"We couldn't believe people would sell us these long-term options so cheaply," said Jamie. "We went looking for more long-dated options."
It instantly became a fantastically profitable strategy: Start with what appeared to be a cheap option to buy or sell some Korean stock, or pork belly, or third-world currency--really anything with a price that seemed poised for some dramatic change--and then work backward to the thing the option allowed you to buy or sell. The options suited the two men's personalities: They never had to be sure of anything. Both were predisposed to feel that people, and by extension markets, were too certain about inherently uncertain things. Both sensed that people, and by extension markets, had difficulty attaching the appropriate probabilities to highly improbable events. Both had trouble generating conviction of their own but no trouble at all reacting to what they viewed as the false conviction of others. Each time they came upon a tantalizing long shot, one of them set to work on making the case for it, in an elaborate presentation, complete with PowerPoint slides. They didn't actually have anyone to whom they might give a presentation. They created them only to hear how plausible they sounded when pitched to each other. They entered markets only because they thought something dramatic might be about to happen in them, on which they could make a small bet with long odds that might pay off in a big way. They didn't know the first thing about Korean stocks or third world currencies, but they didn't really need to. If they found what appeared to be a cheap bet on the price movements of any security, they could then hire an expert to help them sort out the details. "That has been a pattern of ours," said Jamie Mai. "To rely on the work of smart people who know more than we do."
They followed their success with Capital One with a similar success, in a distressed European cable television company called United Pan-European Cable. This time, since they had more money, they bought $500,000 in call options, struck at a price far from the market. When UPC rallied, they turned a quick $5 million profit. "We're now getting really, really excited," says Jamie. Next they bet on a company that delivered oxygen tanks directly to sick people in their homes. That $200,000 bet quickly turned into $3 million. "We're now three for three," said Charlie. "We think it's hilarious. For the first time I could see myself doing this for a really long time."
They had stumbled either upon a serious flaw in modern financial markets or into a great gambling run. Characteristically, they were not sure which it was. As Charlie pointed out, "It's really hard to know when you're lucky and when you're smart." They reckoned that by the time they had a statistically valid track record they'd be dead, or close to it, and so they didn't spend a lot of time worrying about whether they'd been lucky, or smart. Either way, they knew they didn't know as much as they should, especially about financial options. They hired a PhD student from the statistics department at the University of California at Berkeley to help them, but he quit after they asked him to study the market for pork belly futures. "It turned out that he was a vegetarian," said Jamie. "He had a problem with capitalism in general, but the pork bellies pushed him over the edge." They were left to grapple on their own with a lot of complicated financial theory. "We spent a lot of time building Black-Scholes models ourselves, and seeing what happened when you changed various assumptions in them," said Jamie. What struck them powerfully was how cheaply the models allowed a person to speculate on situations that were likely to end in one of two dramatic ways. If, in the next year, a stock was going to be worth nothing or $100 a share, it was silly for anyone to sell a year-long option to buy the stock at $50 a share for $3. Yet the market often did something just like that. The model used by Wall Street to price trillions of dollars' worth of derivatives thought of the financial world as an orderly, continuous process. But the world was not continuous; it changed discontinuously, and often by accident.
Event-driven investing: That was the name they either coined or stole for what they were doing. That made it sound a lot less fun than it was. One day Charlie found himself intrigued by the market for ethanol futures. He didn't know much about ethanol, but he could see that it enjoyed a U.S. government subsidy of 50 cents a gallon, and so was supposed to trade at a 50-cent-a-gallon premium to gasoline, and always had. In early 2005, when he became interested, it traded, briefly, at a 50-cent discount to gas. He didn't know why and never found out; instead, Charlie bought two rail cars' worth of ethanol futures, and made headlines in Ethanol Today, a magazine of whose existence he was previously unaware. To the intense irritation of Cornwall's broker, they wound up having to accept rail cars filled with ethanol in some stockyard in Chicago--to make a sum of money that struck the broker as absurdly small. "The administrative complexity of what we were doing was out of proportion to our assets," said Charlie. "People who were our size didn't trade across asset classes."
