Fortune's Formula (29 page)

Mark Rubinstein (coinventor of portfolio insurance, which played a major role in the crash) estimated the chance of the market falling 29 percent (as S&P futures did) in a single day as 1 in 10160. That’s the number you get by writing 160 zeros after a “1.” According to Rubinstein,

Crashes were not exactly a new concept. There had been one in 1929, though (as Rubinstein’s words suggest) it seemed not to figure much in the thinking of many economists a half century later. One who had taken notice was Robert C. Merton. In the 1970s, Merton wrote that the market could act like a flea as well as an ant. Most of the time, stock prices wandered back and forth like an ant. Every now and then, prices would take a flealike jump. Merton reasoned that these jumps should be accounted for in pricing options. The existence of these jumps implies that many of the popular models, including the Black-Scholes formula, are not exactly right.

The Kelly system is not married to any specific model of how the market is “supposed” to behave, including the log-normal random walk. The prescription of maximizing the geometric mean works with flealike jumps, or with any model that can be described precisely. In contrast, mean-variance analysis is ill suited to handle flealike jumps, for they cannot be described solely by the two numbers Markowitz theory uses.

I
N
1988,
OUT OF THE BLUE,
Paul Samuelson wrote a letter to Stanford information theorist Thomas Cover. Samuelson had been sent one of Cover’s papers on portfolio theory for review. “If I did use
some
of your procedures,” Samuelson wrote, “I would not let that…bias my portfolio choice toward the choices my alien cousin with log [Wealth] utility function would make.” He chides Kelly, Latané, Markowitz, “and various Ph.D’s who appear with Poisson-distribution probabilities most Junes.”

Cover was flattered to receive a letter from the great Samuelson (albeit one ripping his paper to shreds). Cover drafted a tactful reply. This initiated a correspondence that ran several years. The more uninhibited Samuelson got off the best lines. Calling the Kelly system a “complete swindle,” Samuelson told Cover that “mathematicians who ignore remainders in approximation should be halved, then quartered, then…

Samuelson wrote his last letter to Cover in words of one syllable. “If I like your ways to guess at chance, I need not (and will not) use your ‘growth’ stuff with them,” he wrote. “Why go to and fro when we have been there once?”

T
HERE WAS FOREVER
an air of mystery about who Ivan Boesky was and what he had been. He told people that his Russian immigrant father had run a chain of delicatessens in Detroit. Actually it was a chain of topless dancing bars called the Brass Rail. An uncle ran a deli.

In high school, one of Boesky’s best friends was an Iranian exchange student named Hushang Wekili. After attending three small and not very prestigious Michigan colleges without graduating from any, Boesky left for Iran. Boesky would later testify under oath that he taught English as a second language to Iranians for the U.S. Information Agency. The U.S. Information Agency said it had no record of anyone named Ivan Boesky working for them.

After his Iranian sojourn, Boesky returned to the U.S. and enrolled in a bottom-rung law school, the Detroit College of Law. He graduated five years later after dropping out twice. No law firm would have him. Boesky’s father made Ivan a partner in the chain of stripper bars.

Boesky’s fortunes turned when he married into a wealthy family. His wife’s father, Ben Silberstein, was a Detroit real estate developer. Boesky heard that buckets of money were being made on Wall Street. He decided that was the life for him. Boesky’s father-in-law set the couple up in a starter apartment in one of Park Avenue’s most exclusive buildings.

Boesky’s specialty was risk arbitrage. When company ABC attempts to acquire XYZ, it offers so many shares of ABC stock for each share of XYZ—assuming that the merger goes through. These terms are favorable to XYZ’s shareholders because the acquiring firm hopes they will approve the merger.

It follows that each share of XYZ should be worth precisely
x
shares of ABC under the terms of the merger. The two companies’ share prices rarely trade in this ratio, however, because there is usually much uncertainty about whether a merger will take place. It can be blocked not only by shareholders but by the government or by the second thoughts of management.

Someone who thinks a merger will go through can buy XYZ and sell short ABC in order to ensure a profit when the merger takes place. Robert C. Merton did this with the 1963 Singer-Friden merger. It amounts to placing a “sports book” bet on the merger happening. The bet can be leveraged for greater gain.

