Scott Patterson covered the markets as a reporter for the Wall Street Journal during the market run up, credit crisis and collapse.
He details the impact in his book The Quants — a highly readable, very entertaining look at the new breed of mathematicians and financial engineers who got caught in the middle of it all.
I spent some time with Scott chatting about the book, the players in it, and life after the WSJ.
Yesterday, was Part I of our interview; Here is part II
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Barry Ritholtz: So if this went in in 2008, the question I was leading up to earlier was…let’s go through some of the characters and find out what happened to them, it’s now two, almost three years later.
Did anybody blow up, did anybody recover? What’s the net takeaway?
Scott Patterson:: Ken Griffin and Citadel is a good example, in late 2008, as I was trying to put the finishing touches on this book, and Ken is a guy that I’ve been following, and he’s really interesting in the arc of this book. Thorp helps set up Citadel, and he actually teaches Griffin some of his trading strategies, he gives him a lot of his own documents and papers, sort of passes the baton.
Q: Does Thorp have a piece of Citadel?
A: He was invested in Citadel from the get-go, so he followed Citadel, and then in 2008, Citadel came a hair’s breadth from imploding, they were totally on the edge, the banks were…
Q: Almost out of capital?
A: Yeah, a lot of it is theoretical, because there’s a lot of derivatives involved, they had exposures all across Wall Street, and they lost billions of dollars, five or six billion dollars. Their main hedge funds, Kensington and Wellington, were down about 55 percent, and these were 15, 16 billion dollar hedge funds. I don’t know if you remember, but there was a time when there were a lot of rumors about Citadel, it was freaking everybody out, because if they went down, they had this massive convertible bond portfolio that would have flooded across the market, it would have been just another domino to fall that would have pushed us closer to that Armageddon scenario that people were worried about.
Q: Long Term Capital Management with a lot more funds sitting right on top of them.
A: Yeah, with leverage, they had 160 to maybe 170 billion in positions, so it was a massive amount. They steadied the ship in ’09, and the convertible bond market had a comeback, and they’re still somewhat wounded, I don’t know if Ken is ever going to get to the top of the heap like he was.
Q: I saw him speak this summer, and I thought he was really interesting and intelligent. There was a bit of an ego between these four guys on the panel at the Saltbridge Conference in Vegas– what was your impression with some of them in terms of dealing with their egos, and why did they want to speak? Most of them don’t want to reveal the secrets and don’t want publicity.
A: Part of it, I guess it’s two things, some people want their story to be told, and I started reporting this book in early 2008 when things were bad, but they didn’t look that bad.
Q: We were in a cyclical recession.
A: Right, Ken Griffin had said that he thought the market would go through a blip in early 2008 and things would come roaring back, which is why they were putting more leverage on at Citadel. Eddie Lampert is the guy who’s not a quant, he was kidnapped…but it’s a mix, and part of it is just being a reporter, like with Pete Muller, he definitely didn’t want to talk to me, but I got enough information about PDT and him and talking to other people that he realized that he should at least try to engage with me. With Pete, it was on and off throughout the whole period.
Q: That’s the Bob Woodward approach.
A: That’s a classic thing, we call it smoke them out of their holes.
Q: That was done in ‘Too Big to Fail,’ where [NYT reporter Andrew Ross] Sorkin seemed to get them on the phone, and say “If you don’t want to tell me your side, we’ll just go with what Jamie Dimon said.” People don’t want to let someone else paint their biography.
Talk a little about Deutsche Bank and Boaz Weinstein. At one time, Deutsche Bank’s trading arm was a monster.
A: And their credit derivatives desk, their bond desk, was one of the biggest in the country, if not the world. At the top of it was this guy, Boaz Weinstein, who’s part of this poker group, he’s friends with Pete Muller and Cliff Asness and other guys who, as I write about in the book, they have this monthly poker game in the city, and he’s part of that. Boaz was positioned perfectly to ride the derivatives boom that started in the late Nineties, he was on Deutsche Bank’s desk when credit default swaps first came out, he was one of the first people to ever trade a credit default swap.
