Goldman, upon learning about the offer, offered him a similar job at GSAM. Asness took it, reasoning that Goldman was closer to home in Roslyn Heights.
"So you"re taking the worse job because you"re a mama"s boy, huh?" his Pimco recruiter quipped.
Asness just laughed. He knew Goldman was the place for him. In 1994, soon after finishing his dissertation, Clifford Asness, Ph.D., launched the Quant.i.tative Research Group at Goldman Sachs. He was twenty-eight years old.
[image]WEINSTEIN[image]
One day in the early 1980s, Boaz Weinstein stared intently at an array of knights, p.a.w.ns, kings, and queens scattered before him. He was nervous and on the defensive. Across the chessboard sat his stone-faced opponent: Joshua Waitzkin, the boy-genius chess master eventually profiled in the 1993 film Searching for Bobby Fischer Searching for Bobby Fischer.
Weinstein lost the match against Waitzkin, played at the famed Manhattan Chess Club, but that didn"t dampen his enthusiasm for chess. He was soon beating his older sister so consistently that she quit playing him. Desperate to keep playing at home, he bugged his father into buying him a computerized chess game. By the time he was sixteen, Weinstein was a national "life master," a few steps away from grandmaster, and No. 3 in the United States in his age group.
Chess wasn"t everything to young Weinstein. There was also the tricky game of investing. A weekly ritual at the Weinstein household was watching the Friday night show Wall Street Week with Louis Rukeyser Wall Street Week with Louis Rukeyser. He started dabbling in the stock market with his spare change, with some success. In his junior year as a student at New York"s elite Stuyvesant High School, he won a stock-picking contest sponsored by Newsday Newsday, beating out five thousand other contestants. Weinstein realized that in order to come out on top, he"d have to make picks with the potential for ma.s.sive gains. His winning strategy was a primitive form of arbitrage: he shorted big gainers while picking beaten-down stocks he thought could rise sharply. The strategy showed that Weinstein could size up a situation and see what it would take to win-even if it was a ma.s.sive gamble.
Indeed, growing up in the privileged Manhattan neighborhood of the Upper East Side, he seemed to have money all around him. While Griffin, Muller, and Asness were all raised relatively far from the cacophonous din of Wall Street, Weinstein practically grew up on a trading floor. When he was fifteen, he took a part-time job doing clerical work for Merrill Lynch, the prestigious firm known for its "thundering herd" of brokers. During his downtime, he would scan research reports scattered around the office, looking for investing tips.
Meanwhile, his sister had taken a job at Goldman Sachs. Weinstein would visit after hours and roam the warrens of the storied bank, dreaming of future glory. One day, while visiting her office, he made a pit stop at the men"s room. He ran into David DeLucia, a junk bond trader he recognized from a chess club they both played at. DeLucia gave Weinstein a quick tour of Goldman"s trading floor, which the starry-eyed Weinstein parlayed into a series of interviews. He eventually landed a part-time job working on Goldman"s high-yield bond trading desk when he was just nineteen years old.
In 1991, he started taking cla.s.ses at the University of Michigan, majoring in philosophy, drawn to the hard logic of Aristotle and the Scottish skeptic David Hume. He also became interested in blackjack, and in 1993 picked up Ed Thorp"s Beat the Dealer Beat the Dealer. He loved how card counting gave him a statistical ability to predict the future. It made him think of Mark Twain"s book A Connecticut Yankee in King Arthur"s Court A Connecticut Yankee in King Arthur"s Court, in which the main character, Hank Morgan, travels back in time and saves his neck by predicting a solar eclipse, having memorized all eclipses up to his own time.
But Weinstein"s true pa.s.sion was trading. He knew that once he left school, his first stop would be Wall Street. After graduating in 1995, he took a spot on the global debt trading desk at Merrill Lynch, where he"d had his first taste of Wall Street. Two years later he moved to a smaller bank, Donaldson Lufkin Jenrette, lured by DeLucia, who"d left Goldman. Weinstein thought it would be a good idea to work at a smaller firm, where he would have a better opportunity to run his own trading desk. At DLJ, he learned the nuts and bolts of credit trading by trafficking in floating-rate notes, bonds that trade with variable interest rates.
For an up-and-coming trader with a nose for gambling such as Weinstein, it was an ideal time to launch a career on Wall Street. A boom in exotic credit derivatives was about to take off. Derivatives on stocks, interest rates, and commodities had been around for years. But not until the mid-1990s did the financial engineers concoct ways to trade derivatives linked to credit.
