a Republican fund-raiser in Houston. “It got drunk, and now it’s got a hangover. The question is, how long will it sober up and not try to do all these fancy financial instruments?”

The credit meltdown of late 2008 had shocked the world with its
intensity. The fear spread far beyond Wall Street, triggering sharp downturns in global trade and battering the world’s economic engine. On Capitol Hill, the government’s finger-pointing machinery cranked up to full throttle. Among the first called to account: Greenspan.

Greenspan, many in Congress believed, had been the prime enabler for Wall Street’s wild ride, too slow to remove the punch bowl of low interest rates earlier in the decade. “We are in the midst of a once-in-a-century credit tsunami,” Greenspan said to Congress in his characteristic sandpaper-dry voice. To his left sat the stone-faced Christopher Cox, head of the Securities and Exchange Commission, in for his own grilling later in the day.

Representative Henry Waxman, a Democrat from California overseeing the hearings, shifted in his seat and adjusted his glasses. A patina of sweat glistened on his egglike dome. Greenspan droned on about the causes of the crisis, the securitization of home mortgages by heedless banks on Wall Street, the poor risk management. It was nothing new. Waxman had heard it all before from countless economists and bankers who had testified before his committee that year. Then Greenspan said something truly strange to viewers unfamiliar with the quants and their minions.

“In recent decades, a vast risk management and pricing system has evolved combining the best insights of mathematicians and finance experts supported by major advances in computer and communications technology,” he said. “A Nobel Prize was awarded for the discovery of the pricing model that underpins much of the advance in derivatives markets,” he added, referring to the Black-Scholes option model. Greenspan kept his eyes glued to the speech laid out on the long wooden table before him.

“The modern risk management paradigm held sway for decades,” he said. “The whole intellectual edifice, however, collapsed in the summer of last year.”

Waxman wanted to know more about this intellectual edifice. “Do you feel that your ideology pushed you to make decisions that you wish you had not made?” he asked, indignant.

“To exist you need an ideology,” Greenspan replied in his signature monotone. “The question is whether it is accurate or not. And what I’m
saying to you is, yes, I have found a flaw. I don’t know how significant or permanent it is. But I have been very distressed by that fact.”

“You found a flaw in the reality?” Waxman asked, seeming genuinely bewildered.

“A flaw in the model that I perceived is the critical functioning structure that defines how the world works, so to speak.”

The model Greenspan referred to was the belief that financial markets and economies are self-correcting—a notion as old as Adam Smith’s mysterious “invisible hand” in which prices guide resources toward the most efficient outcome through the laws of supply and demand. Economic agents (traders, lenders, homeowners, consumers, etc.) acting in their own self-interest create the best of all possible worlds, as it were—guiding them inexorably to the Truth, the efficient market machine the quants put their faith in. Government intervention, as a rule, only hinders this process. Thus Greenspan had for years advocated an aggressive policy of deregulation before these very same congressmen in speech after speech. Investment banks, hedge funds, the derivatives industry—the core elements of the sprawling shadow banking system—left to their own devices, he believed, would create a more efficient and cost-effective financial system.

But as the banking collapse of 2008 showed, unregulated banks and hedge funds with young quick-draw traders with billions at their disposal and huge incentives to swing for the fences don’t always operate in the most efficient manner possible. They might even make so many bad trades that they threaten to destabilize the system itself. Greenspan wasn’t sure how to fix the system, aside from forcing banks to hold a percentage of loans they make on their own balance sheets, giving them the incentive to actually care about whether the loans might default or not. (Of course, the banks could always hedge those loans with credit default swaps.)

Greenspan’s confession was stunning. It marked a dramatic shift for the eighty-two-year-old banker who for so long had been hailed variously as the most powerful man on the planet and the wise central banker with a Midas touch. In a May 2005 speech he’d hailed the system he now doubted. “The growing array of derivatives and the related application of more sophisticated methods for measuring and
managing risks had been key factors underlying the remarkable resilience of the banking system, which had recently shrugged off severe shocks to the economy and the financial system.”

Now Greenspan was turning his back on the very system he had championed for decades. In congressional testimony in 2000, Vermont representative Bernie Sanders had asked Greenspan, “Aren’t you concerned with such a growing concentration of wealth that if one of these huge institutions fails it will have a horrendous impact on the national and global economy?”

Greenspan didn’t bat an eye. “No, I’m not,” he’d replied. “I believe that the general growth in large institutions has occurred in the context of an underlying structure of markets in which many of the larger risks are dramatically—I should say fully—hedged.”

Times had changed. Greenspan seemed befuddled by the meltdown, out of touch with the elephantine growth of a vast risk-taking apparatus on Wall Street that had taken place under his nose—and by many accounts had been encouraged by his policies.

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