The Quants: How a New Breed of Math Whizzes Conquered Wall Street and Nearly Destroyed It (41 page)

“These so-called financial engineers experience events that can only happen once, in the history of mankind, according to the laws of probability, every few years,” he told the room (full, of course, of financial engineers). “Something is wrong with this picture. Do you see my point?”

Another slide showed a giant man sitting on the right side of a scale, tipping it heavily, while a group of tiny people scatter and fall on the left side. The slide read “Two Domains: Type 1—Mild ‘Mediocristan’ (Gauss, etc.); Type 2—Wild ‘Extremistan.’”

The slide was a key to Taleb’s vision about extreme events in the market and why the mathematics used in the physical world—the science used to put a man on the moon, fly an airplane across the ocean, microwave a sandwich—doesn’t apply in the world of finance. The physical world, he said, is “Mediocristan.” Bell curves are perfect for measuring the heights or weights of people. If you measure the height of a thousand people, the next measurement isn’t likely to change the average.

In finance, however, a sudden swing in prices can change everything. This is Taleb’s world of “Extremistan.” Income distributions, for
instance, exhibit signs of Extremistan, a discovery Benoit Mandelbrot had made more than half a century before. Measure the wealth of a thousand people plucked off the street. On a typical day, the distribution will be normal. But what if you select Bill Gates, the richest man in the world? The distribution is suddenly, massively skewed. Market prices can also change rapidly, unexpectedly, and massively.

Taleb continued to address the sparse audience for another thirty minutes. He talked about fat tails. Uncertainty. Randomness. But he could tell his audience was fried. They didn’t need to be told about black swans. They’d just seen one, and it had terrified them.

Still, few could believe that the downturn would get much worse. A year of unfathomable volatility was just beginning. Later that January, it emerged that a thirty-one-year-old rogue trader at Société Générale, a large French bank, lost $7.2 billion on complex derivatives trades. The trader, Jérôme Kerviel, used futures contracts tied to European stock indexes to build up a staggering $73 billion worth of positions that were basically one-way bets that the market would rise. After the bank discovered the trades, which Kerviel covered up by hacking its risk-control software, it decided to unwind them, triggering a staggering global market sell-off. In response to the volatility, the Federal Reserve, which didn’t know about the SocGen trades, slashed short-term rates by three-quarters of a point, a bold move that frightened investors because it smacked of panic.

Still, even as the system teetered on the edge, many of the smartest investors in the world couldn’t see the destructive tsunami heading directly for them. The implosion of Bear Stearns in March was a wake-up call.

The Doomsday Clock was ticking.

Around 1:00 p.m
. on March 13, 2008, Jimmy Cayne sat down at a card table in Detroit and began to craft his strategy. The seventy-four-year-old chairman of Bear Stearns, seeded fourth in a group of 130 in the IMP Pairs category of the North American Bridge Championship, was squarely focused on the cards in his hand.

Bridge was an obsession for Cayne, a product of Chicago’s hardscrabble
South Side, and he wasn’t going to let his company’s troubles get in the way of one of the most important competitions of the year.

At the same time, back at Bear’s New York headquarters on Madison Avenue, about forty of the firm’s top executives had gathered in a twelfth-floor dining area to strategize. Everyone knew trouble was brewing. Bear’s anemic stock price told the story all too clearly. But no one was sure exactly how bad it was. Around 12:45
P.M
., Bear chief executive Alan Schwartz appeared to assure the troops that all was well.

No one was buying it. Bear Stearns, founded in 1923, was teetering on the edge of collapse as its trading clients pulled billions from the bank in a white-hot panic. Insiders at the firm knew it was serious when one of its most cherished clients pulled out more than $5 billion in the first half of March. The client: Renaissance Technologies. Then another top client bolted for the exits with $5 billion more in hand: D. E. Shaw.

The quants were killing Bear Stearns.

To this day, former Bear Stearns employees believe the firm was taken out in a ruthless mugging. During its final week as a public entity, it had $18 billion in cash reserves on hand. But once Bear’s blood was in the water, jittery clients who traded with Bear weren’t willing to wait around to see what happened. The worry was that the bank would implode before they could pull out their money. It wasn’t worth the risk. There were other investment banks more than willing to take their funds, such as Lehman Brothers.