"We were doing the sort of things that might cause your investors to yell at you," said Jamie, "but we didn't get yelled at by investors because we didn't have any investors."
They actually thought about handing their winnings over to some certified, qualified, sanitized, honest-to-God professional investor to run the money for them. They raced around New York for several weeks, interviewing hedge fund managers. "They all sounded great when you listened to them," said Jamie, "but then you'd look at their numbers and they were always flat." They decided to keep on investing their money themselves. Two years after they'd opened for business, they were running $12 million of their own and had moved themselves and their world headquarters from the Berkeley shed to an office in Manhattan--a floor of the Greenwich Village studio of the artist Julian Schnabel.
They'd also moved their account, from Schwab to Bear Stearns. They longed for a relationship with some big Wall Street trading firm and mentioned the desire to their accountant. "He said he knew Ace Greenberg and he could introduce us to him, and so we said great," said Charlie. The former chairman and CEO of Bear Stearns, and a Wall Street legend, Greenberg still kept an office at the firm and acted as a broker for a handful of presumably special investors. When Cornwall Capital moved their assets to Bear Stearns, sure enough, their brokerage statements soon came back with Ace Greenberg's name on top.
Like most of what befell them in the financial markets, their first brush with a big Wall Street firm was delightfully weird but ultimately inexplicable. Just like that, without ever having laid eyes on Ace Greenberg, they were his customers. "We were like, 'So how is it that Ace Greenberg is our broker?'" said Charlie. "I mean, we were nobody. And we'd never actually met Ace Greenberg." The mystery grew with their every attempt to speak with Greenberg. They had what they assumed was his phone number, but when they called it someone other than Greenberg answered. "It was totally bizarre," said Charlie. "Occasionally, Ace Greenberg himself would pick up the phone. But all he'd say was, 'Hold on.' Then a secretary would come on the line and take our order."
At length they talked their way into a face-to-face encounter with the Wall Street legend. The encounter was so brief, however, that they could not honestly say whether they had met Ace Greenberg, or an actor playing Ace Greenberg. "We were ushered in for thirty seconds--literally thirty seconds--and then unceremoniously ushered out," says Jamie. Ace Greenberg was still their broker. They just never spoke to him.
"The whole Ace Greenberg thing still doesn't make sense to us," says Charlie.
The man to whom they now referred as "the actor who plays Ace Greenberg" failed to resolve what they viewed as their biggest problem. They were small private investors. The Wall Street firms were largely a mystery to them. "I've never actually, like, been on the inside of a bank," said Charlie. "I can only imagine what's going on inside by imagining it through someone else's eyes." To do the sort of trades they wanted to do, they needed to be mistaken by the big Wall Street firms for investors who knew their way around a big Wall Street firm. "As a private investor you are a second-class citizen," said Jamie. "The prices you get are worse, the service is worse, everything is worse."
The thought had ga
ined force with the help of Jamie's new neighbor in Berkeley, Ben Hockett. Hockett, also in his early thirties, had spent nine years selling and then trading derivatives for Deutsche Bank in Tokyo. Like Jamie and Charlie, he had the tangy, sweet-smelling aroma of the dropout about him. "When I started I was single and twenty-two," he said. "Now I have a wife and a baby and a dog. I'm sick of the business. I don't like who I am when I get home from work. I didn't want my kid to grow up with that as a dad. I thought, I gotta get out of here." When he went in to quit, his Deutsche Bank bosses insisted that he list his grievances. "I told them I don't like going into an office. I don't like wearing a suit. And I don't like living in a big city. And they said, 'Fine.'" They told him he could wear whatever he wanted to wear, live wherever he wanted to live, and work wherever he wanted to work--and do it all while remaining employed by Deutsche Bank.