It is called
risk
arbitrage because anyone who does this risks losing money if the merger fails to happen. Boesky got his first real shot at arbitrage at a firm called Kalb Voorhis. In a single trade he lost $20,000 of the company’s money and was fired.

After several other misstarts, Boesky decided it was time to open his own company. He took out ads in
The Wall Street Journal
touting the fantastic profits to be made in arbitrage.

Private investment firms did not generally advertise, much less take a hard-sell approach. (Thorp and Regan’s fund had an unlisted phone number, and this was typical.) Despite his unimpressive record, Boesky proposed to charge investors 45 percent of profits for his services. If Boesky lost money, the investors would be responsible for 95 percent of the losses.

Those fees must have shooed away any sensible investors. The Silberstein family pumped in money, and in 1975 the Ivan F. Boesky Company was off and running.

Boesky would order a croissant for breakfast, poke it a few times, and end up eating a single flake of crust. One employee saw him take a normal-size bite once. “Ivan, you little pig!” Boesky scolded himself.

“Piggy” was Wall Street’s nickname for Boesky. It referred to his appetite for large positions, leverage, and risk. When Boesky believed a merger was highly likely, he used leverage to increase his anticipated profits. How much leverage? “The maximum permitted by law,” according to the Boesky Corporation.

The Federal Reserve permitted 2-to-1 leverage in “retail” security transactions. Private lenders, such as Boesky used, could set their own limits. Asked by a
Fortune
magazine reporter about rumors that Boesky had violated debt covenants with his lenders, Boesky answered, “Not at all.” Confronted with a few more facts, Boesky qualified that: “In principle, we’re always in compliance with our covenants.”

In 1984 the Boesky Corporation claimed 9-to-1 leverage. This was apparently possible through a then-new technique called rolling. Rolling is like buying a fancy dress and wearing it to a party, then returning it the next day. Instead of a party dress, Boesky reportedly would buy and sell the same amount of stock simultaneously. The “buyer” and “seller” (both Boesky) each had five days to hand over the money or stock. Boesky could thereby arrange to own a block of stock for five days (after which it had to go back to the “store”). During that time, he could put up the stock as collateral for a 90 percent bank credit.

Asked by a reporter whether he engaged in rolling, Boesky answered, “You are insinuating improprieties, and the answer is no. Some people don’t like the color of my hair, so they are going to say whatever they like.”

Boesky had no illusions about the strong form of the efficient market hypothesis. His business plan was to convert inside information to capital growth. This procedure had a long history, some of it respectable. Stockbrokers in the age of Adam Smith freely traded tips and used them to make timely purchases and sales with their own money. This system was unfair to anyone not privy to the tips, though apparently not many people thought of it in quite that way. Prior to electronic communications, the unfairness was manifest. It took days for news to reach rural England.

Instantaneous communications changed things for brokers as surely as they did for bookies. The telegraph and Edison’s ticker tape machine accelerated the flow of information. Still, no one pretended that Manhattanites didn’t have better access to financial information than people on the frontier. The watershed, as with so many things relating to the market, was the 1929 crash. Fortunes were lost in hours. Some people on Wall Street were able to salvage their wealth by selling early into the crash. These early sales by insiders depressed prices further. That now seemed unfair to investors across the country who learned of the crash late.

Congress responded by setting up the Securities and Exchange Commission. One goal of the agency was to assure small investors that they would not be exploited by insiders who received information first. U.S. securities law draws a big (inevitably arbitrary) line between private and public information. It is illegal to profit from unreleased corporate information. This is a law with a thousand shades of gray, yet it is vital to an economy that expects to raise large amounts of capital from average citizens.

Like many risk-takers, Boesky seems to have thrived on risk and existed in a denial of it. When he had a tip on a merger, he tried to confirm it through independent channels. He cultivated a lot of sources. When they agreed, Boesky tended to act as if it were a sure thing, borrowing to increase his profit. In 1982 Boesky learned that Gulf Oil was going to buy Cities Service at $63 a share. Boesky bought $70 million of Cities Service stock. That was about equal to the net worth of Boesky’s trading corporation.