By March 15, 2008, a Saturday, Bear Stearns was nearly finished. Federal Reserve and Treasury Department officials and bankers from J. P. Morgan roamed the halls of its midtown Manhattan skyscraper like scavengers picking over a cadaver. Bear executives were frantic, worried about a shotgun wedding and jamming the phones for any kind of last-minute salvation. Nothing worked. On Sunday, Cayne and the rest of Bear’s board agreed to sell the eighty-five-year-old institution to J. P. Morgan for $2 a share. A week later, the deal was boosted to $10 a share.

For a time, optimistic investors believed the death of Bear marked
the high-water mark of the credit crisis. The stock market shot up. The system had seen its moment of crisis and come through largely unscathed. Or so it seemed.

Dick Fuld
was putting on a classic performance. The Lehman Brothers CEO, known as the “Gorilla” for his heavy-browed Cro-Magnon glare, monosyllabic grunts, and fiery rampages, had been ranting for more than a half hour to a roomful of managing directors.

Fuld screamed. Jumped up and down. Shook his fists in defiance.

It was June 2008. Lehman’s stock had been getting hammered all year as investors fretted about the firm’s shaky balance sheet. Now it was getting worse. The firm had just posted a quarterly loss of $2.8 billion, including $3.7 billion in write-downs for toxic assets such as mortgages and commercial real estate investments. It was the bank’s first quarterly loss since 1994, when it was spun off from American Express. Despite the losses, Fuld and his lieutenants had kept a straight face publicly, insisting everything was fine. It wasn’t.

Fuld had called a meeting of the firm’s managing directors to clear the air and explain the situation. He began with an announcement: “I spoke to the board this weekend,” he said. Some in the room wondered whether he’d offered to resign. Just a week earlier, the sixty-two-year-old CEO had scrambled the firm’s executive office, replacing president Joe Gregory with his longtime partner Herbert “Bart” McDade. Was it Fuld’s turn to fall on his sword? Some in the room hoped so.

“I told them,” Fuld said, “I’m not taking a bonus this year.”

The room seemed to release an audible sigh of despair. Fuld quickly started going through the math, laying out how strong Lehman was, how solid its balance sheet remained. He talked about how the firm would crush the short sellers who’d been pile-driving Lehman’s stock into dust.

Someone raised a hand. “We hear everything you’re saying, Dick. But talk is cheap. Acting is louder than words. When are you going to buy a million shares?”

Fuld didn’t miss a beat. “When Kathy sells some art.”

Fuld was referring to his wife, Kathy Fuld, known for her expensive
art collection. Was he joking? Some wondered. Fuld wasn’t laughing. There was the classic furrowed brow. It was a moment when some of Lehman’s top lieutenants started to wonder in earnest whether Lehman was in fact doomed. Their CEO seemed detached from reality.
When Kathy sells some art?

There was
a yell, a smash, the sound of glass breaking and crashing to the floor. AQR’s researchers and traders jolted in their seats, looking up shocked from their computer screens toward John Liew’s office, where the sudden crash had come from, breaking the standard office calm typified by the constant low hum and snick of quants typing furiously at keyboards.

Through the windows, they could see their boss, Cliff Asness, peering back at them, smiling sheepishly. He opened the door.

“Everyone is okay,” he said. “Calm down.”

It was another outburst. Asness had hurled a hard object at the wall, scoring a direct hit on a framed picture in Liew’s office, shattering the glass. Asness had already destroyed several computer screens as well as an office chair as AQR’s fortunes continued to sour. It was late summer 2008. The mood in the office had grown tense. The carefree days of just over a year ago were long gone, replaced by paranoia, fear, and worry. Some believed the firm was losing direction, but no one dared challenge the mercurial boss. Asness had surrounded himself with yes-men, some complained, and brooked no deviation from the carefully wrought models that had made him wildly rich. “It will all come back,” he said repeatedly, like a mantra. “When the insanity goes away.”

Others weren’t so sure, and some employees were getting increasingly alarmed by the fund manager’s outbursts. “He was losing it a little more and more every day,” said a former employee. “He was off his rocker. Things were spinning out of control.”

