The Quants: How a New Breed of Math Whizzes Conquered Wall Street and Nearly Destroyed It (11 page)

Mandelbrot’s theories were shelved by the financial engineers who didn’t want to deal with the messy, chaotic world they evoked. But they always loomed like a bad memory in the back of their minds, and were from time to time thrust to the forefront during wild periods of volatility such as Black Monday, only to be forgotten again when the markets eventually calmed down, as they always seemed to do.

Inevitably, though, the deadly volatility returns. About a decade after
Black Monday, the math geniuses behind a massive quant hedge fund known as Long-Term Capital Management came face-to-face with Mandelbrot’s wild markets. In a matter of weeks in the summer of 1998, LTCM lost billions, threatening to destabilize global markets and prompting a massive bailout organized by Fed chairman Alan Greenspan. LTCM’s trades, based on sophisticated computer models and risk management strategies, employed unfathomable amounts of leverage. When the market behaved in ways those models never could have predicted, the layers of leverage caused the fund’s capital to evaporate.

The traders behind LTCM, whose partners included option-formula creators Myron Scholes and Robert Merton, have often said that if they’d been able to hold on to their positions long enough, they’d have made money. It’s a nice theory. The reality is far more simple. LTCM went all in and lost.

Black Monday
left an indelible stamp on the very fabric of the market’s structure. Soon after the crash, options traders started to notice a strange pattern on charts of stock-option prices. Prices for deep out-of-the-money puts—long-shot bets on huge price declines—were unusually high, compared with prices for puts closer to the current price of the stock. Graphs of these prices displayed a curvy kink around such options that, according to the prevailing theory, shouldn’t exist. Traders soon came up with a name for this phenomenon: the “volatility smile.” It was the grim memory of Black Monday grinning sinisterly from within the very prices that underpinned the market.

The volatility smile disobeyed the orderly world of “no arbitrage” laid out by Black-Scholes and modern portfolio theory, since it implied that traders could make a lot of money by selling these out-of-the-money puts. If the puts were too expensive for the risk they carried (according to the formula), the smart move would be to sell them hand over fist. Eventually that would drive the price down to where it should be. But, oddly, traders weren’t doing that. They were presumably frightened that another crash like Black Monday could wipe them out. They never got over the fear. The volatility smile persists to this day.

The volatility smile perplexed Wall Street’s quants. For one thing,
it made a hash of their carefully calibrated hedging strategies. It also raised questions about the underlying theory itself.

“I realized that the existence of the smile was completely at odds with Black and Scholes’s 20-year-old foundation of options theory,” wrote Emanuel Derman, a longtime financial engineer who worked alongside Fischer Black at Goldman Sachs, in his book
My Life as a Quant
. “And, if the Black-Scholes formula was wrong, then so was the predicted sensitivity of an option’s price to movements in its underlying index. … The smile, therefore, poked a small hole deep into the dike of theory that sheltered options trading.”

Black Monday did more than that. It poked a hole not only in the Black-Scholes formula but in the foundations underlying the quantitative revolution itself. Stocks didn’t move in the tiny incremental ticks predicted by Brownian motion and the random walk theory. They leapt around like Mexican jumping beans. Investors weren’t rational, as quant theory assumed they were; they panicked like rats on a sinking ship.

Worse, the engine behind the crash, portfolio insurance, was the spawn of the quants, a product designed to
protect
investors from big losses. Instead, it created the very losses it was meant to avoid.

Not everyone suffered catastrophic losses on Black Monday. Princeton/Newport Partners, due to Thorp’s fancy footwork, lost only a few million dollars that day. After the crash, Thorp’s models, scanning the marketplace like heat-seeking missiles, sought out numerous good deals. The fund closed the month flat. For the year, the fund earned a 27 percent return, compared with a 5 percent gain by the S&P 500.

Thorp had managed to survive the most devastating drawdown in the history of the stock market. Everything was looking up. Then, out of the blue, disaster struck Princeton/Newport Partners. It was Ed Thorp’s black swan.

In mid-December
1987, an army of vans pulled up in front of a nondescript office complex in the heart of sleepy Princeton. A squad of fifty armed federal marshals clad in bulletproof vests burst from the
vans and rushed into the office of Princeton/Newport Partners, which was perched in a small space over a Häagen-Dazs shop.

They were searching for documents related to the fund’s dealings with Michael Milken’s junk bond empire at Drexel Burnham Lambert. The man in charge of the case was Rudolph Giuliani, the U.S. attorney for the Southern District of New York. He was trying to build more evidence for the government’s case against Drexel and was hoping employees of the hedge fund, threatened with stiff fines and possible prison terms, would turn against Milken.

It didn’t work. In August 1989, a Manhattan jury convicted five Princeton/Newport executives—including Regan—of sixty-three felony counts related to illegal stock trading plots. Thorp, more than two thousand miles away at the Newport Beach office and oblivious to the alleged dark dealings in the fund’s Princeton headquarters, was never charged. But Regan and the other convicted partners at Princeton/Newport refused to testify against Milken or acknowledge wrongdoing. Instead, they fought the government’s charges—and won. In June 1991, a federal appeals court tossed out the racketeering convictions in the government’s fraud case. Early the following year, prosecutors dropped the case. Not a single employee of Princeton/Newport spent a day in prison.