It proved to be a revolution that changed the way Wall Street worked forever. Young bucks who hadn"t been trained in the old ways of credit trading-when all you needed to worry about was whether the borrower would pay the loan back and where interest rates might go-could dance circles around dinosaur rivals who couldn"t compete in the strange new world of derivatives. What"s more, banks were increasingly encouraging traders to push the envelope and generate fat returns. And a golden age of hedge funds, once largely the domain of freewheeling eccentrics such as George Soros or math geeks such as Ed Thorp, was taking off. Banks would compete against hedge funds for profits, eventually morphing into giant, lumbering hedge funds themselves.
In 1998, Weinstein learned that a job had opened up at the German firm Deutsche Bank, where a number of the traders and researchers he"d worked with at Merrill had popped up. Deutsche was making a big push to transform itself from a stuffy, traditional commercial bank into a derivatives powerhouse. It was laying plans to purchase Bankers Trust, a cowboy New York investment bank packed with quants who thrived on designing complex securities. The deal, announced soon after Weinstein joined the firm, would make Deutsche the world"s largest bank, with more than $800 billion in a.s.sets at its fingertips.
Weinstein thought it might be a good fit-the job was for a small desk, with little compet.i.tion, at a firm making a big push into a field he was certain had plenty of room to grow. Soon after joining Deutsche, he was learning how to trade a relatively new derivative known as credit-linked notes. Eventually they would become more commonly called credit default swaps.
Credit default swaps are derivatives because their value is linked to an underlying security-a loan. They were created in the early 1990s by Bankers Trust, but it wasn"t until the math wizards at J. P. Morgan got their mitts on them that credit derivatives really took off. When Weinstein arrived at Deutsche, only a few notes or swaps traded every day-light-years from the megatrillion-dollar trading in swaps that went on in cybers.p.a.ce a decade later.
Weinstein was taught how the notes worked by Deutsche Bank"s global head of credit trading, Ronald Tanemura, a trailblazer of the credit derivatives world who"d cut his teeth juggling complex securities in j.a.pan and Europe for Salomon Brothers in the 1980s.
Credit derivatives were, in a way, like insurance contracts for a loan, Tanemura explained to Weinstein at Deutsche"s New York headquarters, which sat in the shadow of the World Trade Center. Investors who buy the insurance on the loan pay a premium for the right to collect if the borrower goes belly up. The buyer and seller of the insurance basically swap their exposure to the risk that the bond will default.
Weinstein quickly grasped the concept. Tanemura could tell he was a quick learner and a hard worker. One colleague thought he was also a bit on the nervous side, jittery and self-conscious.
The swaps were commonly priced according to how much a trader would pay to insure several million dollars" worth of bonds over a certain period of time, often five years, Tanemura explained. For instance, it may cost about $1 million to purchase insurance for $10 million worth of General Motors debt over five years, implying a 10 percent chance that the automaker would default during that time period. If GM does default, the party that provided insurance would need to cough up $10 million, or some percentage of the amount determined after the bankruptcy.
Most of the trades were "bespoke," custom-designed between two trading parties like a tailored London suit. "Credit derivatives basically give our customers exactly what they need," Tanemura added. "And we supply it."
Weinstein soaked it up like a sponge with his photographic memory-and soon realized that the CDS market wasn"t about buy and hold until the bond matured, it was about the perception of default. Traders didn"t need to wait around for a company to blow up. A trader who purchased a swap on GM for $1 million could potentially sell the swap to another trader later on for, say, $2 million, simply on the perception that GM"s fate had worsened.
At the end of the day, it was all very simple: traders were betting on a level, just like a stock. If the company looked shaky, the CDS cost would rise.
In theory, hundreds of swaps, or more, can be written on a single bond. More commonly, swaps are written on baskets of hundreds or thousands of bonds and on other kinds of loans. They could metastasize without end-and did-reaching a value of more than $60 trillion a decade after Weinstein arrived on the scene.
What"s more, since the trades were commonly done on a case-by-case basis on the so-called over-the-counter market, with no central clearinghouse to track the action, CDS trading was done in the shadow world of Wall Street, with virtually no regulatory oversight and zero transparency. And that was just the way the industry wanted it.
Soon after Weinstein took the job, his boss (not Tanemura) jumped ship. Suddenly he was the only trader at Deutsche in New York juggling the new derivatives. It was no big deal, or at least it seemed that way. It was a sleepy business, and few traders even knew what they were or how to use the exotic swaps-or had any idea that they represented a new front in the quants" ascendancy over Wall Street. Indeed, they would prove to be one of the most powerful weapons in their a.r.s.enal. The quants were steadily growing, moving ever higher into the upper echelons of the financial universe.
