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How Math Whizzes Helped Sink the Economy [Book Excerpt]

Scott Patterson's book The Quants profiles the quantitative-minded investors who helped inflate the hedge fund bubble
Quants book cover



RANDOM HOUSE

[Editor's note: This excerpt from The Quants, by Scott Patterson (Crown Business, 2010), describes the 2006 Wall Street Poker Night Tournament, which featured professional poker players T. J. Cloutier and Clonie Gowen. It also featured several powerful money managers representing a new kind of Wall Streeter, the math-savvy investors known as "quants." The quants in attendance that night in 2006 included Peter Muller of Morgan Stanley, Ken Griffin of Citadel Investment Group, Cliff Asness of AQR Capital Management, Boaz Weinstein of Deutsche Bank and Jim Simons of Renaissance Technologies.]


No matter how hard they might play elsewhere, no poker game mattered more than when the gamblers around the table were their fellow quants. It was more than a battle of wits over massive pots—it was a battle of enormous egos. Every day they went head-to-head on Wall Street, facing off in a computerized game of high-stakes poker in financial markets around the globe, measuring one another's wins and losses from afar, but here was a chance to measure their mettle face-to-face. Each had his own particular strategy for beating the market. Griffin specialized in finding cheap bonds through mathematical formulas, or, via the same logic, cheap, down-on-their-luck companies ripe for the picking. Muller liked to buy and sell stocks at a superfast pace using Morgan Stanley's high-powered computers. Asness used historical tests of market trends going back decades to detect hidden patterns no one else knew about. Weinstein was a wizard with credit derivatives—securities whose value derives from some underlying asset, such as a stock or a bond. Weinstein was especially adept with a newfangled derivative known as a credit default swap, which is essentially an insurance policy on a bond.

Regardless of which signature trade each man favored, they had something far more powerful in common: an epic quest for an elusive, ethereal quality the quants sometimes referred to in hushed, reverent tones as the Truth.

The Truth was a 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 built giant machines— turbocharged computers linked to financial markets around the globe—to search for the Truth, and to deploy it in their quest to make untold fortunes. The bigger the machine, the more Truth they knew, and the more Truth they knew, the more they could bet. And from that, they reasoned, the richer they'd be. Think of white-coated scientists building ever more powerful devices to replicate conditions at the moment of the Big Bang to understand the forces at the root of creation. It was about money, of course, but it was also about proof. Each added dollar was another tiny step toward proving they had fulfilled their academic promise and uncovered the Truth.

The quants created a name for the Truth, a name that smacked of cabalistic studies of magical formulas: alpha. Alpha is a code word for an elusive skill certain individuals are endowed with that gives them the ability to consistently beat the market. It is used in contrast with another Greek term, beta, which is shorthand for plain-vanilla market returns anyone with half a brain can achieve.

To the quants, beta is bad, alpha is good. Alpha is the Truth. If you have it, you can be rich beyond your wildest dreams.

The notion of alpha, and its ephemeral promise of vast riches, was everywhere in the hedge fund world. The trade magazine of choice for hedge funds was called Alpha. A popular website frequented by the hedge fund community was called Seeking Alpha. Several of the quants in the room had already laid claim, in some form or another, to the possession of alpha. Asness named his first hedge fund, hatched inside Goldman in the mid-1990s, Global Alpha. Before moving on to Morgan in 1992, Muller had helped construct a computerized investing system called Alphabuilder for a quant farm in Berkeley called BARRA. An old poster from a 1960s film noir by Jean-Luc Godard called Alphaville hung on the walls of PDT's office in Morgan's midtown Manhattan headquarters.

But there was always a worry haunting the beauty of the quants' algorithms. Perhaps their successes weren't due to skill at all. Perhaps it was all just dumb luck, fool's gold, a good run that could come to an end on any given day. What if the markets weren't predictable? What if their computer models didn't always work? What if the truth wasn't knowable? Worse, what if there wasn't any Truth?

In their day jobs, as they searched for the Truth, channeling their hidden alpha nerds, the quants were isolated in their trading rooms and hedge funds. At the poker table, they could look one another in the eye, smiling over their cards as they tossed another ten grand worth of chips on the table and called, looking for the telltale wince of the bluffer. Sure, it was a charity event. But it was also a test. Skill at poker meant skill at trading. And it potentially meant something even more: the magical presence of alpha.

As the night rolled on, the quants fared well. Muller chalked up victories against Gowen and Cloutier in the early rounds. Weinstein was knocked out early, but Muller and Asness kept dominating their opponents. Griffin made it into the final ten before running out of luck and chips, as did Einhorn. The action got more intense as the hour grew late. Around 1:30 a.m., only three players were left: Muller, Asness, and Andrei Paraschivescu, a portfolio manager who worked for Griffin at Citadel.

Asness didn't like his first two cards on the next deal and quickly folded, happy to wait for a better draw, leaving the pot to Muller and Paraschivescu. The crowd fell quiet. The incessant honking city whir of Fifth Avenue penetrated the suddenly hushed room.

Breaking the silence, Griffin shouted a warning to his underling: "Andrei, don't bother coming into work next week if you don't knock Pete out." Some in the crowd wondered if he meant it. With Griffin, you never knew.

The room went quiet again. Paraschivescu lifted a corner of the two cards facedown on the table before him. Pair of fours. Not bad. Muller bent the corner of his two cards and eyed a pair of kings. He decided to go all in, sweeping his chips into the pot. Suspecting a bluff, Paraschivescu pushed his mound of chips forward and called, flipping over his pair of fours. Muller showed his kings, his only show of emotion a winsome glint in his blue eyes. A groan went up from the crowd, the loudest from Griffin. The other cards dealt in the hand couldn't help Paraschivescu, and he was out.

