Bizarrely, the ratings weren’t based on the relative quality of the underlying loans. The AAA tranches could hold loans of the same value and quality as those in the lowest-rated tranches. The ratings, rather, were based on who got paid first in the stack of loans. The owners of AAA tranches had the first dibs on payments. When borrowers started to default, the owners of the lowest-tier tranches got whacked first. If enough borrowers defaulted, higher-rated tranches would start to suffer.
One of the problems with the Byzantine practice of carving up CDOs into all of these slices was figuring out how to price them. Sometime around 2000, the quants came up with an answer: correlation. By getting the price of one small part of the bundle of slices, quants could figure out the “right” prices of all the other slices by looking at how correlated they were with one another. If the pool of loans started experiencing, say, a 5 percent rate of defaults, the quants could calculate the impact on each of the slices through their computers and figure out the correlations between each slice of the pie, all the way up to the AAA slice.
It was assumed, of course, that the poor-quality slices and the AAA slices had very little in common in terms of the likelihood of defaults by the homeowners who received the original mortgages. Put another way, the correlation between them was extremely low, almost infinitesimal.
Weinstein and several other traders at Deutsche Bank (and a number of clever hedge funds) figured out that the correlations in most models were off by miles. When they peered into the underlying loans in the CDOs, they discovered that many of the loans were so shaky, and so similar, that when one slice of the pie started to go bad, that meant the entire pie would be rotten. So many low-quality loans had been stuffed into the CDOs that even owners of seemingly safe, high-rated tranches would suffer. In other words, the correlations were very high. But most people buying and selling the slices thought they were very low.
To Weinstein, that meant a trade. Through even more esoteric quant alchemy, there were ways to “short” CDO slices through Weinstein’s favorite method: credit default swaps. By purchasing a swap, or a bunch of swaps bundled together, Weinstein would effectively take out an insurance policy on the underlying subprime loans. If those loans went belly up—which Weinstein thought most likely—the policy paid out. In simple terms, Weinstein was betting that the market was underestimating the toxicity of the subprime mortgage market.
Even better for Weinstein, most traders were so enthusiastic about the housing market and the CDOs bundling all those loans that the cost of shorting the market was extremely cheap. Weinstein saw this as an almost can’t-lose bet. Huge profits could be made. And if he was wrong, he’d lose only the scant amount he’d paid for the insurance policy.
“We’re putting on the trade at Deutsche,” Weinstein said, gazing at his cards.
Asness and Muller nodded. It was typical quant shoptalk, one trader describing a clever new bet to his peers, but they were getting bored. It was time to get down to the business at hand. The only bet on their minds at the moment involved a pile of chips worth several thousand dollars in the center of the table.
Weinstein looked at his hand and grimaced. He had nothing and folded.
“Raise a thousand,” Asness said, tossing more chips on the pile.
Muller peered at Asness, who sat back in his chair and grinned nervously, his face reddening. Poor Cliff. It’s so easy to tell when he’s bluffing. No poker face whatsoever on the man.
“Call,” Muller said, throwing down another winning hand to Asness’s agonized groan. Muller was on a hot streak, and he laughed as he swept the chips into the steadily rising pile in front of him.
Boaz Weinstein wasn’t the only one worrying about the health of CDOs in 2007. Aaron Brown—the quant who’d beaten Liar’s Poker in the 1980s—had gotten his hands dirty in the securitization industry almost since its inception. His career had provided him with a front-row seat on its evolution and cancerous growth throughout Wall Street. For years he had watched with increasing trepidation as the CDO industry grew larger and, at the same time, more divorced from reality. By 2007, Brown was working at Morgan Stanley as a risk manager and growing uncomfortable with Morgan’s subprime exposure. He was ready to get out.
He’d already been in low-level discussions about a job with a hedge fund that was staffing up for an IPO: AQR. Cliff Asness’s firm was looking for a risk management veteran to deal with thorny issues such as international risk regulations. Brown loved the idea. He’d never worked at a hedge fund and was eager to give it a shot. In June 2007, he signed on as AQR’s chief risk officer.