Ben moved from Tokyo to the San Francisco Bay area, along with $100 million of Deutsche Bank's money, which he traded from the comfort of his new home in Berkeley Hills. He suspected, not unreasonably, that he might be the only person in Berkeley looking for arbitrage opportunities in the market for credit derivatives. The existence just down the street of a guy roaming the globe in his mind looking to buy long-term options on financial drama caught him by surprise. Ben and Jamie took to walking their dogs together. Jamie pumped Ben for information about how big Wall Street firms and esoteric financial markets worked, and finally prodded him to quit his real job and join Cornwall Capital. "After three years in a room by myself, I thought it would be nice to work with people," said Ben. He quit Deutsche Bank to join the happy hunt for accident and disaster, and pretty quickly found himself working alone again. Charlie moved back to Manhattan as soon as he could afford the ticket, and, when his relationship with his girlfriend ended, Jamie eagerly followed.
Theirs was a union of the weirdly like-minded. Ben shared Charlie and Jamie's view that people, and markets, tended to underestimate the probability of extreme change, but he took his thinking a step further. Charlie and Jamie were interested chiefly in the probabilities of disasters in financial markets. Ben walked around with some very tiny fraction of his mind alert to the probabilities of disasters in real life. People underestimated these, too, he believed, because they didn't want to think about them. There was a tendency, in markets and life, for people to respond to the possibility of extreme events in one of two ways: flight or fight. "Fight is, 'I'm going to get my guns,'" he said. "Flight is, 'We're all doomed so I can't do anything about it.'" Charlie and Jamie were flight types. When he'd mention to them the possibility that global warming might cause sea levels to rise by twenty feet, for instance, they'd just shrug and say, "I can't do anything about it, so why worry about it?" Or: "If that happens I don't want to be alive anyway."
"They're two single guys in Manhattan," said Ben. "They're both like, 'And if we can't live in Manhattan, we don't want to live at all.'" He was surprised that Charlie and Jamie, both now so alive to the possibility of dramatic change in the financial markets, were less alert and responsive to the possibilities outside those markets. "I'm trying to prepare myself and my children for an environment that is unpredictable," Ben said.
Charlie and Jamie preferred Ben to keep his apocalyptic talk to himself. It made people uncomfortable. There was no reason anyone needed to know, for example, that Ben had bought a small farm in the country, north of San Francisco, in a remote place without road access, planted with fruit and vegetables sufficient to feed his family, on the off chance of the end of the world as we know it. It was hard for Ben to keep his worldview to himself, however, especially since it was the first cousin of their investment strategy: The possibility of accident and disaster was just never very far from their conversations. One day on the phone with Ben, Charlie said, You hate taking even remote risks, but you live in a house on top of a mountain that's on a fault line, in a housing market that's at an all-time high. "He just said, 'I gotta go,' and hung up," recalled Charlie. "We had trouble getting hold of him for, like, two months."
"I got off the phone," said Ben, "and I realized, I have to sell my house. Right now." His house was worth a million dollars and maybe more yet would rent for no more than $2,500 a month. "It was trading more than thirty times gross rental," said Ben. "The rule of thumb is that you buy at ten and sell at twenty." In October 2005 he moved his family into a rental unit, away from the fault.
Ben thought of Charlie and Jamie less as professional money managers than as dilettantes or, as he put it, "a couple of smart guys just punting around in the markets." But their strategy of buying cheap tickets to some hoped-for financial drama resonated with him. It was hardly foolproof; indeed, it was almost certain to fail more often than it succeeded. Sometimes the hoped-for drama never occurred; sometimes they actually didn't know what they were doing. Once, Charlie found what he thought was a strange price discrepancy in the market for gasoline futures, and quickly bought one gas contract, sold another, and made what he took to be a riskless profit--only to discover, as Jamie put it, "one was unleaded gasoline and the other was, like, diesel." Another time, the premise was right but the conclusion was wrong. "One day Ben calls me and says, 'Dude, I think there's going to be a coup in Thailand,'" said Jamie. There'd been nothing in the newspapers about a coup in Thailand; this was a genuine scoop. "I said, 'C'mon, Ben, you're crazy, there's not going to be a coup. Anyway, how would you even know? You're in Berkeley!'" Ben swore he had talked to a guy he used to work with in Singapore, who had his finger on the pulse in Thailand. He was so insistent that they went into the Thai currency market and bought what appeared to be stunningly cheap three-month puts (options to sell) on the Thai baht. One week later, the Thai military overthrew the elected prime minister. The Thai baht didn't budge. "We predicted a coup, and we lost money," said Jamie.
