The Quants

by Scott Patterson

  With a razor-thin capital cushion, LTCM’s assets evaporated into thin air. By the end of August the fund had lost $1.9 billion, 44 percent of its capital. The plunge in capital caused its leverage ratio to spike to an estimated 100 to 1 or more. In desperation, LTCM appealed to deep-pocketed investors such as Warren Buffett and George Soros. Buffett nearly purchased LTCM’s portfolio, but technicalities nixed the deal at the last minute. Soros, however, wouldn’t touch it. LTCM’s quantitative approach to investing was the antithesis of the trade-by-the-gut style that Soros was famous for. According to Soros: “The increasing skill in measuring risk and modeling risk led to the neglect of uncertainty at LTCM, and the result is you could use a lot more leverage than you should if you recognize uncertainty. LTCM used leverage far above what should have been the case. They didn’t recognize that the model is flawed and it neglected this thick tail in the bell curve.”

  The wind-down of the fund was brutal, involving a massive bailout by a consortium of fourteen U.S. and European banks organized by the Federal Reserve. Many of the partners who had invested their life savings in the fund suffered massive personal losses.

  As painful as the financial cost was, it was an even more humiliating fall for a group of intelligent investors who had ridden atop the financial universe for years and lorded it over their dumber, slower, less quantitatively gifted rivals. What’s more, their cavalier use of leverage nearly shattered the global financial system, hurting everyday investors who were increasingly counting on their 401(k)s to carry them through retirement.

  LTCM’s fall didn’t just tarnish the reputation of its high-profile partners. It also gave a black eye to an ascendant force on Wall Street: the quants. Long-Term’s high-powered models, its space-age risk management systems as advanced as NASA’s mission control, had failed in spectacular fashion—just like that other quant concoction, portfolio insurance. The quants had two strikes against them. Strike three would come a decade later, starting in August 2007.

  Ironically, the collapse of LTCM proved to be one of the best things that ever happened to Boaz Weinstein. As markets around the world descended into chaos and investors dove for safety in liquid markets, the credit derivatives business caught fire. Aside from Deutsche Bank and J. P. Morgan, other banking titans started to leap into the game: Citigroup, Bear Stearns, Credit Suisse, Lehman Brothers, UBS, the Royal Bank of Scotland, and eventually Goldman Sachs, Merrill Lynch, Morgan Stanley, and many others, lured by the lucrative fees for brokering the deals, as well as the ability to unload unwanted risk from their balance sheets. Banks and hedge funds sought to protect themselves from the mounting turmoil by lapping up as much insurance as they could get on bonds they owned. Others, including American International Group, the insurance behemoth—specifically its hard-charging London unit full of quants who specialized in derivatives, AIG Financial Products—were more than willing to provide that insurance.

  Another boom came in the form of a new breed of hedge funds such as Citadel—or Citadel copycats—that specialized in convertible-bond arbitrage. Traditionally, just as Ed Thorp had discovered in the 1960s, the strategy involved hedging corporate bond positions with stock. Now, with credit default swaps, there was an even better way to hedge.

  Suddenly, those exotic derivatives that Weinstein had been juggling were getting passed around like baseball cards. By late 2000, nearly $1 trillion worth of credit default swaps had been created. Few knew more about how they worked than the baby-faced card-counting chess whiz at Deutsche Bank. In a flash, thanks in part to Russia’s default and LTCM’s collapse, Weinstein went from being a bit player to a rising star at the center of the action, putting him on the fast track to becoming one of the hottest, highest-paid, and most powerful credit traders on Wall Street.

  Ona spring afternoon in 1985, a young mortgage trader named Aaron Brown strode confidently onto the trading floor of Kidder, Peabody & Co.’s Manhattan headquarters at 20 Exchange Place. Brown checked his watch. It was two o’clock, the time Kidder’s bond traders gathered nearly every day for the Game. Brown loved the Game. And he was out to destroy it.

  This is going to be good, Brown thought as Kidder’s traders gathered around. It was a moment he’d been planning for months.

  As with any evolutionary change in history, there’s no single shining moment that marks the quants’ ascent to the summit of Wall Street’s pyramid. But the quants certainly established a base camp the day Brown and his like-minded friends beat Liar’s Poker.