A key player had abandoned ship. Earlier in the year, Mani Mahjouri, one of AQR’s whiz kids who’d been with the firm since 2000, had quit. He’d grown tired of Asness’s tongue-lashings, the battle-axe emails. Manjouri had been an idol of the younger quants at AQR. A
student of Ken French’s at MIT in the 1990s with degrees in math, physics, and finance, he was on the verge of becoming a partner, living proof that a young gun could rise to the top in a culture dominated by Goldman veterans. He was also the class clown of the fund, turning his office into a haunted house during Halloween, decorating the cubicles of a researcher on his or her birthday with balloons and party hats (unbeknownst to the researcher), and hacking into the target’s email and writing: “Today is my birthday, please come to my cubicle and celebrate with me,” sending the message to the entire firm—hugely embarrassing to certain antisocial quants.

The fun and games were over. Mahjouri was gone. The IPO was history, a bad reminder of better days. As the summer of 2008 neared an end, few of the quants at AQR could fathom—probably Asness most of all—that the pain was about to get much worse.

By September
9, Dick Fuld’s confidence in Lehman Brothers was visibly shaken. In his thirty-first-floor office at the bank’s midtown Manhattan headquarters, equipped with a shower, library, and expansive views of the Hudson, the Wall Street mogul raged against his tormentors like Ahab on the deck of the
Pequod
. That morning, news broke that Lehman’s white knight, the Korea Development Bank, had decided not to purchase a stake in the bank. Making matters worse, if not catastrophic, J. P. Morgan’s cochief of investment banking, Steven Black, called Fuld and told him that Morgan needed $5 billion in extra collateral and cash. Lehman had been margin-called. It was a dagger. Lehman’s shares were in free fall, down more than 40 percent.

“We’ve got to act fast so this financial tsunami doesn’t wash us away,” Fuld said to his underlings, a manic tone in his voice.

But it was too late. The firm that Fuld had joined in 1969 was in a death spiral. Over the weekend of September 13, 2008, Lehman’s fate was decided among a select group of individuals at the Federal Reserve’s concrete fortress on Liberty Street in downtown Manhattan. Fuld wasn’t even present. Instead, Hubert McDade and Alex Kirk, a fixed-income expert, sat at the table with Treasury secretary Paulson and New York Fed president Tim Geithner, President Obama’s future Treasury secretary.

Fuld machine-gunned phone calls to the meeting, frantically making offers, spinning new deals. “How about this? How about this?”

Nothing worked. London banking giant Barclays, run by Bob Diamond, briefly considered ponying up some cash for Lehman, so long as the Fed backed the deal as it had with Bear. Paulson said no.

Derivatives traders, frantic about the demise of one of the world’s largest banks, convened at the New York Fed’s office Saturday night. The goal was to create a game plan for settling trades in case Lehman imploded. Among those traders was Boaz Weinstein. Deutsche Bank had done a significant amount of trading through Lehman, and Weinstein was concerned about the impact of a Lehman collapse on his positions. He seemed calm and relaxed, as poker-faced as ever. Beneath his calm exterior, Weinstein was nervous, realizing that he could be facing the biggest test of his trading career.

Sunday morning a consortium of bankers briefly cobbled together a deal to back a Barclays-led buyout, but the plan fell apart. Regulators in the United Kingdom had gotten cold feet and wouldn’t sign off. It spelled doom for Lehman. Sunday night McDade returned to Lehman’s midtown headquarters and told Fuld the bad news. Lehman would have to file for bankruptcy.

“I want to throw up,” Fuld moaned.

That Sunday
, Lehman quant Matthew Rothman was furious. His bank was teetering. And still his bosses wanted him to fly to Europe for a series of quant conferences in London, Paris, Milan, Frankfurt, and Zurich?
Idiots
.

He checked his schedule. He was on tap to give the keynote speech for Lehman’s quantitative conference in London the following day. The previous week he’d sent an email to the team in Europe organizing the conference: “We may be filing for bankruptcy; there’s a good chance we may not even be here.” The response:
You’re crazy
.

Rothman’s boss, Ravi Mattu, was bombarded with complaints about Rothman.
He’s not a team player. He’s psycho. Of course Lehman Brothers isn’t going to declare bankruptcy!

Rothman was incredulous. He wanted to be available for his team in case anything happened. Like a platoon sergeant in a foxhole, he
didn’t want to leave his troops when the shit hit the fan. And he could see it coming. So he reached a compromise: he’d take the red-eye to London for Monday’s conference, then head straight back to Heathrow for the red-eye back to New York. It would suck, but at least he’d be around in case anything happened.