The biggest casualty of the government’s assault was Princeton/Newport. It became impossible for Thorp to keep the ship steady amid all the controversy, and his associates in Princeton were obviously distracted dealing with the charges against them. Worried investors pulled out of the fund.

Thorp decided
to simplify his life. He took a brief break from managing money for others, though he continued to invest his own sizable funds in the market.

He also worked as a consultant for pension funds and endowments. In 1991, a company asked Thorp to look over its investment portfolio. As he combed through the various holdings, he noticed one particular investment vehicle that had produced stunning returns throughout the 1980s. Every single year, it put up returns of 20 percent or more, far outpacing anything Thorp had ever seen—even Princeton/Newport.
Intrigued, and a bit dubious, he delved further into the fund’s strategies, requesting documents that listed its trading activities. The fund, based in New York’s famed Lipstick Building on Third Avenue, supposedly traded stock options on a rapid-fire basis, benefiting from a secret formula that allowed it to buy low and sell high. The trading record the fund sent Thorp listed the trades—how many options it bought, which companies, how much money it made or lost on the trades.

It took Thorp about a day to realize the fund was a fraud. The number of options it reported having bought and sold far outpaced the total number traded on public exchanges. For instance, on April 16, 1991, the firm reported that it had purchased 123 call options on Procter & Gamble stock. But only 20 P&G options
in total
had changed hands that day (this was well before the explosion in options trading that occurred over the following decade). Similar discrepancies appeared for trades on IBM, Disney, and Merck options, among others, Thorp’s research revealed. He told the firm that had made the investment to pull its money out of the fund, which was called Bernard L. Madoff Investment Securities.

In late 2008, the fund, run by New York financier Bernard Madoff, was revealed as the greatest Ponzi scheme of all time, a massive fraud that had bilked investors out of tens of billions. Regulators had been repeatedly warned about the fund, but they never could determine whether its trading strategies were legitimate.

While Thorp
was taking a break from the investing game, the stage for the amazing rise of the quants had been set. Peter Muller, working at a quant factory in California, was itching to branch out and start trading serious money. Cliff Asness was entering an elite finance program at the University of Chicago. Boaz Weinstein was still in high school but already had his eyes trained on Wall Street’s action-packed trading floors.

As Thorp wound down Princeton/Newport Partners, he handed off his hedge fund baton to a twenty-two-year-old prodigy who would go on to become one of the most powerful hedge fund managers in the world—and who would play a central role in the market meltdown that began in August 2007.

GRIFFIN

In 1990, Ed Thorp took a call from one of his longtime investors, a reclusive financier named Frank Meyer with a gimlet eye for talent. Meyer had a special request. “I’ve got a great prospect,” Meyer told Thorp, his gruff, no-nonsense voice booming over the line. He sounded as excited as a college football coach who’d just spotted the next Heisman Trophy winner. “One of the savviest guys I’ve ever met. Traded convertible bonds out of his dorm room on his grandmother’s bank account.”

“Who is he?”

“A whip-smart Harvard grad named Ken Griffin. Reminds me of you, Ed.”

“Harvard?” the MIT–educated Thorp snorted. “How old?”

“Twenty-one.”

“Wow, that is young. What do you want from me?”

“Docs.”

Hoping to save money, Meyer wanted to use Princeton/Newport’s offering documents as a template for a hedge fund he was setting up for Griffin, a lanky, six-foot math whiz with a singular focus on making money. Thorp agreed and shipped a copy of PNP’s legal papers (Thorp had renamed the fund Sierra Partners after the Giuliani debacle) to Meyer’s office. At the time, it typically cost roughly $100,000 to draft the papers needed to set up a hedge fund. Using the shortcut—Meyer’s lawyers essentially changed names on the partnership papers—it cost less than $10,000. The joke around Meyer’s office was that they used the law firm of Cookie & Cutter to launch Griffin’s fund. It would eventually be called Citadel Investment Group, a name designed to evoke the image of high ramparts that could withstand the most awesome financial onslaughts imaginable.

Meyer ran
a “fund of hedge funds” in Chicago called Glenwood Capital Management. A fund of funds invests in batches of other hedge funds, passing the gains on to clients while taking a cut for themselves, typically around 10¢ on the dollar. The fund of funds industry is massive today, with hundreds of billions of dollars under management (though it shrank like a punctured balloon after the credit crisis). When Meyer launched Glenwood in 1987, the industry was practically nonexistent.

Indeed, when Princeton/Newport Partners had closed its doors in the late 1980s, hedge funds were still an obscure backwater in the rapidly expanding global financial ecosystem, a Wild West full of quick-draw gunslingers such as Paul Tudor Jones and George Soros willing to heave millions in a single bet based on gut instincts. Other upstarts included an obscure group of market wizards in Princeton, New Jersey, called Commodity Corp., a cutting-edge fund that largely dabbled in commodity futures. Commodity Corp. spawned legendary traders such as Louis Moore Bacon (who went on to manage the $10 billion fund Moore Capital Management) and Bruce Kovner (manager of Caxton Associates, with $6 billion). In New York, an aggressive and
cerebral trader named Julian Robertson was in the process of turning a start-up stash of $8 million into more than $20 billion at Tiger Management. In West Palm Beach, a group of traders at a fund called Illinois Income Investors, better known as III or Triple I, was launching innovative strategies in mortgage-backed securities, currencies, and derivatives.