What could go wrong?
As it turned out, a great deal-a four-letter word: LTCM.
In 1994, John Meriwether, a former star bond trader at Salomon Brothers, launched a ma.s.sive hedge fund known as Long-Term Capital Management. LTCM was manned by an all-star staff of quants from Salomon as well as future n.o.bel Prize winners Myron Scholes and Robert Merton. On February 24 of that year, the fund started trading with $1 billion in investor capital. 1994, John Meriwether, a former star bond trader at Salomon Brothers, launched a ma.s.sive hedge fund known as Long-Term Capital Management. LTCM was manned by an all-star staff of quants from Salomon as well as future n.o.bel Prize winners Myron Scholes and Robert Merton. On February 24 of that year, the fund started trading with $1 billion in investor capital.
LTCM, at bottom, was a thought experiment, a laboratory test conducted by academics trained in mathematics and economics-quants. The very structure of the fund was based on the breakthroughs in modern portfolio theory that started in 1952 with Harry Markowitz and even stretched as far back as Robert Brown in the nineteenth century.
LTCM specialized in relative-value trades, looking for relationships between securities that were out of whack. It made money by placing bets on pairs of securities that drifted out of their natural relationship, ringing the cash register when the natural order-the Truth-was restored.
One of LTCM"s favorite bets was to purchase old, "off the run" Treasuries-bonds that had been issued previously but had been supplanted by a fresh batch-while selling short the new "on the run" bonds. It was a trade that dated back to Meriwether"s days at Salomon Brothers. Meriwether had noticed that the newest batch of bonds of equal maturity-ten years, thirty years, five years, whatever-almost always traded at a higher price than bonds that had gone into retirement. That made no sense. They were essentially the same bond. The reason for the higher price was that certain investors-mutual funds, banks, foreign governments-placed a premium on the fact that newer bonds were easy to trade. They were liquid. That made them more expensive than more seasoned bonds. Okay Okay, thought Meriwether, I"ll take the liquidity risk, and the premium, betting that the bonds eventually converge in price I"ll take the liquidity risk, and the premium, betting that the bonds eventually converge in price.
One problem with this trade is that it doesn"t pay much. The spread between new and old bonds is fairly small, perhaps a few basis points (a basis point is one-hundredth of a percentage point). The solution: leverage. Just borrow as much cash as possible, amp up the trade, and you basically have a printing press for money.
Meriwether spent $20 million on a state-of-the-art computer system and hired a crack team of financial engineers to run the show at LTCM, which set up shop in Greenwich, Connecticut. It was risk management on an industrial level.
The princ.i.p.al risk management tool used by LTCM had been created by a team of quants at J. P. Morgan. In the early 1990s, Wall Street"s banks were desperate for a methodology to capture the entire risk faced by the bank on any given day. It was a monumental task, since positions could fluctuate dramatically on a daily basis. What was required was a sophisticated radar system that could monitor risk on a global level and spit out a number printed on a single sheet of paper that would let the firm"s CEO sleep at night.
Getting the daily positions was hard but not impossible. Advances in computer technology enabled rapid calculations that could aggregate all the bank"s holdings. The trouble was determining the global risk. The model the J. P. Morgan quants created measured the daily volatility of the firm"s positions and then translated that volatility into a dollar amount. It was a statistical distribution of average volatility based on Brownian motion. Plotted on a graph, that volatility looked like a bell curve.
The result was a model they called value-at-risk, or VAR. It was a metric showing the amount of money the bank could lose over a twenty-four-hour period within a 95 percent probability.
The powerful VAR radar system had a dangerous allure. If risk could be quantified, it also could be controlled through sophisticated hedging strategies. This belief can be seen in LTCM"s October 1993 prospectus: "The reduction in the Portfolio Company"s volatility through hedging could permit the leveraging up of the resulting position to the same expected level of volatility as an unhedged position, but with a larger expected return."
If you can make risk disappear-poof!-in a quant.i.tative sleight of hand, you can layer on even more leverage without looking like a reckless gambler.
Others weren"t so sure. In 1994, a financial engineering firm doing consulting work for LTCM was also working with Ed Thorp, who that year had started a new stat arb fund in Newport Beach called Ridgeline Partners. An employee of the consulting firm told Thorp about LTCM and said it would be a great investment.
Thorp was familiar with Scholes, Merton, and Meriwether-but he hesitated. The academics didn"t have enough real-world experience, he thought. Thorp had also heard that Meriwether was something of a high roller. He decided to take a pa.s.s.