  At the time, the quants were known as rocket scientists, since many came from research hotbeds such as Bell Labs, where cell phones were invented, or Los Alamos National Laboratory, birthplace of the atomic bomb. Wall Street’s gut traders eventually proved to be no match for such explosive brainpower.

  Michael Lewis’s Wall Street classic, Liar’s Poker, exemplified and exposed the old-school Big Swinging Dick trader of the 1980s, the age of Gordon Gekko’s “greed is good.” Lewis Ranieri, the mortgage-bond trader made famous in the book, made huge bets based on his burger-fueled gut. Michael Milken of Drexel Burhman for a time ruled the Street, financing ballsy leveraged buyouts with billions in junk bonds. Nothing could be more different from the cerebral, computerized universe of the quants.

  Those two worlds collided when Aaron Brown strode onto Kidder’s trading floor. As an up-and-coming mortgage trader at a rival New York firm, Brown was an interloper at Kidder. And he was hard to miss. A tall bear of a man with a rugged brown beard, Brown stood out even in a crowd of roughneck bond traders.

  As Brown watched, a group of Kidder traders gathered in a circle, each with a fresh $20 bill clutched in his palm. They were playing a Wall Street version of the game of chicken, using the serial numbers on the bills to bluff each other into submission. The rules were simple. The first trader in the circle called out some small number, such as four 2s. It was a bet that the serial numbers of all of the twenties in the circle collectively contained at least four 2s—a pretty safe bet, since each serial number has eight digits.

  The next trader in the circle, moving left, had a choice. He could up the ante—four of a higher number (in this case, higher than 2) or five or more of any number—or he could call. If he called and there were, in fact, four 2s among the serial numbers, he would have to pay everyone in the circle $100 each (or whatever sum was agreed upon when the game began).

  This was meant to continue until someone called. Usually the bets would rise steadily, to something on the order of twelve 9s or thirteen 5s. Then, when the next man—and in the 1980s they were almost always men—called, it would be time to check the twenties to see if the last trader who bet was correct. Say the last bet was twelve 9s. If the bills did in fact have twelve 9s, the trader who called would have to pay everyone. If the bills didn’t have twelve 9s, the trader who made the bet paid up.

  In Lewis’s book, the game involved Salomon chairman John Gutfreund and the firm’s star bond trader John Meriwether, future founder of the doomed hedge fund LTCM. One day, Gutfreund challenged Meriwether to play a $1 million hand of Liar’s Poker. Meriwether shot back: “If we’re going to play for those kind of numbers, I’d rather play for real money. Ten million dollars. No tears.” Gutfreund’s response as he backed away from Meriwether’s bluff: “You’re crazy.”

  Top traders such as Meriwether dominated Liar’s Poker. There was a pecking order in the game that gave an advantage to players who made the earliest guesses, and the top traders always somehow managed to be first in line. Obviously no one would challenge a call of four 2s. But as the game moved toward the end of the line, things got a lot more risky. And the poor schleps at the end of the line were usually the quants, the big-brained rocket scientists. Like Aaron Brown.

  The quants were deploying all the firepower of quantum physics, differential calculus, and advanced geometry to try to subdue the rebellious forces of the market. But in the 1980s, they were at best second-class citizens on investment banks’ trading floors. The kings of Wall Street
were the trade-by-the-gut swashbucklers who relied more on experience and intuition than on number crunching.

  The quants were not happy about the situation. They especially didn’t like being victimized on a daily basis by soft-brained Big Swinging Dicks playing Liar’s Poker, a game that was almost purely determined by probabilities and statistics. Quant stuff.

  Brown fumed over the trader-dominated system’s abuse of the quants. He knew about odds and betting systems. As a teenager he’d haunted the backroom poker games in Seattle and had sat at more than one high-stakes table in Las Vegas, going head-to-head with some of the smartest cardsharps in the country. And he had his pride. So Brown set about beating Liar’s Poker.