A: Early adopter, loved the asset class…
Q: He helped spread them around the industry, he’d go on these calls to pension funds and banks and say, “We’ve got this cool new thing, credit default swap, you should try it,” because they’re looking for counter-parties to make a market, so he helped create the market, he came up with a strategy called capital structure arbitrage…it’s an arbitrage between the stocks and debt, and he’s using a credit default swap to do the trade.
Q: So it’s a debt equity arbitrage.
A: Yeah.
Q: Amongst the same stock – if you have Lehman, you might be short.
A: He would discover inefficiencies between the price of the stock and the bond and became really good at putting these trades on, so he ended up running Deutsche Bank’s global bond desk at the age of 33, and he was in charge of this other prop trading arm at Deutsche Bank that he called ‘saba,’ which is a Hebrew word for ‘grandfather,’ and he was this incredibly powerful guy making huge bets…
Q: And a kid, essentially.
A: Yeah, but in a way, he was representing the evolution of Wall Street, the older guys who were used to playing vanilla bonds, they had no idea how to use these new derivatives, and to him, it was natural, that’s just how he grew up trading, so it was an evolution of the market, he road that wave, he was very good at it, and when Lehman went down, the CDS market just froze, and it screwed up his trades, because he’d hedged these positions with CDS, and the CDS market just froze, it wasn’t moving, so he ended up having these losses on his books that if the CDS market was working as it should have, he probably would have been OK, but it didn’t, and he was using quantitative formulas to put all these trades together, and it’s just another example of how when things don’t work out in panics, which seems to happen a lot on Wall Street, these very careful, calibrated trades, if you’re using a lot of leverage, which he was, can blow up in your face, and they ended up losing about two billion dollars in the course of about a month or two.
Q: Which, in the scheme of things, is not a huge amount of money relative to what it threw off in profits. Some shops seem to have wiped out previous decades worth of profits.
A: When you add up how much he’d made over the past few years to how much he lost, he ended up kind of flat.
Q: So he gave back all the profits he made?
A: Yeah, it looks like Boaz did not make money for Deutsche Bank over the three or four years leading up to, at least on that prop desk. Now he was also running the flow desk, which can raise questions itself, Chinese walls…he was in charge of that flow desk, which had billions of dollars flowing through it, and I’m sure they were profitable.
Q: I was going to ask about the Gaussian Copula, but I don’t know if you really want to get that far into the weeds.
A: It’s difficult to talk about, it’s the formula that most of Wall Street was using, and the rating agencies, to price these CDOs or synthetic CDOs, more than anything, the bundles of credit default swaps that were designed to mimic cash CDOs, and they were basically, in a nutshell, trying to calculate the correlations between the various tranches of the synthetic CDOs, and it was a very complicated formula. It was also based on correlation, so if one tranche of triple As is trading at 99 cents on the dollar based on historical performance, the triple B tranche is going to be at 92, so you ended up having, based on this formula, a new breed of trader that rose up in Wall Street in the 2000s called correlation traders, and they were making bets on the various tranches of synthetic CDOs, shorting some tranches, going long other tranches, using the model, and that is basically what blew up Morgan Stanley. Morgan Stanley was doing correlation bets on synthetic CDOs.
Q: And heavily leaned into it.
A: Yeah.
Q: How much of what took place…when you trade straight up stocks or bonds, there’s an exchange, the trade is guaranteed to clear, and it’s so liquid, unless you’re trading some of these stupid penny stocks. You want to sell 100 million shares of Cisco, you can. If you need to get out of millions of shares of Apple or Citigroup, you could move billions of dollars pretty easily.
How much of the problems that someone like Boaz ran into is the fact that this is really a bespoke investment, and you’re like, “Let me find somebody…” No one sets up a hedge fund that they’re going to fill with ‘Star Wars’ collectables and Beanie Babies, because the zero liquidity, they have to sell it in a panic, there’s nobody on the other side, as opposed to a market with a market-maker, although since the flash crash, that’s even arguable these days.
