The Quants: How a New Breed of Math Whizzes Conquered Wall Street and Nearly Destroyed It (48 page)

The passage, by Cootner himself, was a stern rebuke to Mandelbrot’s essay detailing strange characteristics he’d observed in the behavior of cotton prices. Market prices, Mandelbrot had found, were subject to sudden violent, wild leaps. It didn’t matter what caused the jumps, whether it was self-reinforcing feedback loops, wild speculation, panicked deleveraging. The fact was that they existed and cropped up time and again in all sorts of markets.

The upshot of Mandelbrot’s research was that markets are far less well behaved than standard financial theory held. Out at the no-man’s-land on the wings of the bell curve lurked a dark side of markets that haunted the quants like a bad dream, one many had seemingly banished into subconsciousness. Mandelbrot’s message had been picked up years later by Nassim Taleb, who repeatedly warned quants that their models were doomed to fail because unforeseen black swans (which reputedly didn’t exist) would swoop in from nowhere and scramble the system. Such notions threatened to devastate the elegant mathematical world of quants such as Cootner and Fama. Mandelbrot had been swiftly attacked, and—though he remained a mathematical legend and created an entire new field known as fractal geometry and pioneering discoveries in the science of chaos—was soon forgotten in the world of quants as little more than a footnote in their long march to victory.

But as the decades passed, Mandelbrot never changed his mind.
He remained convinced the quants who ignored his warnings were doomed to fail—it wasn’t a question of if, only when. As he watched the markets fall apart in 2008, he saw his unheeded warnings manifest themselves in daily headlines of financial meltdowns that presumably no one—or almost no one—could have foreseen.

If vindication gave him any pleasure, Mandelbrot didn’t show it. He wasn’t so cavalier about the pain caused by the meltdown as to enjoy any sort of last laugh.

“The only serious criticism of my work, expressed by Cootner, was that if I am right, all of our previous work is wrong,” Mandelbrot said, staring out his window at the Charles. “Well, all of their previous work
is
wrong. They’ve made assumptions which were not valid.”

He paused a moment and shrugged. “The models are bad.”

In February
2008, Ed Thorp gazed out of the windows of his twelfth-floor corner office in the exclusive city of Newport Beach, California. The glistening expanse of the whitecapped Pacific Ocean stretched far into a blue horizon past Newport Harbor toward the green jewel of Catalina Island. “Not a bad view,” he said to a reporter with a smile.

Thorp was angry even though the full fury of the crisis was yet to strike. The banks and hedge funds blowing up didn’t know how to manage risk. They used leverage to juice returns in a high-stakes game they didn’t understand. It was a lesson he’d learned long before he founded his hedge fund, when he was sitting at the blackjack tables of Las Vegas and proving he could beat the dealer. At bottom, he learned, risk management is about avoiding the mistake of betting so much you can lose it all—the mistake made by nearly every bank and hedge fund that ran into trouble in 2007 and 2008. It can be tricky in financial markets, which can exhibit wild, Mandelbrotian swings at a moment’s notice. Banks juggling billions need to realize the market can be far more chaotic over short periods of time than standard financial models reflect.

Thorp stood ramrod straight from his habit of continual exercise. Until 1998, when he injured his back, he ran a few marathons a year. He was trim, six feet tall, with the etched features of an aging athlete. His gaze was clear and steady behind a pair of square gold-framed
glasses. Thorp had been taking a large number of pills every day, as part of his hope that he will live forever. After he dies, his body will be cryogenically frozen. If technology someday advances far enough, he’ll be revived. Thorp estimates that his odds of recovering from death are 2 percent (he’s quantitative literally to the end and beyond). It is his ultimate shot at beating the dealer.

Even if corporeal immortality was unlikely, Thorp’s mark on Wall Street was vast and indelible. One measure of that influence lay in a squat chalk-white building, its flat-topped roof flared like an upside-down wedding cake, a short walk from his office in Newport Beach.