It was down to Muller and Asness, quant versus quant. Asness was at a huge disadvantage. Muller outchipped him eight to one after having taken Paraschivescu to the cleaners. Asness would have to win several hands in a row to even have a chance. He was at Muller's mercy.

Griffin, still smarting from his ace trader's loss, promised to donate $10,000 to Asness's favorite charity if he beat Muller. "Aren't you a billionaire?" Asness chortled. "That's a little chintzy, Ken."

After the deal, Muller had a king and a seven. Not bad, but not great. He decided to go all in anyway. He had plenty of chips. It looked like a bad move: Asness had a better hand, an ace and a ten. As each successive card was dealt, it looked as though Asness was sure to take the pot. But on the final card, Muller drew another king. Odds were against it, but he won anyway. The real world works like that sometimes.

The crowd applauded as Griffin rained catcalls on Muller. Afterward Muller and Asness posed for photos with their silver trophies and with Clonie Gowen flashing a million-dollar smile between them. The biggest grin belonged to Muller.

As the well-heeled crowd of millionaires and billionaires fanned into the streets of Manhattan that night, they were on top of the world. The stock market was in the midst of one of the longest bull runs in history. The housing market was booming. Economists were full of talk of a Goldilocks economy—not too hot, not too cold—in which steady growth would continue as far as the eye could see.

A brilliant Princeton economist, Ben Bernanke, had just taken over the helm of the Federal Reserve from Alan Greenspan. In February 2004, Bernanke had given a speech in Washington, D.C., that captured the buoyant mood of the times. Called "The Great Moderation," the speech told of a bold new economic era in which volatility—the jarring jolts and spasms that wreaked havoc on people's lives and their pocketbooks—was permanently eradicated. One of the primary forces behind this economic Shangri-la, he said, was an "increased depth and sophistication of financial markets."

In other words, quants, such as Griffin, Asness, Muller, Weinstein, Simons, and the rest of the math wizards who had taken over Wall Street, had helped tame the market's volatility. Out of chaos they had created order through their ever-increasing knowledge of the Truth. Every time the market lurched too far out of equilibrium, their supercomputers raced to the rescue, gobbling up the mispriced securities and restoring stability to the troubled kingdom. The financial system had become a finely tuned machine, humming blissfully along in the crystalline mathematical universe of the quants.

For providing this service to society, the quants were paid handsomely. But who could complain? Average workers were seeing their 401(k)s rise with the market, housing prices kept ticking ever upward, banks had plenty of money to lend, prognosticators imagined a Dow Jones Industrial Average that rose without fail, year after year. And much of the thanks went to the quants. It was a great time to be alive and rich and brilliant on Wall Street.

The money poured in, crazy money. Pension funds across America, burned by the dot-com collapse in 2000, rushed into hedge funds, the favored vehicle of the quants, entrusting their members' retirement savings to this group of secretive and opaque investors. Cliff Asness's hedge fund, AQR, had started with $1 billion in 1998. By mid-2007, its assets under management neared $40 billion. Citadel's kitty topped $20 billion. In 2005, Jim Simons announced that Renaissance would launch a fund that could juggle a record $100 billion in assets. Boaz Weinstein, just thirty-three, was wielding roughly $30 billion worth of positions for Deutsche Bank.

The growth had come rapid-fire. In 1990, hedge funds held $39 billion in assets. By 2000, the amount had leapt to $490 billion, and by 2007 it had exploded to $2 trillion. And those figures didn't capture the hundreds of billions of hedge fund dollars marshaled by banks such as Morgan Stanley, Goldman Sachs, Citigroup, Lehman Brothers, Bear Stearns, and Deutsche Bank, which were rapidly transforming from staid white-shoe bank companies into hot-rod hedge fund vehicles fixated on the fast buck—or the trillions more in leverage that juiced their returns like anabolic steroids.

The Great Hedge Fund Bubble—for it was a true bubble—was one of the most frenzied gold rushes of all time. Thousands of hedge fund jockeys became wealthy beyond their wildest dreams. One of the quickest tickets to the party was a background in math and computer science. On Wall Street Poker Night in 2006, Simons, Griffin, Asness, Muller, and Weinstein sat at the top of the heap, living outsized lives of private jets, luxury yachts, and sprawling mansions.

A year later, each of the players in the room that night would find himself in the crosshairs of one of the most brutal market meltdowns ever seen, one they had helped to create. Indeed, in their search for Truth, in their quest for alpha, the quants had unwittingly primed the bomb and lit the fuse for the financial catastrophe that began to explode in spectacular fashion in August 2007.

The result was possibly the biggest, fastest, and strangest financial collapse ever seen, and the starting point for the worst global economic crisis since the Great Depression.

Amazingly, not one of the quants, despite their chart-topping IQs, their walls of degrees, their impressive Ph.D.'s, their billions of wealth earned by anticipating every bob and weave the market threw their way, their decades studying every statistical quirk of the market under the sun, saw the train wreck coming.

How could they have missed it? What went wrong?

A hint to the answer was captured centuries ago by a man whose name emblazoned the poker chips the quants wagered with that night: Isaac Newton. After losing £20,000 on a vast Ponzi scheme known as the South Sea Bubble in 1720, Newton observed: "I can calculate the motion of heavenly bodies but not the madness of people."


From The Quants: How a New Breed of Math Whizzes Conquered Wall Street and Nearly Destroyed It; © 2010 by Scott Patterson. Excerpt reprinted with the permission of the publisher.

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