Boesky’s sources were right about Gulf’s intentions. Unfortunately, Gulf worried that the deal would raise antitrust concerns and backed out of the deal. Cities Service stock plunged. Boesky was almost ruined.

Like John Kelly, Boesky had to place a precise value on information streams. One of Boesky’s most important tipsters was a young investment banker at Kidder Peabody named Martin Siegel. Boesky and Siegel struck a deal where Boesky would pay a single lump sum, the amount to be negotiated annually, for all the information Siegel supplied over a calendar year. The first year of this arrangement, Siegel leaked to Boesky word of Bendix’s hostile takeover of Martin Marietta. Kidder Peabody had been helping Martin Marietta defend itself against the takeover. Boesky used the timely scoop to make a lot of money—Siegel didn’t know how much. He asked Boesky for a $150,000 cash payment. Boesky planned a drop.

In January 1983 Siegel went to the lobby of the Plaza Hotel. He was approached by a muscular Iranian who said “Red light.”

“Green light,” Siegel replied.

The courier handed Siegel a briefcase. He took it to his East Seventy-second Street apartment. Inside were stacks of hundred-dollar bills, tied with ribbons that said “Caesar’s Palace.”

Boesky justified the cloak-and-dagger by telling Siegel that he had once been a CIA agent in Iran. The next year, Siegel asked for $250,000 (he had passed word on deals involving Natomas and Getty Oil). Again Boesky agreed without haggling. Siegel went to the Plaza, met the same courier, and exchanged the code words. When he opened the briefcase the bills were tied with the same Caesar’s Palace ribbons.

This time, some of the bills were singles rather than hundreds. Siegel counted carefully, and the money came to $210,000.

Siegel told Boesky the payment was $40,000 short. He tactfully suggested that maybe the courier had skimmed it. Boesky insisted that was impossible. The courier was a man of impeccable character who would never steal money. Boesky did not attempt to complete the syllogism.

Privately, Siegel decided to factor some shrinkage into the next year’s request.

The next year was different. Siegel’s conscience was bothering him, and he wanted out. He avoided calling Boesky. When he took a call, he avoided giving Boesky any confidential information. After a while, Boesky’s calls, which had been daily, let up.

This left the payoff for 1984. Earlier in the year, Siegel had passed on lucrative tips about the Carnation-Nestlé merger. Siegel was not so conscience-stricken as to forget that. In January 1985 Siegel asked Boesky for $400,000.

Boesky said it was too risky to use the Plaza again. He directed Siegel to meet his courier at a pay phone booth at Fifty-fifth Street and First Avenue. Siegel would pretend to make a call. The courier would pretend to be another guy waiting to use the phone. He would place the briefcase by Siegel’s left leg. Then the courier would walk away.

Siegel got there early and ducked into a coffee shop to get out of the cold. As he drank his coffee, he spotted the courier out the window. He was a dark Middle Easterner, carrying a briefcase, loitering near the pay phone.

Before he could go make the call, Siegel saw another man. He was watching the first man.

Boesky had said nothing about two men. Siegel half seriously wondered whether Boesky was plotting to kill him. Why pay someone whose usefulness is over? The man might come up behind Siegel and shoot him in the back…

Siegel left without making the pickup.

The next day at the office, Boesky called. He wanted to know how it went. Siegel explained what happened. Boesky said of course there was a second man; he always sent a second man to check up on the first (the one with impeccable character). Boesky urged Siegel to agree to another drop. Siegel refused, but Boesky kept pestering him. After a few weeks it all seemed so ridiculous that Siegel consented.

The drop went off as planned. Siegel counted the money. Some of it was missing.

He didn’t bother to tell Boesky. Siegel was not calling Boesky. When Boesky did call, Siegel feigned being too busy to talk.

“What’s the matter, Marty?” Boesky asked during one of these truncated conversations. “You never want to talk to me. You never call anymore. I never see you. Don’t you love me anymore?”