The building houses Pimco, one of the largest money managers in the world, with nearly $1 trillion at its disposal. Pimco is run by Bill Gross, the “Bond King,” possibly the most well-known and powerful investor in the world besides Warren Buffett. A decision by Gross to buy or sell can send shock waves through global fixed-income markets. His investing prowess is legendary, as is his physical stamina. When he was fifty-three, he decided to run a series of marathons—five of them, in five days. On the fifth day, his kidney ruptured. He saw blood streaming down his leg. But Gross didn’t stop. He finished the race, collapsing into a waiting ambulance past the finish line.

Gross would never have become the Bond King without Ed Thorp. In 1966, while a student at Duke University, Gross was in a car accident that almost killed him—he was nearly scalped, as a layer of skin was ripped from the top of his head. He spent six months recovering in the hospital. With lots of time to kill, he cracked open
Beat the Dealer
, testing the strategy in his hospital room over and over again.

“The only way I could know if Ed was telling the truth was to play,” said Gross later that day in a conference room just off Pimco’s expansive trading floor. His red tie hung jauntily untied around his neck like a scarf. A tall, lanky man with combed-back orange-tinted hair who meditates daily, Gross appeared so relaxed it was as if he were getting an invisible massage as he sat in his chair. “And lo and behold, it worked!” Thorp, sitting to Gross’s right, gave a knowing chuckle.

After he recovered from his accident, Gross decided to see if he
could make the system pay off in the real world, just as Thorp had done in the early 1960s. With $200, he headed out to Las Vegas. In rapid fashion, he parlayed that into $100,000. The wad of cash helped pay for graduate school at the University of California, Los Angeles, where Gross studied finance. That’s where he came across
Beat the Market
. Gross’s master’s thesis was based on the convertible-bond investment strategies laid out in the book—the same strategies Ken Griffin used to build Citadel.

Soon after reading Thorp’s book, Gross had an interview at a firm then called Pacific Mutual Life. He had no experience trading and had little chance of landing a job. But his interviewer noticed that his thesis was on convertible bonds. “The people who hired me said, ‘We have a lot of smart candidates, but this guy is interested in the bond market.’ So I got my job because of Ed,” said Gross.

As Gross and Thorp sat together in Pimco’s conference room, they got to musing about the Kelly criterion, the risk management strategy Thorp used starting with his blackjack days in the 1960s. Pimco, Gross noted, uses a version of Kelly. “Our sector concentration is predicated on that—blackjack and investments,” he said, gesturing toward the trading floor. “I hate to stretch it, but professional blackjack is being played in this trading room from the standpoint of risk management, and that ultimately is a big part of our success.”

Thorp nodded in agreement. The key behind Kelly is that it keeps investors from getting in over their heads, Thorp explained. “The thing you have to make sure of is that you don’t overbet,” he said.

The conversation turned to hedge funds and leverage. A river of money had flowed into hedge funds in recent years, turning it from an industry with less than $100 billion under management in the early 1990s to a $2 trillion force of nature. But the amount of actual investing opportunities hadn’t changed very much, Thorp said. The edge had diminished, but hedge fund managers’ and bankers’ appetite for gigantic profits had only grown more voracious. That led to massive use of leverage—in other words, overbetting. The inevitable end result: gambler’s ruin on a global scale.

“A classic example is Long-Term Capital Management,” Thorp said. “We’ll be seeing more of that now.”

“The available edge has been diminished,” Gross agreed, noting that Pimco, like Warren Buffett’s Berkshire Hathaway, used very little leverage. “And that led to increased leverage to maintain the same returns. It’s leverage, the overbetting, that leads to the big unwind. Stability leads to instability, and here we are. The supposed stability deceived people.”

“Any good investment, sufficiently leveraged, can lead to ruin,” Thorp said.

After about an hour, Gross stood, shook hands with the man responsible for getting him started, and walked onto Pimco’s trading floor to keep an eye on the nearly $1 trillion in assets he ran.

Thorp walked back to his own office. It turned out that he was doing a little trading himself.

Sick and tired of watching screwups by managers he’d hired to care for his money, Thorp had decided to take the reins himself once again. He’d developed a strategy that looked promising. (What was it? Thorp wasn’t talking.) In early 2008, he started running about $36 million with the strategy.