For a while, it looked like Thorp had made the wrong call. LTCM earned 28 percent in 1994 and 43 percent the following year. In 1996, the fund earned 41 percent, followed by a 17 percent gain in 1997. Indeed, the fund"s partners grew so confident that at the end of 1997 they decided to return $3 billion in capital to investors. That meant more of the gains from LTCM"s trades would go to the partners themselves, many of whom were plowing a great deal of their personal wealth into the fund. It was the equivalent of taking all of one"s chips, shoving them into the pot, and announcing, "All in."
Meriwether and his merry band of quants had been so successful, first at Salomon Brothers and then at LTCM, that bond trading desks across Wall Street, from Goldman Sachs to Lehman Brothers to Bear Stearns, were doing their level best to imitate their strategies. That ultimately spelled doom for LTCM, known by many as Salomon North.
The first blow was a mere mosquito bite that LTCM barely felt. Salomon Brothers" fixed-income arbitrage desk had been ordered to shut down by its new masters, Travelers Group, which didn"t like the risk they were taking on. As Salomon began to unwind its positions-often the very same positions held by LTCM-Meriwether"s arbitrage trades started to sour. It set off a cascade as computer models at firms with similar positions, alerted to trouble, spat out more sell orders.
By August 1998, the liquidation of relative-value trades across Wall Street had caused severe pain to LTCM"s positions. Still, the fund"s partners had little clue that disaster was around the corner. They believed in their models. Indeed, the models were telling them that the trades were more attractive than ever. They a.s.sumed that other arbitrageurs in the market-Fama"s piranhas-would swoop in and gobble up the free lunch. But in the late summer of 1998, the piranhas were nowhere to be found.
The fatal blow came on August 17, when the Russian government defaulted on its debt. It was a catastrophe for LTCM. The unthinkable move by Russia shook global markets to their core, triggering, in the parlance of Wall Street, a "flight to liquidity."
Investors, fearful of some kind of financial collapse, piled out of anything perceived as risky-emerging-market stocks, currencies, junk bonds, whatever didn"t pa.s.s the smell test-and s.n.a.t.c.hed up the safest, most liquid a.s.sets. And the safest, most liquid a.s.sets in the world are recently issued, on-the-run U.S. Treasury bonds.
The trouble was, LTCM had a ma.s.sive short bet against those on-the-run Treasuries because of its ingenious relative-value trades.
The off-the-run/on-the-run Treasury trade was crushed. Investors were loading up on newly minted Treasuries, the ones LTCM had shorted, and selling more seasoned bonds. They were willing to pay the extra toll for the liquidity the fresher Treasuries provided. It was a kind of market that didn"t exist in the quant.i.tative models created by LTCM"s n.o.bel Prize winners.
As Roger Lowenstein wrote in his chronicle of LTCM"s collapse, When Genius Failed: When Genius Failed: "Despite the ballyhooed growth in derivatives, there was no liquidity in credit markets. There never is when everyone wants out at the same time. This is what the models had missed. When losses mount, leveraged investors such as Long-Term are forced to sell, lest their losses overwhelm them. When a firm has to sell in a market without buyers, prices run to the extremes beyond the bell curve." "Despite the ballyhooed growth in derivatives, there was no liquidity in credit markets. There never is when everyone wants out at the same time. This is what the models had missed. When losses mount, leveraged investors such as Long-Term are forced to sell, lest their losses overwhelm them. When a firm has to sell in a market without buyers, prices run to the extremes beyond the bell curve."
Prices for everything from stocks to currencies to bonds held by LTCM moved in a bizarre fashion that defied logic. LTCM had relied on complex hedging strategies, ma.s.sive hairb.a.l.l.s of derivatives, and risk management tools such as VAR to allow it to leverage up to the maximum amount possible. By carefully hedging its holdings, LTCM could reduce its capital, otherwise known as equity. That freed up cash to make other bets. As Myron Scholes explained before the disaster struck: "I like to think of equity as an all-purpose risk cushion. The more I have, the less risk I have, because I can"t get hurt. On the other hand, if I have systematic hedging-a more targeted approach-that"s interesting because there"s a trade-off: it"s costly to hedge, but it"s also costly to use equity."
