The Quants: How a New Breed of Math Whizzes Conquered Wall Street and Nearly Destroyed It (49 page)

But there was Peter Muller, walking briskly among the poker crowd in a brown jacket, well tanned, slapping old friends on the back, beaming that California smile.

Muller seemed calm on the outside, and with good reason: having earned north of $20 million in 2008, he was one of Morgan’s highest earners for the year. Inside, he was seething. The
Wall Street Journal
had broken a story the week before that PDT might split off from Morgan Stanley, in part because its top traders were worried that the government, which had given the bank federal bailout funds, would curb their massive bonuses. Muller had been working on a new business model for PDT for more than a year but was biding his time before he went public with his plans. The
Journal
article beat him to the punch, causing him no end of bureaucratic headaches. PDT had, in a flash, become a pawn in a game of giants—Wall Street versus the U.S. government. The move looked to some as if Morgan had crafted
a plan to have its cake and eat it, too—spin off PDT, make a big investment, and get the same rewards while none of the traders lost a dime of their fat bonuses.

To Muller, it was a nightmare. Ironically, Morgan insiders even accused Muller of leaking the story to the press. Of course, he hadn’t: Muller didn’t talk to the press unless he absolutely needed to.

But he had one thing to look forward to: poker. And when it came to poker, Muller was all business.

Jim Simons, now seventy-one years old, was in attendance, hunched over a crowded dining table in a blue blazer and gray slacks, philosophically stroking his scraggly gray beard. But all was not well in Renaissance land. While the $9 billion Medallion fund continued to print money, gaining 12 percent in the first four months of the year, the firm’s RIEF fund—the fabled fund that Simons once boasted could handle a whopping $100 billion (a fantasy it never even approached)—had lost 17 percent so far in 2009, even as the stock market was rising, tarnishing Simons’s reputation as a can’t-lose rainmaker. RIEF investors were getting upset about the disparity between the two funds, even though Simons had never promised that it could even approach the performance of Medallion. Assets in Renaissance had fallen sharply, sliding $12 billion in 2008 to $18 billion, down from a peak of about $35 billion in mid-2007, just before the August 2007 meltdown.

There were other big changes in Simons’s life, hints that he was preparing to step down from the firm he’d first launched in 1982. In 2008, he’d traveled to China to propose a sale of part of Renaissance to the China Investment Corp., the $200 billion fund owned and run by the Chinese government. No deal was struck, but it was a clear sign that the aging math whiz was ready to step aside. Indeed, later in the year Simons retired as CEO of Renaissance, replaced by the former IBM voice recognition gurus Peter Brown and Robert Mercer.

Perhaps most shocking of all, the three-pack-a-day Simons had quit smoking.

Meanwhile, other top quants mixed and mingled. Neil Chriss, whose wedding had seen the clash of Taleb and Muller over whether it was possible to beat the market, held session at a table with several friends. Chriss was a fast-rising and brilliant quant, a true mathematician
who’d taught for a time at Harvard. He’d recently launched his own hedge fund, Hutchin Hill Capital, which received financial backing from Renaissance and had knocked the cover off the ball in 2008.

In a back room, before play began, a small private poker game was in session. Two hired-gun poker pros, Clonie Gowen and T. J. Cloutier, looked on, wincing from time to time at the clumsy play.

The crowd, still well heeled despite the market trauma, was dining on rack of lamb, puff pastry, and lobster salad. Wine and champagne were served at the bar, but most were taking it slow. There was still a lot of poker to play. And the party atmosphere of years gone by was diminished.

A chime rang out, summoning the players to the main room. Rows of tables with cards fanned out across them and dealers prim in their vested suits awaited them. Simons addressed the gathering crowd, talking about how the tournament had been getting better and better every year, helping advance the cause of teaching students mathematics. The quants in attendance somehow didn’t think it ironic that their own profession amounted to a massive brain drain of mathematically gifted people who could otherwise find careers in developing more efficient cars, faster computers, or better mousetraps rather than devising clever methods to make money for the already rich.

Soon enough play began. The winner that night was Chriss, whose hot hand at trading spilled over to the poker table. Muller didn’t make the final rounds.

