Fortune's Formula (20 page)

I
N HIS OWN WAY,
Milken founded his career on the less-than-perfect efficiency of the market. As a Berkeley business student, Milken came across a study by W. Braddock Hickman on the bonds of companies with poor credit ratings. Hickman determined that a diversified portfolio of these neglected bonds was in fact a relatively safe and high-yielding investment. His study examined the period from 1900 to 1943. No one paid much attention to Hickman’s study except for Milken and a certain T. R. Atkinson, who extended it to cover the period 1944–65 and came to much the same conclusion.

What Milken did with this finding was entirely different from what Thorp was doing with market inefficiencies. Milken was a salesman. He christened these unloved securities “junk bonds.” He began selling them aggressively at his employer, the investment bank Drexel Burnham Lambert.

Milken was such a superb salesman that in time he largely nullified Hickman’s reason for buying junk bonds. At the height of Milken’s influence, junk bonds had become so popular, and were selling at such elevated prices, that the conclusions of the Hickman and Atkinson studies probably no longer applied.

Milken had ideas of his own. One was that companies with doubtful credit could issue their own “junk bonds” at high interest rates. The companies would use the capital to buy other companies and sell off their assets to pay the bond interest. This was called corporate raiding. When successful, it was a form of arbitrage. The acquired companies were sometimes worth more than the irrationally low value the market assigned to them.

Corporate raiding made Milken unpopular with the press and many corporate executives. It also made him wealthy and powerful. Milken was so powerful at Drexel Burnham that he was able to open his own office in Beverly Hills. He liked the freedom of being a continent away from the Drexel Burnham leadership in New York. It was said that Milken purposely surrounded himself with hardworking loyal people of mediocre talent. He wanted people who would owe everything to him.

“No one who’s been with me for five years is worth less than twenty million,” Milken reportedly told Drexel’s Robert Wallace in 1983. Quotes of people in Milken’s circle showed an almost creepy level of devotion: “Michael is the most important individual who has lived in this century,” said Drexel employee Dort Cameron. Another felt, “Someone like Mike comes along once every five hundred years.”

Milken spoke of wanting to make his family the wealthiest in the world. Yet if his whole life was devoted to making money, he seemed not to care much about spending it. He lived in a relatively unpretentious Encino home that had once been the guesthouse on the estate of Clark Gable and Carole Lombard. Milken ate lunch off paper plates, wore a reasonably priced toupee, and drove an Oldsmobile.

Thorp and Regan began using Milken as their fund’s primary broker in the early 1970s. In all the time that Thorp’s fortunes were connected to Milken’s, the two men never met. Thorp once met Milken’s attorney brother, Lowell, who had an office in the same Beverly Hills building and who handled Michael’s legal affairs. Thorp’s closest approach to Michael Milken, however, was seeing him across Drexel’s Beverly Hills trading floor—behind a pane of glass.

In the early 1970s, Steve Ross and Caesar Kimmel believed that it might make sense to take Warner Communications private. They wanted to buy back most of the stock issued, limiting ownership to the few biggest shareholders.

To get the necessary money, Warner Communications would have to issue junk bonds. Ross asked Michael Milken for advice. Milken devised a plan and met with Ross in New York to discuss it.

Milken explained that Ross would have to give up 40 percent of Warner’s stock as an inducement to get people to buy the junk bonds. This was a standard equity kicker. People would not buy these junk bonds unless they also got stock.

Drexel would get another 35 percent cut of the company’s stock as payment for services rendered. That left a mere 25 percent of the company for Ross’s group.

“What are you talking about?” Ross said. “All you’re doing is financing this deal, and you get 35 percent?”

Milken—who genuinely admired Ross and told one friend he saw Ross as a kindred spirit—would not back down on these terms. Ross had no intention of giving away 75 percent of the company. He dropped the plan to take the company private.

Milken repeated this pitch to clients, with variations, many times. Many of them accepted Milken’s terms. What the clients didn’t know was that the equity kicker was rarely if ever offered to bond buyers. Milken’s salespeople were able to sell the bonds without it. Instead, the stock allotted for bond buyers quietly went into Milken’s private accounts.

T
HE ACADEMIC WORLD
was starting to show interest in warrants and options. One of the key figures was Paul Samuelson’s most brilliant protégé, Robert C. Merton. Merton was the son of a famous Columbia University sociologist, Robert K. Merton. The elder Merton was known for inventing the focus group and popularizing the terms “role model” and “self-fulfilling prophecy.” Robert K. taught his son about the stock market and poker. The younger Merton was always trying to find an edge in both. In poker, Robert C. believed he could achieve that by staring at lightbulbs during games. The light contracted his pupils, making his reactions harder to read.

In 1963 it was announced that Singer Company, which made sewing machines, was going to buy the Friden Company, which made calculators. The nineteen-year-old Merton bought Friden stock and sold short Singer, making a nice profit when the merger went through.

After graduating from Columbia, Robert C. started graduate work in math at Caltech. But Merton had been hooked by his amateur success in the market. He found himself haunting a Pasadena brokerage before classes started in order to check prices on the New York exchanges.