With a razor-thin capital cushion, LTCM"s a.s.sets evaporated into thin air. By the end of August the fund had lost $1.9 billion, 44 percent of its capital. The plunge in capital caused its leverage ratio to spike to an estimated 100 to 1 or more. In desperation, LTCM appealed to deep-pocketed investors such as Warren Buffett and George Soros. Buffett nearly purchased LTCM"s portfolio, but technicalities nixed the deal at the last minute. Soros, however, wouldn"t touch it. LTCM"s quant.i.tative approach to investing was the ant.i.thesis of the trade-by-the-gut style that Soros was famous for. According to Soros: "The increasing skill in measuring risk and modeling risk led to the neglect of uncertainty at LTCM, and the result is you could use a lot more leverage than you should if you recognize uncertainty. LTCM used leverage far above what should have been the case. They didn"t recognize that the model is flawed and it neglected this thick tail in the bell curve."
The wind-down of the fund was brutal, involving a ma.s.sive bailout by a consortium of fourteen U.S. and European banks organized by the Federal Reserve. Many of the partners who had invested their life savings in the fund suffered ma.s.sive personal losses.
As painful as the financial cost was, it was an even more humiliating fall for a group of intelligent investors who had ridden atop the financial universe for years and lorded it over their dumber, slower, less quant.i.tatively gifted rivals. What"s more, their cavalier use of leverage nearly shattered the global financial system, hurting everyday investors who were increasingly counting on their 401(k)s to carry them through retirement.
LTCM"s fall didn"t just tarnish the reputation of its high-profile partners. It also gave a black eye to an ascendant force on Wall Street: the quants. Long-Term"s high-powered models, its s.p.a.ce-age risk management systems as advanced as NASA"s mission control, had failed in spectacular fashion-just like that other quant concoction, portfolio insurance. The quants had two strikes against them. Strike three would come a decade later, starting in August 2007.
Ironically, the collapse of LTCM proved to be one of the best things that ever happened to Boaz Weinstein. As markets around the world descended into chaos and investors dove for safety in liquid markets, the credit derivatives business caught fire. Aside from Deutsche Bank and J. P. Morgan, other banking t.i.tans started to leap into the game: Citigroup, Bear Stearns, Credit Suisse, Lehman Brothers, UBS, the Royal Bank of Scotland, and eventually Goldman Sachs, Merrill Lynch, Morgan Stanley, and many others, lured by the lucrative fees for brokering the deals, as well as the ability to unload unwanted risk from their balance sheets. Banks and hedge funds sought to protect themselves from the mounting turmoil by lapping up as much insurance as they could get on bonds they owned. Others, including American International Group, the insurance behemoth-specifically its hard-charging London unit full of quants who specialized in derivatives, AIG Financial Products-were more than willing to provide that insurance. collapse of LTCM proved to be one of the best things that ever happened to Boaz Weinstein. As markets around the world descended into chaos and investors dove for safety in liquid markets, the credit derivatives business caught fire. Aside from Deutsche Bank and J. P. Morgan, other banking t.i.tans started to leap into the game: Citigroup, Bear Stearns, Credit Suisse, Lehman Brothers, UBS, the Royal Bank of Scotland, and eventually Goldman Sachs, Merrill Lynch, Morgan Stanley, and many others, lured by the lucrative fees for brokering the deals, as well as the ability to unload unwanted risk from their balance sheets. Banks and hedge funds sought to protect themselves from the mounting turmoil by lapping up as much insurance as they could get on bonds they owned. Others, including American International Group, the insurance behemoth-specifically its hard-charging London unit full of quants who specialized in derivatives, AIG Financial Products-were more than willing to provide that insurance.
Another boom came in the form of a new breed of hedge funds such as Citadel-or Citadel copycats-that specialized in convertible-bond arbitrage. Traditionally, just as Ed Thorp had discovered in the 1960s, the strategy involved hedging corporate bond positions with stock. Now, with credit default swaps, there was an even better way to hedge.
Suddenly, those exotic derivatives that Weinstein had been juggling were getting pa.s.sed around like baseball cards. By late 2000, nearly $1 trillion worth of credit default swaps had been created. Few knew more about how they worked than the baby-faced card-counting chess whiz at Deutsche Bank. In a flash, thanks in part to Russia"s default and LTCM"s collapse, Weinstein went from being a bit player to a rising star at the center of the action, putting him on the fast track to becoming one of the hottest, highest-paid, and most powerful credit traders on Wall Street.