It had
been a wildly tumultuous three years on Wall Street, drastically changing the lives of all the traders and hedge fund managers who’d attended the poker tournament in 2006. A golden era had come and passed. There was still money to make, but the big money, the
insane
money, billions upon billions … that train had left the station for everyone but a select few.

Muller, ensconced in his Santa Barbara San Simeon, was hatching his plans for PDT. Its new direction wasn’t just a change for Muller and company; it marked a seminal shift for Morgan Stanley, once one of the most aggressive kill-or-be-killed investment banks on Wall
Street. By 2009, PDT, even in its shrunken state, was the largest proprietary trading operation still standing at Morgan. Its departure, if it happened, would cement the historic bank’s transformation from a cowboy, risk-hungry, money-printing hot rod into a staid white-shoe banking company of old that made money by making loans and doing deals—not by flinging credit default swaps like so many Frisbees through the Money Grid and trading billions in other tangled derivatives through souped-up computers and clumsy quant models.

Most assuredly, it would be a big change for PDT, once Morgan’s secret quant money machine, and its mercurial captain.

Griffin, Muller, Asness, and Weinstein were all intent on making it work again, looking boldly into the future, chastened somewhat by the monstrous losses but confident they’d learned their lessons.

But more risk lurked. Hedge fund managers who’ve seen big losses can be especially dangerous. Investors, burned by the losses, may become demanding and impatient. If big gains don’t materialize quickly, they may bolt for the exits. If that happens, the game is over.

That means there can be a significant incentive to push the limits of the fund’s capacity to generate large gains and erase the memory of the blowup. If a big loss is no worse than a small loss or meager gains—since either can mean curtains—the temptation to jack up the leverage and roll the dice can be powerful.

Such perverse and potentially self-destructive behavior isn’t countenanced by the standard dogmas of modern finance, such as the efficient-market hypothesis or the belief that the market always trends toward a stable equilibrium point. Those theories were increasingly coming under a cloud, questioned even by staunch believers such as Alan Greenspan, who claimed to have detected a flaw in the rational order of economics he’d long championed.

In recent years, new theories that captured the more chaotic behavior of financial markets had arisen. Andrew Lo, once Cliff Asness’s teacher at Wharton and the author of the report on the quant meltdown of August 2007 that warned of a ticking Doomsday Clock, had developed a new theory he called the “adaptive market hypothesis.” Instead of a rational dance in which market prices waltz efficiently to a finely tuned Bach cantata, Lo’s view of the market was more like a
drum-pounding heavy-metal concert of dueling forces that compete for power in a Darwinian death dance. Market participants were constantly at war trying to squeeze out the last dime from inefficiencies, causing the inefficiencies to disappear (during which the market returns briefly to some semblance of equilibrium), after which they start hunting for fresh meat—or die—creating a constant, often chaotic cycle of destruction and innovation.

While such a vision seems unnerving, it appeared to many to be far more realistic, and certainly captured the nature of the wild ride that started in August 2007.

Then there were the behavioral finance theories of Daniel Kahneman, who picked up a Nobel Prize for economics in 2002 (his colleague, Amos Tversk, had passed away years earlier). The findings of behavioral finance—often studies conducted on hapless undergraduate students in stark university labs—had shown time and again that people don’t always make optimal choices when it comes to money.

A similar strand of thought, called neuroeconomics, was delving into the hardwiring of the brain to investigate why people often make decisions that aren’t rational. Some investors pick stocks that sound similar to their own name, for instance, and others pick stocks with recognizable ticker symbols, such as HOG (Harley-Davidson). Evidence was emerging that certain parts of the brain are subject to a “money illusion” that blinds people to the impact of future events, such as the effect of inflation on the present value of cash—or the possibility of a speculative bubble bursting.

A small group of researchers at a cutting-edge think tank called the Sante Fe Institute, led by Doyne Farmer (the hedge fund manager and chaotician who briefly met Peter Muller in the early 1990s), was developing a new way to look at financial markets as an ecology of interacting forces. The hope was that by viewing markets in terms of competing forces vying for limited resources, much like Lo’s evolutionary vision, economists, analysts, and even traders will gain a more comprehensive understanding of how markets work—and how to interact with those markets—without destroying them.