The losses, by design, were no big deal; the losses were part of the plan. They had more losers than winners, but their losses, the cost of the options, had been trivial compared to their gains. There was a possible explanation for their success, which Charlie and Jamie had only intuited but which Ben, who had priced options for a big Wall Street firm, came ready to explain: Financial options were systematically mispriced. The market often underestimated the likelihood of extreme moves in prices. The options market also tended to presuppose that the distant future would look more like the present than it usually did. Finally, the price of an option was a function of the volatility of the underlying stock or currency or commodity, and the options market tended to rely on the recent past to determine how volatile a stock or currency or commodity might be. When IBM stock was trading at $34 a share and had been hopping around madly for the past year, an option to buy it for $35 a share anytime soon was seldom underpriced. When gold had been trading around $650 an ounce for the past two years, an option to buy it for $2,000 an ounce anytime during the next ten years might well be badly underpriced. The longer-term the option, the sillier the results generated by the Black-Scholes option pricing model, and the greater the opportunity for people who didn't use it.
Oddly, it was Ben, the least personally conventional of the three, who had the Potemkin-village effect of making Cornwall Capital appear to outsiders to be a conventional institutional money manager. He knew his way around Wall Street trading floors and so also knew the extent to which Charlie and Jamie were being penalized for being perceived by the big Wall Street firms as a not terribly serious investor or, as Ben put it, "a garage band hedge fund." The longest options available to individual investors on public exchanges were LEAPs, which were two-and-a-half-year options on common stocks. You know, Ben said to Charlie and Jamie, if you established yourself as a serious institutional investor, you could phone up Lehman Brothers or Morgan Stanley and buy eight-year options on whatever you wanted. Would you like that?
They would! They wanted badly to be able to deal directly with the source of what they viewed as the most underpriced options: the most sophisticated, quantitative trading desks at Goldman
Sachs, Deutsche Bank, Bear Stearns, and the rest. The hunting license, they called it. The hunting license had a name: an ISDA. They were the same agreements, dreamed up by the International Swaps and Derivatives Association, that Mike Burry secured before he bought his first credit default swaps. If you got your ISDA, you could in theory trade with the big Wall Street firms, if not as an equal then at least as a grown-up. The trouble was that, despite their success running money, they still didn't have much of it. Worse, what they had was their own. Inside Wall Street they were classified, at best, as "high net worth individuals." Rich people. Rich people received a better class of service from Wall Street than middle-class people, but they were still second-class citizens compared to institutional money managers. More to the point, rich people were typically not invited to buy and sell esoteric securities, such as credit default swaps, not traded on open exchanges. Securities that were, increasingly, the beating heart of Wall Street.
By early 2006, Cornwall Capital had grown its stash to almost $30 million, but even that, to the desks inside the Wall Street firms that sold credit default swaps, was a risibly small sum. "We called Goldman Sachs," said Jamie, "and it was just immediately clear they didn't want our business. Lehman Brothers just laughed at us. There was this impenetrable fortress you had either to scale or dig underneath." "J.P. Morgan actually fired us as a customer," said Charlie. "They said we were too much trouble." And they were! In possession of childish sums of money, they wanted to be treated as grown-ups. "We wanted to buy options on platinum from Deutsche Bank," said Charlie, "and they were like, 'Sorry we can't do this with you.'" Wall Street made you pay for managing your own money rather than paying someone on Wall Street to do it for you. "No one was going to take us," said Jamie. "We called around and it was one hundred million bucks, minimum, to be credible."
The Big Short: Inside the Doomsday Machine Page 13