THE WOLF
Ona spring afternoon in 1985, a young mortgage trader named Aaron Brown strode confidently onto the trading floor of Kidder, Peabody & Co."s Manhattan headquarters at 20 Exchange Place. Brown checked his watch. It was two o"clock, the time Kidder"s bond traders gathered nearly every day for the Game. Brown loved the Game. And he was out to destroy it. spring afternoon in 1985, a young mortgage trader named Aaron Brown strode confidently onto the trading floor of Kidder, Peabody & Co."s Manhattan headquarters at 20 Exchange Place. Brown checked his watch. It was two o"clock, the time Kidder"s bond traders gathered nearly every day for the Game. Brown loved the Game. And he was out to destroy it.
This is going to be good, Brown thought as Kidder"s traders gathered around. It was a moment he"d been planning for months.
As with any evolutionary change in history, there"s no single shining moment that marks the quants" ascent to the summit of Wall Street"s pyramid. But the quants certainly established a base camp the day Brown and his like-minded friends beat Liar"s Poker. any evolutionary change in history, there"s no single shining moment that marks the quants" ascent to the summit of Wall Street"s pyramid. But the quants certainly established a base camp the day Brown and his like-minded friends beat Liar"s Poker.
At the time, the quants were known as rocket scientists, since many came from research hotbeds such as Bell Labs, where cell phones were invented, or Los Alamos National Laboratory, birthplace of the atomic bomb. Wall Street"s gut traders eventually proved to be no match for such explosive brainpower.
Michael Lewis"s Wall Street cla.s.sic, Liar"s Poker Liar"s Poker, exemplified and exposed the old-school Big Swinging d.i.c.k trader of the 1980s, the age of Gordon Gekko"s "greed is good." Lewis Ranieri, the mortgage-bond trader made famous in the book, made huge bets based on his burger-fueled gut. Michael Milken of Drexel Burhman for a time ruled the Street, financing b.a.l.l.sy leveraged buyouts with billions in junk bonds. Nothing could be more different from the cerebral, computerized universe of the quants.
Those two worlds collided when Aaron Brown strode onto Kidder"s trading floor. As an up-and-coming mortgage trader at a rival New York firm, Brown was an interloper at Kidder. And he was hard to miss. A tall bear of a man with a rugged brown beard, Brown stood out even in a crowd of roughneck bond traders.
As Brown watched, a group of Kidder traders gathered in a circle, each with a fresh $20 bill clutched in his palm. They were playing a Wall Street version of the game of chicken, using the serial numbers on the bills to bluff each other into submission. The rules were simple. The first trader in the circle called out some small number, such as four 2s. It was a bet that the serial numbers of all of the twenties in the circle collectively contained at least four 2s-a pretty safe bet, since each serial number has eight digits.
The next trader in the circle, moving left, had a choice. He could up the ante-four of a higher number (in this case, higher than 2) or five or more of any number-or he could call. If he called and there were, in fact, four 2s among the serial numbers, he would have to pay everyone in the circle $100 each (or whatever sum was agreed upon when the game began).
This was meant to continue until someone called. Usually the bets would rise steadily, to something on the order of twelve 9s or thirteen 5s. Then, when the next man-and in the 1980s they were almost always men-called, it would be time to check the twenties to see if the last trader who bet was correct. Say the last bet was twelve 9s. If the bills did in fact have twelve 9s, the trader who called would have to pay everyone. If the bills didn"t have twelve 9s, the trader who made the bet paid up.
In Lewis"s book, the game involved Salomon chairman John Gutfreund and the firm"s star bond trader John Meriwether, future founder of the doomed hedge fund LTCM. One day, Gutfreund challenged Meriwether to play a $1 million hand of Liar"s Poker. Meriwether shot back: "If we"re going to play for those kind of numbers, I"d rather play for real money. Ten million dollars. No tears." Gutfreund"s response as he backed away from Meriwether"s bluff: "You"re crazy."
Top traders such as Meriwether dominated Liar"s Poker. There was a pecking order in the game that gave an advantage to players who made the earliest guesses, and the top traders always somehow managed to be first in line. Obviously no one would challenge a call of four 2s. But as the game moved toward the end of the line, things got a lot more risky. And the poor schleps at the end of the line were usually the quants, the big-brained rocket scientists. Like Aaron Brown.
The quants were deploying all the firepower of quantum physics, differential calculus, and advanced geometry to try to subdue the rebellious forces of the market. But in the 1980s, they were at best second-cla.s.s citizens on investment banks" trading floors. The kings of Wall Street were the trade-by-the-gut swashbucklers who relied more on experience and intuition than on number crunching.
The quants were not happy about the situation. They especially didn"t like being victimized on a daily basis by soft-brained Big Swinging d.i.c.ks playing Liar"s Poker, a game that was almost purely determined by probabilities and statistics. Quant stuff.