And while quants were being widely blamed for their role in the financial crisis, few—aside from zealots such as Taleb—were calling
for them to be cast out of Wall Street. That would be tantamount to banishing civil engineers from the bridge-making profession after a bridge collapse. Instead, many believed the goal should be to design better bridges—or, in the case of the quants, better, more robust models that could withstand financial tsunamis, not create them.

There were some promising signs. Increasingly, firms were adapting models that incorporated the wild, fat-tailed swings described by Mandelbrot decades earlier. J. P. Morgan, the creator of the bell curve–based VAR risk model, was pushing a new asset-allocation model incorporating fat-tailed distributions. Morningstar, a Chicago investment-research group, was offering retirement-plan participants portfolio forecasts based on fat-tailed assumptions. A team of quants at MSCI BARRA, Peter Muller’s old company, had developed a cutting-edge risk-management strategy that accounted for potential black swans.

Meanwhile, the markets continued to behave strangely. In 2009 the gut-churning thousand-point swings of late 2008 were a thing of the past, but stocks were still mired in a ditch despite an early-year rally; the housing market looked as if it would keep cratering until the next decade. Banks had dramatically reduced their leverage and promised their new investor—the U.S. government—that they would behave. But there were signs of more trouble brewing.

As early as the spring of 2009, several banks reported stronger earnings numbers than most expected—in part due to clever accounting tricks. Talk emerged about the return of big bonuses on Wall Street. “They’re starting to sin again,” Brad Hintz, a respected bank analyst, told the
New York Times
.

Quant funds were also suffering another wave of volatility. In April, indexes that track quant strategies suffered “some of the best and worst days ever … when measured over approximately 15,000 days,” according to a report by Barclays quant researcher Matthew Rothman (formerly of Lehman Brothers).

Many of the toxic culprits of the meltdown were dying away. The CDOs were gone. Trading in credit default swaps was drying up. But there were other potentially dangerous quant gadgets being forged in the dark smithies of Wall Street.

Concerns about investment vehicles called exchange-traded funds were cropping up. Investors seemed to be piling into a number of highly leveraged ETFs, which track various slices of the market, from oil to gold mining companies to bank stocks. In March 2009 alone, $3.4 billion of new money found its way into leveraged ETFs. Quant trading desks at banks and hedge funds started tracking their behavior using customized spreadsheets, attempting to predict when the funds would start buying or selling. If they could predict the future—if they knew the Truth—they could anticipate the move by trading first.

The worry was that with all the funds pouring money into the market at once—or pulling it out, since there were many ETFs that shorted stocks—a massive, destabilizing cascade could unfold. In a report on the products, Minder Cheng and Ananth Madhavan, two top researchers at Barclays Global Investors, said the vehicles could create unintended consequences and potentially pose systemic risk to the market. “There is a close analogy to the role played by portfolio insurance in the crash of 1987,” they warned.

Another concern was an explosion in trading volume from computer-driven, high-frequency funds similar to Renaissance and PDT. Faster chips, faster connections, faster algorithms—the race for speed was one of the hottest going. Funds were trading at speeds measured in microseconds—or one-millionth of a second. In Mahwah, New Jersey, about thirty-five miles from downtown Manhattan, the New York Stock Exchange was building a giant data center three football fields long, bigger than a World War II aircraft carrier, that would do nothing but process computerized trades. “When people talk about the New York Stock Exchange, this is it,” NYSE co-chief information officer Stanley Young told the
Wall Street Journal
. “This is our future.”

But regulators were concerned. The Securities and Exchange Commission was worried about a rising trend of high-frequency trading firms that were getting so-called naked access to exchanges from brokerages that lent out their computer identification codes. While high-frequency firms were in many ways beneficial for the market, making it easier for investors to buy and sell stocks since there always
seemed to be a high-frequency player willing to take the other side of a trade, the concern was that a rogue fund with poor risk-management practices could trigger a destabilizing sell-off.