Merton resolved to switch to economics. His Caltech adviser, Gerald Whitman, thought it was very odd that someone would want to leave mathematics. Whitman helped Merton apply to half a dozen schools. Only one accepted him.

It was MIT. It offered a full fellowship, and Merton transferred in fall 1967.

One of his first MIT courses was taught by Samuelson. Samuelson was immediately impressed with Merton. The following spring, Samuelson hired him as his research assistant, an incredible honor for someone who had only recently decided to study economics.

Samuelson encouraged Merton to tackle the still-unsolved problem of pricing options. Samuelson had worked on this problem himself and had come close to a solution. He sensed that Merton might be the one to succeed.

Other people at MIT were working on the problem. Merton soon became aware of the work of MIT’s Myron Scholes and Fischer Black, then employed at the consulting firm of Arthur D. Little. Merton reasoned that the “correct” price for options is the one where no one can make a profit by buying them or selling them short. This is the assumption of “no arbitrage.” From this, and the assumption that stock prices move in a geometric random walk, Merton derived Black and Scholes’s pricing formulas.

All three men were curious about how well their new formulas reflected reality. The option traders of the day were bottom-feeders, existing on the fringe of the securities business. Would these people from the wrong side of Wall Street’s tracks instinctively arrive at the mathematically “correct” option prices?

Black, Scholes, and Merton examined ads for over-the-counter options in Sunday newspapers and compared them with their formula’s predictions. Some options traded close to the formula’s price. Some weren’t so close. Occasionally they found options that were real bargains.

Did that mean that it was possible to beat the market after all? On Monday mornings, Scholes called the dealers who had advertised the bargain options. He was always told that they had just sold out of the cheap options. But they had another option, just as good…Scholes realized it was bait and switch.

Scholes later had one of his students analyze the options offered by one dealer. The student concluded that some options were mispriced, but dealers charged such high transaction costs that no one could make a profit.

Then the group discovered warrants. Because warrants were traded on the regular stock exchanges, there was no bait and switch. The price quoted is the price you get. Of the warrants then being traded, those of a company called National General were the most underpriced relative to the formula. National General was a conglomerate that had just failed in a bid to acquire Warner Brothers, losing out to the company that owned Kinney parking lots.

Black, Scholes, and Merton dipped into their savings and bought a block of National General warrants. “For a while,” Black recalled, “it looked as if we had done just the right thing.”

In 1972 American Financial announced plans to acquire National General. As part of the deal, it changed the terms of the warrants, and the change was bad for warrant holders. The MIT group lost everything they’d invested.

Black theorized that the warrants had been cheap because insiders had advance word of the takeover bid. The insiders sold early, tricking Black, Scholes, and Merton into buying what they concluded was a cheap warrant. “Although our trading didn’t turn out very well, this event helped validate our formula,” Black said. “The market was out of line for a very good reason.”

It took a while for Black and Scholes to get their paper into shape for publication. When it was about ready, Black sent a preprint to someone he thought might be interested: Ed Thorp.

Black knew of the delta hedging technique described in
Beat the Market
. He explained in the cover letter that he had taken Thorp’s reasoning a step further. In a perfectly rational world, no risk-free investment should be worth more than any other. A delta hedge is (theoretically) a risk-free investment. Ergo, it should offer the same return as other risk-free investments like treasury bills—when options are priced “correctly.”

As Thorp scanned it, it looked like Black and Scholes had derived his own option-pricing formulas. He couldn’t be sure because the equations were structured differently.

One of Thorp’s prized “toys” at the time was a Hewlett-Packard 9830A. This was one of the first small computers. It cost just under $6,000, had 7,616
bytes
of memory, a full typewriter keyboard, and was programmable in BASIC. In lieu of a monitor, it had a single-line text display and a plotter that drew graphs in color.

Thorp quickly programmed Black and Scholes’s formulas into the machine and had it plot a pricing graph. He compared it to a graph produced with Thorp’s own formulas. They were the same except for an exponential factor incorporating the risk-free interest rate. Thorp had not included this because the over-the-counter options he traded did not credit the trader with the short-sale proceeds. The rules were changed when options began trading on the Chicago Board of Exchange. Black and Scholes accounted for this. Otherwise, the formulas were equivalent.

The Black-Scholes formula, as it was quickly christened, was published in 1973. That name deprived both Merton and Thorp of credit.

In Merton’s case, it was a matter of courtesy. Because he had built on Black and Scholes’s work, he delayed publishing his derivation until their article appeared. Merton published his paper in a new journal that was being started by AT&T, the
Bell Journal of Economics and Management Science
. This journal was an acknowledgment of how profoundly quantitative methods from information theory and physical science were transforming formerly alien fields like finance.

Thorp considers the Merton paper “a masterpiece.” “I never thought about credit, actually,” Thorp said, “and the reason is that I came from outside the economics and finance profession. The great importance that was attached to this problem wasn’t part of my thinking. What I saw was a way to make a lot of money.”