Brown fumed over the trader-dominated system"s abuse of the quants. He knew about odds and betting systems. As a teenager he"d haunted the backroom poker games in Seattle and had sat at more than one high-stakes table in Las Vegas, going head-to-head with some of the smartest cardsharps in the country. And he had his pride. So Brown set about beating Liar"s Poker.
Brown first realized an important fact about the game: you have to be highly confident to issue a challenge. In a ten-person game, if you"re right when you issue a challenge, you gain $100-but if you"re wrong, you lose $900. In other words, you wanted to be 90 percent certain that you were correct to challenge. If he could figure out a pattern for making bets and challenges, he would have an edge over the traders, who were basically playing by gut instinct. The quants would know when to keep betting and when to challenge.
Brown crunched the numbers and came up with a key insight: A game of Liar"s Poker follows one of two paths. In one path, a single number is pa.s.sed around, and no one changes the number for the entire round until a challenge is made (five 2s, seven 2s, ten 2s, etc.). In the other path, someone does change the number-usually, Brown figured, somewhere around the tenth bid. In the first path, there is virtually no chance of seeing the same digit appear fourteen times or more in a group of ten $20 bills. But in the second path, if someone changes the number and ups the bid, that often means he has a large number of the same digit on his bill, perhaps three of four. That boosts the odds significantly that there are more than fourteen instances of that digit in the circle.
Knowing how the two paths differed, along with the odds that accompanied each challenge, helped Brown crack the game. It wasn"t rocket science, but he believed it was enough to do the trick.
He started circulating his strategy on electronic bulletin boards, and even created a simulator that let the quants practice on their home computers. They focused on speed. Rapid-fire bets would unnerve the traders. They also realized it was often optimal to raise the bets dramatically if they had more than one of the same digit on their twenty, something that hadn"t normally been done in the past. A bet of eight 6s could suddenly shoot to fourteen 7s.
Their testing complete, the quants finally decided to put their strategy into action on Kidder Peabody"s trading floor. Brown surveyed the action from a distance, chuckling to himself as the bidding started off as normal. The traders were predictable, playing it safe: four 2s.
When the quants" turn came, the bids came in fast and furious. Bid ... bid ... bid. Ten 7s. Twelve 8s. Thirteen 9s. They machine-gunned around the circle back to the top trader, who had started the bidding. Kidder"s traders were dumbfounded. The silence lasted a full minute. The quants struggled to keep straight faces. Brown nearly doubled up with laughter.
The head trader finally decided to challenge the last quant. Bad move. There were fifteen 9s in the circle. He lost, but he refused to pay, accusing the quants of cheating. The quants just laughed, high-fiving. Brown had expected this. Traders never admit to losing.
The Liar"s Poker game at Kidder Peabody quietly died off soon after the quant uprising. Brown"s strategy spread to quants at other firms. Within a year, Liar"s Poker had virtually vanished from Wall Street"s trading floors. The quants had killed it.
The quants were proving themselves to be a force to be reckoned with on Wall Street. No longer would they stand at the end of the line and be victimized by the Big Swinging d.i.c.ks.
Indeed, the quants were flooding into Wall Street in the 1980s from outposts such as BARRA in Berkeley, where Muller was earning his quant chops by creating factor models, or the University of Chicago, where Asness was studying at the feet of Fama and French. The rise of the personal computer, increased volatility due to fluctuating inflation and interest rates, and options and futures exchanges in Chicago and New York created the perfect environment for the brainiacs from academia. Physicists, electrical engineers, even code breakers trained by the military-industrial complex found that they could use the math they"d always loved to make millions in the financial markets. Eventually programs dedicated to the singular goal of training financial engineers cropped up in major universities around the country, from Columbia and Princeton to Stanford and Berkeley.
The first wave of quants went to banks such as Salomon Brothers, Morgan Stanley, and Goldman Sachs. But a few renegades struck off on their own, forming secretive hedge funds in the tradition of Ed Thorp. In a small, isolated town on Long Island one such group emerged. In time, it would become one of the most successful investing powerhouses the world had ever seen. Its name was Renaissance Technologies.
[image]
It is fitting that Renaissance Technologies, the most secretive hedge fund in the world, founded by a man who once worked as a code breaker for the U.S. government, is based in a small Long Island town that once was the center of a Revolutionary War spy ring.
The town of Setauket dates from 1655, when a half dozen men purchased a thirty-square-mile strip of land facing Long Island Sound from the Setalcott Indian tribe. When the War for Independence started more than a century later, it had become the most densely settled town in the region. Long Island largely lay in the hands of the British during the war after George Washington"s defeat in the Battle of Brooklyn in 1776. Setauket, a port town, boasted its share of guerillas, however. The redcoats cracked down, turning it into a garrison town.
