Scott Patterson covered the markets as a reporter for the Wall Street Journal during the market run up, credit crisis and collapse.
He details the impact in his book The Quants — a highly readable, very entertaining look at the new breed of mathematicians and financial engineers who got caught in the middle of it all.
I spent some time with Scott chatting about the book, the players in it, and life after the WSJ.
Yesterday, was Part I of our interview; Here is part II
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Barry Ritholtz: So if this went in in 2008, the question I was leading up to earlier was"¦let's go through some of the characters and find out what happened to them, it's now two, almost three years later.
Did anybody blow up, did anybody recover? What's the net takeaway?
Scott Patterson:: Ken Griffin and Citadel is a good example, in late 2008, as I was trying to put the finishing touches on this book, and Ken is a guy that I've been following, and he's really interesting in the arc of this book. Thorp helps set up Citadel, and he actually teaches Griffin some of his trading strategies, he gives him a lot of his own documents and papers, sort of passes the baton.
Q: Does Thorp have a piece of Citadel?
A: He was invested in Citadel from the get-go, so he followed Citadel, and then in 2008, Citadel came a hair's breadth from imploding, they were totally on the edge, the banks were"¦
Q: Almost out of capital?
A: Yeah, a lot of it is theoretical, because there's a lot of derivatives involved, they had exposures all across Wall Street, and they lost billions of dollars, five or six billion dollars. Their main hedge funds, Kensington and Wellington, were down about 55 percent, and these were 15, 16 billion dollar hedge funds. I don't know if you remember, but there was a time when there were a lot of rumors about Citadel, it was freaking everybody out, because if they went down, they had this massive convertible bond portfolio that would have flooded across the market, it would have been just another domino to fall that would have pushed us closer to that Armageddon scenario that people were worried about.
Q: Long Term Capital Management with a lot more funds sitting right on top of them.
A: Yeah, with leverage, they had 160 to maybe 170 billion in positions, so it was a massive amount. They steadied the ship in '09, and the convertible bond market had a comeback, and they're still somewhat wounded, I don't know if Ken is ever going to get to the top of the heap like he was.
Q: I saw him speak this summer, and I thought he was really interesting and intelligent. There was a bit of an ego between these four guys on the panel at the Saltbridge Conference in Vegas– what was your impression with some of them in terms of dealing with their egos, and why did they want to speak? Most of them don't want to reveal the secrets and don't want publicity.
A: Part of it, I guess it's two things, some people want their story to be told, and I started reporting this book in early 2008 when things were bad, but they didn't look that bad.
Q: We were in a cyclical recession.
A: Right, Ken Griffin had said that he thought the market would go through a blip in early 2008 and things would come roaring back, which is why they were putting more leverage on at Citadel. Eddie Lampert is the guy who's not a quant, he was kidnapped"¦but it's a mix, and part of it is just being a reporter, like with Pete Muller, he definitely didn't want to talk to me, but I got enough information about PDT and him and talking to other people that he realized that he should at least try to engage with me. With Pete, it was on and off throughout the whole period.
Q: That's the Bob Woodward approach.
A: That's a classic thing, we call it smoke them out of their holes.
Q: That was done in "?Too Big to Fail,' where [NYT reporter Andrew Ross] Sorkin seemed to get them on the phone, and say "If you don't want to tell me your side, we'll just go with what Jamie Dimon said." People don't want to let someone else paint their biography.
Talk a little about Deutsche Bank and Boaz Weinstein. At one time, Deutsche Bank's trading arm was a monster.
A: And their credit derivatives desk, their bond desk, was one of the biggest in the country, if not the world. At the top of it was this guy, Boaz Weinstein, who's part of this poker group, he's friends with Pete Muller and Cliff Asness and other guys who, as I write about in the book, they have this monthly poker game in the city, and he's part of that. Boaz was positioned perfectly to ride the derivatives boom that started in the late Nineties, he was on Deutsche Bank's desk when credit default swaps first came out, he was one of the first people to ever trade a credit default swap.
A: Early adopter, loved the asset class"¦
Q: He helped spread them around the industry, he'd go on these calls to pension funds and banks and say, "We've got this cool new thing, credit default swap, you should try it," because they're looking for counter-parties to make a market, so he helped create the market, he came up with a strategy called capital structure arbitrage"¦it's an arbitrage between the stocks and debt, and he's using a credit default swap to do the trade.
Q: So it's a debt equity arbitrage.
A: Yeah.
Q: Amongst the same stock "“ if you have Lehman, you might be short.
A: He would discover inefficiencies between the price of the stock and the bond and became really good at putting these trades on, so he ended up running Deutsche Bank's global bond desk at the age of 33, and he was in charge of this other prop trading arm at Deutsche Bank that he called "?saba,' which is a Hebrew word for "?grandfather,' and he was this incredibly powerful guy making huge bets"¦
Q: And a kid, essentially.