But when we’re looking at these credit default swaps and they’re frozen, how do you go from a position where you’re essentially fully-hedged and can’t take the loss, because the worse this gets, the better that gets, to it blows up on you anyway? How do you work around that?
A: I think in a way, you’re talking about how a dealer market works, and it’s a dark market, it’s opaque. The dealers control it, and they know what the prices are, so that’s how the stock market…the NASDAQ market used to be like that, it was controlled by dealers. On black Monday in October 1987, the dealers just walked away from the phones, and you couldn’t trade, so the market froze. That changed with the rise of electronic markets, things became a lot more transparent.
Q: Is this the inevitable outcome of the post-’87 crash, that as we’ve moved to electronics and computers, we’ve made ourselves vulnerable to Skynet setting up a trading system?
A: I think that the electronic markets bring some real positive benefits. The U.S. stock market has become a lot more transparent in many ways, although we have dark pools and high frequency firms, I think things have gotten to a level of complexity that maybe it’s shifting into the dark again.
Q: Quote-stuffing…
A: There’s a lot of weird stuff going on. What I’m saying is in a dealer-controlled market, there is very little transparency, and I think what happened in the summer of 2007 in this market, when Bear Stearns started dumping bonds, or Merrill Lynch seized Bear’s collateral and started dumping the collateral on the market, the market froze, and the dealers were not talking to each other, nobody really knew what the fair price was for these securities, and essentially, these derivatives went into a black hole, and nobody knew what the price was, and they’ve been using this really screwed up Gaussian Copula model to trade it, that thing blew up, it didn’t work anymore. I’ve talked to quants who used it and just said that it became so screwed up, you couldn’t get anything.
Q: Are people still using it?
A: There’s this whole push to come up with a new synthetic CDO model of factoring in black swan stuff, and I think basically they have to realize that the whole notion of bundling credit default swaps into these monstrous packages of derivatives is just a bad idea, they don’t need to do it. With the financial reform, there is this push to get CDS trading onto a clearinghouse, and eventually make it exchange-traded.
Q: It will eventually be forced where counterparties will be known, there will be reserve requirements…
A: There will be a lot more transparency, people will see what the prices are, and I think that there’s this big push in the derivatives market to get derivatives into the light onto the exchanges, and who’s fighting that? Look back in the 1990s, who was fighting the reform that people were pushing in the stock market, it was the dealer market, the Wall Street giant banks, like Goldman Sachs and JP Morgan, these guys are going to fight this to the death.
Q: It’s just a function of money.
A: They control the market, they have wide spreads, and that’s billions in profits for those guys, so they got killed in the late Nineties when the electronic markets rose up, the ECNs, the market-makers just went away, and the high frequency guys stepped in their place, so now we have this new market, and we’re encountering its own problems, and people are concerned about that. There’s no question that spreads narrowed, and that sucked money out of the banks, so now the banks, I think the same fight is going on in the derivatives market.
Q: The difference is, we want dealers to be able to make a living buying and trading stocks on behalf of principal or agency, and high frequency traders are not a substitute for dealers, because they have no obligation to make a market as we saw when they said, “We don’t like this market,” and shut off their computers, everything disappeared. At least a NASDAQ market-maker has an obligation for if only 100 shares, to honor their bid, so there’s some actual liquidity there. It’s like someone lending you an umbrella only when it’s not raining.
A: Although don’t forget, on Black Monday, the dealers weren’t there, either.
Q: Is it that the dealers weren’t there, or the plumbing of the exchange being a mess? Back in the day, they were closing the market one day a week to let dealers catch up with the paperwork, they were so behind. Some of that was being shortsighted and cheap and not hiring enough back office people. You’re in the middle of a recession or a bear market in the late Sixties and early Seventies, so have a lot of basic plumbing, the infrastructure, that were pretty messy.
A: I’m not just saying the market-makers were the cause, because it’s pretty obvious that portfolio insurance was the thing that caused it to go over the cliff. I’m just saying that the…
Q: Stop and think about how every time I hear a description of portfolio insurance, I can’t believe it wasn’t obvious with foresight at the time. In hindsight, each morning based on the futures, you buy more options to ensure your portfolio, but if there’s any sort of a downward movement, this becomes a fireball that expands.