The Culver Spy Ring sprang up a year later. Robert Townsend of nearby Oyster Bay posed as a Tory merchant in Manhattan to gather information on British maneuvers. He pa.s.sed along information to an innkeeper in Setauket who frequently traveled to New York, who relayed the messages to a Setauket farmer, who handed the intelligence to a whaleboat captain named Caleb Brewster. Brewster carried the package across Long Island Sound to Setauket native Major Benjamin Tallmadge, who was headquartered in Connecticut. At last, Tallmadge posted the messages to General Washington.
After the war, Washington made a tour of Long Island and visited Setauket to meet the spies. He stayed at Roe"s Tavern on the night of April 22, 1790, and wrote in his diary that the town was "tolerably decent."
In Washington"s day, Roe"s Tavern was located on a road that"s now called Route 25A-the same road where Renaissance Technologies" headquarters can be found today.
Renaissance"s flagship Medallion fund, launched in the late 1980s, is considered by many to be the most successful hedge fund in the world. Its returns, at roughly 40 percent a year over the course of three decades, are by a wide margin unmatched in the investing world. By comparison, before the recent stock market implosion, Warren Buffett"s storied Berkshire Hathaway averaged an annual return of about 20 percent. (Of course, scale matters: Medallion has about $5 billion in capital, while Berkshire is worth about $150 billion, give or take a few billion.) Indeed, Medallion"s phenomenal returns have been so consistent that many in quantdom wonder whether it possesses that most elusive essence of all: the Truth.
As a toddler growing up in a small town just outside of Boston, James Harris Simons was stunned to learn that a car could run out of gas. He reasoned that if the tank was half full, and then lost another half, and another half, it should always retain half of the previous amount. He had stumbled upon a logical riddle known as Zeno"s paradox, not exactly common fare for a preschooler. toddler growing up in a small town just outside of Boston, James Harris Simons was stunned to learn that a car could run out of gas. He reasoned that if the tank was half full, and then lost another half, and another half, it should always retain half of the previous amount. He had stumbled upon a logical riddle known as Zeno"s paradox, not exactly common fare for a preschooler.
Simons excelled at math in high school, and in 1955 he enrolled at MIT. He soon caught the poker bug, playing with friends into the late hours of the night before piling into his Volkswagen Beetle and driving to Jack & Marion"s deli in nearby Brookline for breakfast.
Simons cruised through MIT"s bachelor"s program in math in three years, aced its master"s program in one, and then enrolled in Berkeley"s Ph.D. program, studying physics. At Berkeley, he got his first taste of commodities trading, making a tidy sum on soybeans. After earning his doctorate, Simons taught cla.s.ses at MIT before moving up the road to Harvard. Dissatisfied with a professor"s salary, he took a job with the Inst.i.tute for Defense a.n.a.lysis, a nonprofit research wing of the Defense Department.
The IDA had been established in the mid-1950s to provide civilian a.s.sistance to the military"s Weapons Systems Evaluation Group, which studies technical aspects of newfangled weapons. By the time Simons arrived, the IDA had set up a branch in Princeton that had become a haven for Cold War code breakers.
The Vietnam War was raging, aggravating many of the more liberal academic types who worked at civilian research labs such as IDA. In 1967, a former chairman of the Joint Chiefs of Staff, Maxwell Taylor, president of IDA, wrote an article in favor of the war for the New York Times Magazine New York Times Magazine. The article elicited an acid response from Simons. "Some of us at the inst.i.tution have a different view," the twenty-nine-year-old Simons wrote in a letter to the magazine"s editors, which was published in October 1967. "The only available course consistent with a rational defense policy is to withdraw with the greatest possible dispatch."
The letter apparently cost Simons his job. But it didn"t take him long to find a new one. In 1968, he took the position of chairman of the math department at the State University of New York at Stony Brook, on Long Island and just up the road from Setauket. He gained a reputation for aggressively recruiting top talent, building the department into a mecca for math prodigies around the country.
Simons left Stony Brook in 1977, a year after winning the Oswald Veblen Prize, one of the highest honors in the geometry world, awarded by the American Mathematics Society every five years. With Shiing-Shen Chern, he developed what"s known as the Chern-Simons theory, which became a key component of the field of string theory, a hypothesis that the universe is composed of tiny strings of energy humming in multidimensional s.p.a.ces.