Monday, February 15, 2010

When the Money Grid Went Dark


In June 2005, John Mack returned to Morgan Stanley as CEO, replacing his bitter rival, the staid Philip Purcell, a one-time McKinsey consultant and the boss of Dean Witter. Since his departure four years earlier, the firm's shares had collapsed 40 percent.

Shareholders—and many of the firm's directors—wanted a more aggressive leader. Goldman Sachs, Bear Stearns and Lehman Brothers now followed a new market paradigm, and Morgan was not keeping pace.

Mack, a former bond trader, had been serving as chairman of the hedge fund giant Pequot Management. He acted swiftly, committing billions in risk capital to proprietary investing and trading. His objective: double revenues in five years while keeping costs flat.

By 2007, own-account trading was dominating the big Wall Street banks' banner profits. Morgan, like its competitors, was leveraged at more than 30 to 1, borrowing $30 for every dollar it owned.

Life was great. Mack and other Wall Street bosses were earning tens of millions of dollars, while their gargantuan firms controlled the world's capital flows.

And then the lights dimmed. It was August, and the party was ending.

In little more than a year, Bear, Lehman and Merrill Lynch would disappear. Morgan would come within days of collapse, and even mighty Goldman could not guarantee a certain future.

Scott Patterson's fascinating new book, The Quants, describes the extraordinary paradigm that catapulted Wall Street into the stratosphere, and ushered its sudden descent. "Quant" is Wall Street lingo for a mathematical whiz-kid, the nerd with the PhD from MIT or the University of Chicago.

For years, brokerage firms confined quants to backrooms, building models supporting front-line traders and research analysts. By the early 90s, quants were proving that their skills were much more valuable, though mostly at small hedge funds.

The big firms noticed, but did not commit completely to their labyrinthine models until after the dot-com meltdown. They were feasting just fine, thank you.

For all their size, Wall Street's mighty banks tend to focus their gambling on a handful of market activities, whether technology banking or proprietary trading—an ironic contrast to the mantra of diversification preached as they peddle their different products and services.

The tech bubble boosted profits, and bankers controlled Wall Street. Quantitative investing exploded from the ashes of the stock market collapse. Its breathtakingly complex strategies and their uncanny success lured billions of dollars from pension funds and endowments, not just wealthy individuals.

Wall Street's new titans were traders, wholly confident in the ability of black-box strategies to mint massive profits.

Character sketches

Using vivid character sketches, Mr. Patterson offers his reader a fast-paced narrative focused on quantdom's central figures. The godfather is Ed Thorp, a math genius whose books Beat the Dealer and Beat the Market became must-reads for the legions who followed him. Thorp devised a mathematical formula for card-counting, which he later applied to the markets as the pioneer of covertible bond arbitrage. Perhaps most important, he perfected a business model to sustain his strategy.

Other characters include Ken Griffin, the imperious founder of Citadel, with whom Thorp shared his trading strategy and business model; Cliff Asness, the hot-tempered founder of AQR; Jim Simons, the reclusive founder of Renaissance Capital; and Peter Muller and Boaz Weinstein, who orchestrated in-house hedge funds at Morgan Stanley and Deutsche Bank.

Sometimes friends, sometimes rivals, these kingpins share an obsession for poker, and would live well as professional players, if not for the enticement of Wall Street's billion dollar payoffs.

They work behind glass doors, travel in private jets and pursue the Truth.

"The Truth was the universal secret about the way the market worked that could only be discovered through mathematics. Revealed through the study of obscure patterns in the market, the Truth was the key to unlocking billions in profits."—The Quants

Another one of Mr. Patterson's core characters is Eugene Fama, who, he writes, "connected the dots and put the efficient-market hypothesis on the map as the central feature of modern portfolio theory". Professor Fama's hypothesis presents the notion of market equilibrium, where the market's various participants in hunting for inefficiency collectively create efficiency and balance.

As the market bounces around, its returns fall along a bell-shaped curve. For quants, the Truth occurs in detecting small price variances caused by market participants continuously working towards an equilibrium, and knowing that small moves are more likely than large ones.

Their mainframe computers deploy rapid-fire, complex algorithms that hunt for microscopic price discrepancies. Leverage allows them to expand small gains into massive gains. For years, they sourced (borrowed) cheap (low-interest rate) Yen-denominated capital, paying it back with their outsized returns and keeping the profits, the so-called carry trade.

Mr. Patterson explains how each of quants "was becoming part of and helping create a massive electronic network, a digitized, computerized money-trading machine that could shift billions around the globe in the blink of an eye, at the click of mouse". He defines this network as the "Money Grid", a machine with "octopuslike tentacles reaching to the farthest corners of civilization, yet it is also practically invisible".

Complex algorithms, the quants would learn, do not account for irrational human behavior, and once-in-every-10,000-years events can occur once every few years—or, even, every few days. The black swan—a term coined by quant-doubter Nassim Nicholas Tabel to describe unexpected events—does not just exist in Australia, it exists in every country on every continent.

Nor do they account for the dangerous concentrations of capital that form when copycat funds plow into similar positions.

New governance
Patterson avoids direct finger pointing, and does not portray quants as nefarious wrong-doers: rather as victims of miscalculated self-confidence. And while it's tempting to blame "hedgies" for collapsing the financial system, it would be wrong to do so.

The system itself allowed hedge funds to emerge and flourish. The irony of Mr. Mack concentrating and leveraging his firm's capital is that he nearly destroyed Morgan Stanley at the behest of his shareholders—or, rather, the core group which brought him back in 2005 to compete with Lehman Brothers and Bear Stearns.

Mr. Mack and his CEO cohorts bear a considerable portion of the blame, as they lorded over the system that fed aggressive risk-taking. But they weren't alone. Government contributed directly to the financial collapse, with poorly crafted legislation and insufficient regulation, in particular rules creating and fostering the sub-prime mortgage market and poor oversight of mounting system-wide risks.

Patterson's book reminds us that Wall Street governance needs to change. Financial innovation is too smart and happens too quickly for any government regulatory body to keep pace. The only way for the system to find balance is for its participants to regulate their own risk-taking.

Clearly, the publicly-traded investment bank model does not work, at least not as scripted. Take basic accounting rules. Even though a firm possesses considerable "intellectual capital"—and, in fact, could not exist without this capital—accounting rules don't force it capitalize this expense and place it on the balance sheet.

Instead bonuses appear as an expense item on the firm's P&L, inflating returns. If firms capitalized employee bonuses, shareholders would view risk-taking much differently.

Ideally, a firm would seek to align itself more closely with shareholders, or government would encourage this. The simplest means for this to happen would be for the firm to scrap its shareholder structure altogether, and return to its original partnership model. Goldman only listed in 1999, and arguably has performed best for having lasted the longest as a private partnership.

Once risk-capital becomes owners' capital the dynamic changes. The dollar you gamble isn't just someone else's dollar, it's mine. So be careful.

For all their perfection, black box models are not perfect. They had survived various currency and debt crises, the spectacular blow-up of Long-Term Capital Management, and numerous other market spasms. The hubris of the narrow cadre of individuals controlling capital flows—investment bankers, central bankers, and government officials—was their belief that the models were indomitable risk-reduction tools.

No doubt, new models will emerge, likely featuring behavioral finance and more "qualitative" elements. Already, many experts are concerned that quant-driven strategies targeting dark pools and flash trading could destabilize the financial system once again.

Until the system itself gets smarter, don't expect smart models to abate volatility anytime soon.