A: Yeah, but in a way, he was representing the evolution of Wall Street, the older guys who were used to playing vanilla bonds, they had no idea how to use these new derivatives, and to him, it was natural, that's just how he grew up trading, so it was an evolution of the market, he road that wave, he was very good at it, and when Lehman went down, the CDS market just froze, and it screwed up his trades, because he'd hedged these positions with CDS, and the CDS market just froze, it wasn't moving, so he ended up having these losses on his books that if the CDS market was working as it should have, he probably would have been OK, but it didn't, and he was using quantitative formulas to put all these trades together, and it's just another example of how when things don't work out in panics, which seems to happen a lot on Wall Street, these very careful, calibrated trades, if you're using a lot of leverage, which he was, can blow up in your face, and they ended up losing about two billion dollars in the course of about a month or two.
Q: Which, in the scheme of things, is not a huge amount of money relative to what it threw off in profits. Some shops seem to have wiped out previous decades worth of profits.
A: When you add up how much he'd made over the past few years to how much he lost, he ended up kind of flat.
Q: So he gave back all the profits he made?
A: Yeah, it looks like Boaz did not make money for Deutsche Bank over the three or four years leading up to, at least on that prop desk. Now he was also running the flow desk, which can raise questions itself, Chinese walls"¦he was in charge of that flow desk, which had billions of dollars flowing through it, and I'm sure they were profitable.
Q: I was going to ask about the Gaussian Copula, but I don't know if you really want to get that far into the weeds.
A: It's difficult to talk about, it's the formula that most of Wall Street was using, and the rating agencies, to price these CDOs or synthetic CDOs, more than anything, the bundles of credit default swaps that were designed to mimic cash CDOs, and they were basically, in a nutshell, trying to calculate the correlations between the various tranches of the synthetic CDOs, and it was a very complicated formula. It was also based on correlation, so if one tranche of triple As is trading at 99 cents on the dollar based on historical performance, the triple B tranche is going to be at 92, so you ended up having, based on this formula, a new breed of trader that rose up in Wall Street in the 2000s called correlation traders, and they were making bets on the various tranches of synthetic CDOs, shorting some tranches, going long other tranches, using the model, and that is basically what blew up Morgan Stanley. Morgan Stanley was doing correlation bets on synthetic CDOs.
Q: And heavily leaned into it.
A: Yeah.
Q: How much of what took place"¦when you trade straight up stocks or bonds, there's an exchange, the trade is guaranteed to clear, and it's so liquid, unless you're trading some of these stupid penny stocks. You want to sell 100 million shares of Cisco, you can. If you need to get out of millions of shares of Apple or Citigroup, you could move billions of dollars pretty easily.
How much of the problems that someone like Boaz ran into is the fact that this is really a bespoke investment, and you're like, "Let me find somebody"¦" No one sets up a hedge fund that they're going to fill with "?Star Wars' collectables and Beanie Babies, because the zero liquidity, they have to sell it in a panic, there's nobody on the other side, as opposed to a market with a market-maker, although since the flash crash, that's even arguable these days.
But when we're looking at these credit default swaps and they're frozen, how do you go from a position where you're essentially fully-hedged and can't take the loss, because the worse this gets, the better that gets, to it blows up on you anyway? How do you work around that?
A: I think in a way, you're talking about how a dealer market works, and it's a dark market, it's opaque. The dealers control it, and they know what the prices are, so that's how the stock market"¦the NASDAQ market used to be like that, it was controlled by dealers. On black Monday in October 1987, the dealers just walked away from the phones, and you couldn't trade, so the market froze. That changed with the rise of electronic markets, things became a lot more transparent.
Q: Is this the inevitable outcome of the post-'87 crash, that as we've moved to electronics and computers, we've made ourselves vulnerable to Skynet setting up a trading system?
A: I think that the electronic markets bring some real positive benefits. The U.S. stock market has become a lot more transparent in many ways, although we have dark pools and high frequency firms, I think things have gotten to a level of complexity that maybe it's shifting into the dark again.
Q: Quote-stuffing"¦
A: There's a lot of weird stuff going on. What I'm saying is in a dealer-controlled market, there is very little transparency, and I think what happened in the summer of 2007 in this market, when Bear Stearns started dumping bonds, or Merrill Lynch seized Bear's collateral and started dumping the collateral on the market, the market froze, and the dealers were not talking to each other, nobody really knew what the fair price was for these securities, and essentially, these derivatives went into a black hole, and nobody knew what the price was, and they've been using this really screwed up Gaussian Copula model to trade it, that thing blew up, it didn't work anymore. I've talked to quants who used it and just said that it became so screwed up, you couldn't get anything.
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