A: Apparently, some of the guys behind portfolio insurance did have some concerns that that could happen, they had conversations about it, but they were making so much money, and again, it’s the greed factor, people see that things…credit default swaps, that’s insurance. In a way, it’s the same thing, insurance is…
Q: It’s insurance with no reserve requirements. So that’s how you end up with AIG writing three trillion dollars worth of this. If it was really an insurance project and they had to put up some reserves, they couldn’t have done 10 percent of that.
A: When is a triple A tranche of a CDO ever going to have any impairment? Never, in theory.
Q: And how did that work out?
A: Not too good.
Q: Before we finish, there’s two other guys I have to ask about, one of whom, Benoit Mandelbrot, just passed away, the father of fractal analysis and a couple of interesting branches of mathematics. Talk about Benoit and how he fit into this whole jigsaw puzzle.
A: In the Sixties, he had done some work on financial markets, I think he was working at IBM at the time. He flitted around a lot, he may have been doing some stuff for Harvard. He discovered that looking at historical prices of cotton, you saw these really crazy moves that did not fit in with the normal random walk model that everybody in the financial industry was using. He was one of the first discoverers of fat tails, he wrote a paper about it, everybody booed and hissed and said, “We can’t have this, get out of here and let’s forget about it. We don’t want to deal with fat tails or black swans.”
Q: For non-mathematical readers, when we talk about a distribution curve, a normal bell curve, a fat tail is when we end up with these outliers on the far right of that bell curve that’s much bigger than the normal distribution should be, so we call that a fat tail, where there’s these outliers far more common than the models would predict.
A: Right, and as Nassim Taleb has sort of become famous for writing about this, and everybody calls these black swans now, those are essentially fat tails, unpredictable, wild markets, and Mandelbrot was one of the first people I went to meet when I started writing this book in the spring of 2008, and he was a really fascinating guy, told me his life’s story, I met him in his apartment in Cambridge, Massachusetts.
One thing interesting about him is I met him for two days and sat with him for several hours. The second day I went to meet him, it was the day after the Celtics had won the championship, and the subways were just cram-packed, so I was a little late getting to his apartment because things were moving really slowly, so I got there and I said, “Sorry I’m late, there’s all the celebration for the Celtics world championship,” and he looked at me and he just shook his head and I said, “The Celtics, they won the NBA championship last night,” and he just shrugged his shoulders, and I said, “Do you know the Celtics?” and he said, “No,” and he just waved his hands like I was talking utter nonsense. “Why don’t we sit down and get to more important matters?” I’m serious, he did not know who the Celtics were, and he lived in Cambridge and worked at Harvard and MIT for decades. He was very focused on mathematics, he was a totally fascinating guy, and it’s sad that he passed away.
Q: How old was he, in his eighties? That’s a good run. He certainly made his contributions. It’s fascinating that he’s done all of these interesting things, but he’s become known as the father of fractals.
A: And he told me he was working on his memoirs, I’m not sure if he finished that.
Q: The other guy I have to talk about is Paul Wilmott, who early on, was saying to his fellow quants, “Hey, what are you guys doing?” And he was pretty much initially ignored when this first started.
A: Kind of like Taleb, he was hated in the quant world.
Q: His reputation has always been that he’s really smart and not a traditional thinker, very much a contrarian. I thought of him as a quant amongst quants.
A: There’s a lot of respect for his mathematical abilities, he’s written some books that are central in the canon. He was doing this long ago, he helped set up Oxford’s financial engineering program, so he’s a major figure.
For a long time, he’s been saying that the financial engineering world is going off the rails because of the complexity, and early on in the mid to late Nineties, he was attacking value at risk as being totally misguided, because it was looking at the 95 percent probabilities of how much you would lose and just ignoring that other five percent, or sometimes 99 percent.
Q: Which is what you have to focus on.
A: Right, he was saying that we have to worry about this five percent, this other thing, the one percent, the fat tails.