  Brown first realized an important fact about the game: you have to be highly confident to issue a challenge. In a ten-person game, if you’re right when you issue a challenge, you gain $100—but if you’re wrong, you lose $900. In other words, you wanted to be 90 percent certain that you were correct to challenge. If he could figure out a pattern for making bets and challenges, he would have an edge over the traders, who were basically playing by gut instinct. The quants would know when to keep betting and when to challenge.

  Brown crunched the numbers and came up with a key insight: A game of Liar’s Poker follows one of two paths. In one path, a single number is passed around, and no one changes the number for the entire round until a challenge is made (five 2s, seven 2s, ten 2s, etc.). In the other path, someone does change the number—usually, Brown figured, somewhere around the tenth bid. In the first path, there is virtually no chance of seeing the same digit appear fourteen times or more in a group of ten $20 bills. But in the second path, if someone changes the number and ups the bid, that often means he has a large number of the same digit on his bill, perhaps three of four. That boosts the odds significantly that there are more than fourteen instances of that digit in the circle.

  Knowing how the two paths differed, along with the odds that accompanied each challenge, helped Brown crack the game. It wasn’t rocket science, but he believed it was enough to do the trick.

  He started circulating his strategy on electronic bulletin boards, and even created a simulator that let the quants practice on their home computers. They focused on speed. Rapid-fire bets would unnerve the traders. They also realized it was often optimal to raise the bets dramatically if they had more than one of the same digit on their twenty, something that hadn’t normally been done in the past. A bet of eight 6s could suddenly shoot to fourteen 7s.

  Their testing complete, the quants finally decided to put their strategy into action on Kidder Peabody’s trading floor. Brown surveyed the action from a distance, chuckling to himself as the bidding started off as normal. The traders were predictable, playing it safe: four 2s.

  When the quants’ turn came, the bids came in fast and furious. Bid … bid … bid. Ten 7s. Twelve 8s. Thirteen 9s. They machine-gunned around the circle back to the top trader, who had started the bidding. Kidder’s traders were dumbfounded. The silence lasted a full minute. The quants struggled to keep straight faces. Brown nearly doubled up with laughter.

  The head trader finally decided to challenge the last quant. Bad move. There were fifteen 9s in the circle. He lost, but he refused to pay, accusing the quants of cheating. The quants just laughed, high-fiving. Brown had expected this. Traders never admit to losing.

  The Liar’s Poker game at Kidder Peabody quietly died off soon after the quant uprising. Brown’s strategy spread to quants at other firms. Within a year, Liar’s Poker had virtually vanished from Wall Street’s trading floors. The quants had killed it.

  The quants were proving themselves to be a force to be reckoned with on Wall Street. No longer would they stand at the end of the line and be victimized by the Big Swinging Dicks.

  Indeed, the quants were flooding into Wall Street in the 1980s from outposts such as BARRA in Berkeley, where Muller was earning his quant chops by creating factor models, or the University of Chicago, where Asness was studying at the feet of Fama and French. The rise of the personal computer, increased volatility due to fluctuating inflation and interest rates, and options and futures exchanges in Chicago and New York created the perfect environment for the brainiacs from academia. Physicists, electrical engineers, even code breakers trained by the military-industrial complex found that they could use the math they’d always loved to make millions in the financial markets. Eventually programs dedicated to the singular goal of training financial engineers cropped up in major universities around the country, from Columbia and Princeton to Stanford and Berkeley.

  The first wave of quants went to banks such as Salomon Brothers, Morgan Stanley, and Goldman Sachs. But a few renegades struck off on their own, forming secretive hedge funds in the tradition of Ed Thorp. In a small, isolated town on Long Island one such group emerged. In time, it would become one of the most successful investing powerhouses the world had ever seen. Its name was Renaissance Technologies.

  It is fitting that Renaissance Technologies, the most secretive hedge fund in the world, founded by a man who once worked as a code breaker for the U.S. government, is based in a small Long Island town that once was the center of a Revolutionary War spy ring.

  The town of Setauket dates from 1655, when a half dozen men purchased a thirty-square-mile strip of land facing Long Island Sound from the Setalcott Indian tribe. When the War for Independence started more than a century later, it had become the most densely settled town in the region. Long Island largely lay in the hands of the British during the war after George Washington’s defeat in the Battle of Brooklyn in 1776. Setauket, a port town, boasted its share of guerillas, however. The redcoats cracked down, turning it into a garrison town.