By the end of 2008, the strategy—which he called System X to outsiders—had gained 18 percent,
with no leverage
. After the first week, System X was in positive territory the entire year, one of the most catastrophic stretches in the history of Wall Street, a year that saw the downfall of Bear Stearns, AIG, Lehman Brothers, and a host of other institutions, a year in which Citadel Investment Group coughed up half of its money, a year in which AQR fell more than 40 percent and Saba lost nearly $2 billion.

Ed Thorp was back in the game.

On a
sultry Tuesday evening in late April 2009, the quants convened for the seventh annual Wall Street Poker Night in the Versailles Room of the St. Regis Hotel in midtown Manhattan.

It was a far more subdued affair than the heady night three years earlier when the elite group of mathematical traders stood atop the investing universe. Many of the former stars of the show—Ken Griffin, Cliff Asness, and Boaz Weinstein—were missing. They didn’t have time for games anymore. In the new landscape, the money wasn’t pouring in as it used to. Now they had to go out and hustle for their dollars.

Griffin was in Beverly Hills hobnobbing with former junk bond king Michael Milken at the Milken Institute Global Conference, where rich people gathered for the primary purpose of reminding one another how smart they are. His IPO dreams had evaporated like a
desert mirage, and he was furiously trying to chart a new path to glory. But the wind was blowing against him in early 2009. Several of his top traders had left the firm. And why not? Citadel’s main fund, Kensington, had lost more than half its assets in 2008. In order to collect those lucrative incentive fees—the pie slice managers keep after posting a profit—the fund would need to gain more than 100 percent just to break even. That could take
years
. To instant-gratification hedge fund managers, you might as well say forever. Or how about never?

Griffin wasn’t shutting down the fund, though. Instead, he was launching new funds, with new strategies—and new incentive fees. He also was venturing into the investment banking world, trying to expand into new businesses as others faded. The irony was rich. As investment banks turned into commercial banks after their failed attempt to become hedge funds, a hedge fund was turning into an investment bank.

Some saw it as a desperate move by Griffin. Others thought it could be another stroke of genius. The toppled hedge fund king from Chicago was moving to take over business from Wall Street as his competitors were shackled by Washington’s bailouts. His funds had made something of a comeback, advancing in the first half of the year as the chaos of the previous year abated. Whatever the case, Griffin hoped investors would see the debacle of 2008 as a one-time catastrophe, never to be repeated. But it was a tough sell.

Weinstein, meanwhile, was in Chicago hustling for his hedge fund launch. He was busy trying to convince investors that the $1.8 billion hole he’d left behind at Deutsche Bank was a fluke, a nutty mishap that could only happen in the most insane kind of market. By July, he’d raised more than $200 million for his new fund, Saba Capital Management, a big fall from the $30 billion in positions he’d juggled for Deutsche Bank. Setting up shop in the Chrysler Building in mid-town Manhattan, Saba was set to start trading in August.

Asness stayed home with his two pairs of twins and watched his beloved New York Rangers lose to the Washington Capitals in the decisive game seven of the National Hockey League’s Eastern Conference playoff series. He was also busy launching new funds of his own.
AQR had even ventured into the plain-vanilla—and low-fee—world of mutual funds. In a display of confidence in his strategies, Asness put a large chunk of his own money into AQR funds, including $5 million in the Absolute Return Fund. He also put $5 million into a new product AQR launched in 2008 called Delta, a low-fee hedge fund that quantitatively replicated all kinds of hedge fund strategies, from long-short to “global macro.” Several of AQR’s funds had gotten off to a good start for the year, particularly his convertible bond funds—the decades-old strategy laid out by Ed Thorp in
Beat the Dealer
that had launched Citadel and hundreds of other hedge funds in the 1990s. Asness even dared to think the worst, finally, was behind him. He managed to find a bit of time to unwind. After working for months straight with barely a weekend off, Asness took a vacation in March to hike the craggy hills of Scotland. He even left his BlackBerry behind. But there were still reminders of his rough year. A newspaper article about AQR mentioned Asness’s penchant for smashing computers. To his credit, he was now able to laugh at the antics he’d indulged in at the height of the turmoil, writing a tongue-in-cheek note to the editor protesting that it had “happened only three times, and on each occasion the computer screen deserved it.”