Q: Right, who cares about the average, the typical, you’re fine when things are running typically.
A: That VAR number is something you put on the CEO’s desk at the end of the day to make him feel good.
Q: And it’s totally misleading.
A: It’s misleading, it leads you into all sorts of problems, you’re ignoring risks, and he actually wrote in 2000 that if things keep up the way they’re going, we’re going to experience a mathematician-led financial meltdown. That was in 2000.
Q: That was after the dot-com implosion?
A: Right. He was looking at derivatives and these risk models that people were using, and the complexity, which really concerned him. He’s obviously a super-advanced mathematician, so it’s not like he didn’t get it, he just saw that things were getting dangerous and he launched his own financial engineering program, certificate of financial engineering. He’s been trying to train his own legions of quants, and explain to them that you need to understand how markets work in the real world. You don’t need to get super complex, be careful with what you’re doing.
That’s the thing that I’ve found, some of these quants really do have a mad scientist approach. They come up with these theories and these models, and they throw them out in the world and say, “OK, let’s see if this blows up.” If it does, cool, because you’ve got more stuff to research, but they’re dealing with people’s financial lives, Americans and people increasingly around the world are putting their livelihoods and their retirements into financial markets. I find it somewhat disturbing that there’s this ‘devil may care’ attitude about it. That may have been fine if you’re just talking about a prop trading desk or maybe a couple of decades ago when everybody didn’t have their money in 401(k)s and pension plans, we are really taking care of people’s retirements, but now, the financial markets have become so engrained in everybody’s lives that this attitude that I have found a lot, that it really doesn’t matter, and Wall Street guys are going to be fine at the end of the day. They make so much money that if you hit a downturn…I know that things have been tough the last few years, but these people still have jobs.
Q: The funny thing is that the 1929 crash did not get back to break even on a nominal basis until 1954, and a lot of the explanation is all the rigged market shenanigans and the trusts and the crazy stuff that went on, people finally recognized that the game was fixed and an entire generation of investors and traders said, “Not for me, this is just a scam and I want nothing to do with it,” Which is why it took almost a decade after World War II to get back to the 1929 peak.
Given the 2000 collapse and the ’08-’09 collapse, and interrelations between the two of them, plus the housing collapse, I have to think that Wall Street guys can’t really say that anymore, “Oh, it’s just a model, it’s just so much math,” because if you lose another generation, do we really want to hang around to 2028 before we get back to break even? That seems like a long time. It’s a decade past the peak in the NASDAQ and we’re still 50 percent below the old highs.
A: Yeah, I don’t know if we’ll ever get back to that.
Q: If we compound at 2 percent, it will eventually get there.
A: In our lifetime, yeah. I know that the SEC is really worried about the general public’s faith and trust in the financial markets right now, and they’re looking into high-frequency trading and they’re worried that even if this is a legitimate activity, and as far as I can tell, most of it is, most of these high-frequency guys aren’t quote-stuffing or whatever.
Q: 15,000 quotes in under a second…
A: It just blows people’s minds when they look at it, and it’s something I’m trying to do in my new book, explain how this stuff works, where it came from, why is it like this, and hopefully from understanding where it came from, we can think about how the market should look in the future. Everyday investors are looking at this stuff and saying, “Get my money out,” they see something like the flash crash and it freaks them out, and money’s been flowing out of mutual funds at an accelerating rate ever since the flash crash. Who knows what’s going to happen next?
Q: The name of the book is ‘The Quants: How a New Breed of Math Whizzes Conquered Wall Street and Nearly Destroyed it’ by Scott Patterson. This was out at the beginning of 2010. You’re still writing the new book?
A: I’m still writing it, it could be late next year or early 2012.
Q: Do we have a title for that?
A: Still working on it.
Q: It will be on high frequency trading and how they’re going to be the next mathematical…
A: It’s high frequency trading, artificial intelligence, and the history of it, too. There’s a really fascinating back story that I think people will be completely blown away by – I am, it’s crazy stuff.
Q: Terrific stuff, Scott. Thanks
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