  The Culver Spy Ring sprang up a year later. Robert Townsend of nearby Oyster Bay posed as a Tory merchant in Manhattan to gather information on British maneuvers. He passed along information to an innkeeper in Setauket who frequently traveled to New York, who relayed the messages to a Setauket farmer, who handed the intelligence to a whaleboat captain named Caleb Brewster. Brewster carried the package across Long Island Sound to Setauket native Major Benjamin Tallmadge, who was headquartered in Connecticut. At last, Tallmadge posted the messages to General Washington.

  After the war, Washington made a tour of Long Island and visited Setauket to meet the spies. He stayed at Roe’s Tavern on the night of April 22, 1790, and wrote in his diary that the town was “tolerably decent.”

  In Washington’s day, Roe’s Tavern was located on a road that’s now called Route 25A—the same road where Renaissance Technologies’ headquarters can be found today.

  Renaissance’s flagship Medallion fund, launched in the late 1980s, is considered by many to be the most successful hedge fund in the world. Its returns, at roughly 40 percent a year over the course of three decades, are by a wide margin unmatched in the investing world. By comparison, before the recent stock market implosion, Warren Buffett’s storied Berkshire Hathaway averaged an annual return of about 20 percent. (Of course, scale matters: Medallion has about $5 billion in capital, while Berkshire is worth about $150 billion, give or take a few billion.)

  Indeed, Medallion’s phenomenal returns have been so consistent that many in quantdom wonder whether it possesses that most elusive essence of all: the Truth.

  As a toddler growing up in a small town just outside of Boston, James Harris Simons was stunned to learn that a car could run out of gas. He reasoned that if the tank was half full, and then lost another half, and another half, it should always retain half of the previous amount. He had stumbled upon a logical riddle known as Zeno’s paradox, not exactly common fare for a preschooler.

  Simons excelled at math in high school, and in 1955 he enrolled at MIT. He soon caught the poker bug, playing with friends into the late hours of the night before piling into his Volkswagen Beetle and driving to Jack & Marion’s deli in nearby Brookline for breakfast.

  Simons cruised through MIT’s bachelor’s program in math in t
hree years, aced its master’s program in one, and then enrolled in Berkeley’s Ph.D. program, studying physics. At Berkeley, he got his first taste of commodities trading, making a tidy sum on soybeans. After earning his doctorate, Simons taught classes at MIT before moving up the road to Harvard. Dissatisfied with a professor’s salary, he took a job with the Institute for Defense Analysis, a nonprofit research wing of the Defense Department.

  The IDA had been established in the mid-1950s to provide civilian assistance to the military’s Weapons Systems Evaluation Group, which studies technical aspects of newfangled weapons. By the time Simons arrived, the IDA had set up a branch in Princeton that had become a haven for Cold War code breakers.

  The Vietnam War was raging, aggravating many of the more liberal academic types who worked at civilian research labs such as IDA. In 1967, a former chairman of the Joint Chiefs of Staff, Maxwell Taylor, president of IDA, wrote an article in favor of the war for the New York Times Magazine. The article elicited an acid response from Simons. “Some of us at the institution have a different view,” the twenty-nine-year-old Simons wrote in a letter to the magazine’s editors, which was published in October 1967. “The only available course consistent with a rational defense policy is to withdraw with the greatest possible dispatch.”

  The letter apparently cost Simons his job. But it didn’t take him long to find a new one. In 1968, he took the position of chairman of the math department at the State University of New York at Stony Brook, on Long Island and just up the road from Setauket. He gained a reputation for aggressively recruiting top talent, building the department into a mecca for math prodigies around the country.

  Simons left Stony Brook in 1977, a year after winning the Oswald Veblen Prize, one of the highest honors in the geometry world, awarded by the American Mathematics Society every five years. With Shiing-Shen Chern, he developed what’s known as the Chern-Simons theory, which became a key component of the field of string theory, a hypothesis that the universe is composed of tiny strings of energy humming in multidimensional spaces.