Brown was well aware of AQR’s reputation as a top-of-the-line quant shop that spoke his language. But he had little idea that AQR, like Morgan Stanley, was sitting on top of a bubbling cauldron of risk that was about to explode in spectacular fashion.
Growing up in Seattle, Brown had always been fascinated by numbers—baseball box scores, weather charts, stock pages. He couldn’t have cared less about the events they denoted—the walk-off home runs, the hurricane-wrecked trailer parks, the mergers of corporate rivals. It was the rows of digits that caught Brown’s fancy, the idea that there was some kind of secret knowledge behind the numbers. His love of mathematics eventually led him to one of the most influential books he would ever read: Ed Thorp’s Beat the Dealer.
Brown devoured the book, mesmerized by the idea that he could use math to make money at a game as simple as blackjack. After mastering Thorp’s card-counting method, he moved on to poker. At fourteen, he became a regular in Seattle’s underground gambling halls. Seattle was a port town full of sailors, hard-luck transients, and been-around-the-world sharpies. Brown couldn’t match them for machismo, but they couldn’t touch his math or his intuition. He quickly realized that he was very good; he excelled not just at figuring the odds of each hand but at reading the poker faces of his opponents. He could sense a bluff a mile away.
In 1974, he graduated from high school with top grades, got perfect scores on his college board exams, and headed straight for Harvard. He studied under Harrison White, a sociologist who applied quantitative models to social networks, and also dove into Harvard’s active poker scene, which included George W. Bush as a regular in Harvard Business School’s poker circles. Indeed, Harvard’s bumper crop of spoiled rich kids seemed eager to lose money to Brown, and he was happy to oblige. But the stakes were usually too low for his taste, or the games too unprofessional. He made his way to a game future Microsoft founder Bill Gates ran at Harvard’s Currier House, but Brown found it too regimented and uptight. A bunch of tense nerds trying to act cool, he thought.
After graduating in 1978, Brown took a job at American Management Systems, a consulting firm in northern Virginia. The job was fine, but the D.C. poker circuit was a bigger draw. It was no trouble to get in on games with the odd congressman. Once he heard about a party that had a hot backroom game. He walked into an apartment and saw a heavyset man wearing a tight T-shirt, girls who looked like dolled-up secretaries hanging from each arm. It was none other than Texas congressman Charlie Wilson, future subject of the book and movie Charlie Wilson’s War. Brown liked Wilson, thought he was a fun guy. Better yet, Wilson loved to play poker. He wasn’t bad at it, either.
Brown wasn’t satisfied with his job, though, and once again felt the tug of academia. In 1980, he started taking classes at the University of Chicago’s graduate school in economics. In Chicago, Brown became enthralled with the mysterious world of stock options. He picked up Thorp’s Beat the Market and quickly mastered the book’s technique for pricing stock warrants and convertible bonds. In short order, he was doing so well trading options that he considered dropping out of school and pursuing a full-time trading career. Instead, he decided to see through his term at Chicago, while trading on the side.
Brown had no intention of becoming an academic, however. His experience trading options had given him a taste for the real thing. After years playing poker and blackjack in backroom card parlors arou
nd the country, he heard the siren song of the world’s biggest casino: Wall Street. After graduating in 1982, he moved to New York. His first job was helping to manage the pension plans of large corporations for Prudential Insurance Company of America. A few years later, he took a job as head of mortgage research at Lepercq, de Neuflize & Co., a boutique investment advisor in New York.
With each move, Brown delved more deeply into quantdom. At the time, quants were seen as second-class citizens at most trading firms, computer nerds who didn’t have the balls to take the kinds of risks that yielded the real money. Brown got sick of seeing the same rich kids he’d suckered at Harvard lord it over the quants in trading-floor games such as Liar’s Poker. That’s when he decided to bust up Liar’s Poker with quant wizardry.
At Lepercq he picked up a new quant skill: the dark art of securitization. Securitization was a hot new business on Wall Street in the mid-1980s. Bankers would purchase loans such as mortgages from thrifts or commercial banks and bundle them up into securities (hence the name). They would slice those securities into tranches and sell off the pieces to investors such as pension funds and insurance companies. Brown quickly learned how to carve up mortgages into slices with all the dexterity of a professional chef.
Prior to the securitization boom, home loans were largely the province of community-based lenders who lived and died by the time-honored business of borrowing cheap and lending at higher rates. A loan was made by the bank and stayed with the bank until it was paid off. Think Jimmy Stewart and the Bailey Building & Loan Association of the Frank Capra classic It’s a Wonderful Life. It was such a stolid business that local bankers lived by what some called the “rule of threes”: borrow money at 3 percent, lend it to home buyers at three points higher, and be on the golf course by three.
But as baby boomers started buying new homes in the 1970s, Wall Street noticed an opportunity. Many savings and loans didn’t have enough capital to satisfy the demand for new loans, especially in Sunbelt states such as California and Florida. Rust Belt thrifts, meanwhile, had too much capital and too little demand. A Salomon bond trader named Bob Dall saw an opening to bring the two together through the financial alchemy of securitization. Salomon would be the middleman, shifting stagnant assets from the Rust Belt to the Sunbelt, plucking out a portion of the money for itself along the way. To trade the newly created bonds, he turned to Lewis Ranieri, a thirty-year-old trader from Brooklyn working on the bank’s utility bond desk.
Over the next few years, Ranieri and colleagues fanned out across the United States, wooing bankers and lawmakers to their bold vision. Mortgage loans made by local banks and thrifts were purchased by Salomon, repackaged into tradable bonds, and sold around the globe. And everybody was happy. Homeowners had access to loans, often at a cheaper interest rate, since there was more demand for the loans from Wall Street. The S&Ls no longer had to worry about borrowers defaulting, because the default risk had been shifted to investors. The banks gobbled up a tidy chunk of middleman fees. And investors could get custom-made, relatively low-risk assets. It was quant heaven.
The Salomon wizards didn’t stop there. Like car salesmen always looking to lure buyers and increase share with shiny new models, they began to concoct something called collateralized mortgage obligations, or CMOs, bondlike certificates built from different tranches of a pool of mortgage-backed securities. (A mortgage-backed security is a bunch of loans sliced into tranches; a CMO is a bunch of those tranches sliced into even more tranches.) The first CMO deal had four tranches worth about $20 million. The tranches were divided into various levels of quality and maturity that spit out different interest payments—as always, greater risk resulting in greater reward. An ancillary benefit, for the banks at least, was that investors who bought these CMOs took on the risk if the underlying loans defaulted or if borrowers refinanced their loans in the event interest rates shifted lower.
That’s where quants such as Brown entered the scene. As Ranieri once said, “Mortgages are math.” With the rising levels of complexity, all those tricky tranches (there would soon be CMOs with a hundred tranches, each one carrying a somewhat different mix of risk and reward), the devil was in figuring out how to price the assets. The quants pulled out their calculators, cracked open their calculus books, and came up with solutions.
With the math whizzes at the helm, it was a relatively safe business, give or take the odd, predictable blowup every few years. Brown ran Lepercq’s securitization business with a steady hand. The bank had tight relationships with local bankers throughout the country. If Brown had questions about a loan he was packaging, he could call up the banker directly and ask about it. “Sure, I just drove by that house the other day, he’s putting in a new garage,” the banker might say.
But in the late 1980s, Lepercq’s business was overwhelmed when Salomon massively ramped up its mortgage securitization business. Salomon poured billions into the business, bidding for every loan it could get its hands on. A single deal by Salomon could match the entire year’s product at Lepercq. Small dealers such as Lepercq couldn’t compete. Salomon didn’t just offer better deals for loans to the bankers Brown was dealing with—Salomon bought the bank. And it didn’t stop at home mortgages. Securitization was the flavor of the financial future, and the future belonged to whoever controlled the supply.
Salomon was soon securitizing every kind of loan known to man: credit cards, car purchases, student loans, junk bonds. As profits kept increasing, so did its appetite and capacity for risk. In the 1990s, it started securitizing riskier loans to borderline borrowers who as a class came to be known as subprime.
Wall Street’s securitization wizards also made use of a relatively new accounting trick called “off-balance-sheet accounting.” Banks created trusts or shell companies in offshore tax havens such as the Cayman Islands or Dublin. The trusts would buy loans, stick them in a “warehouse,” and package them up like Christmas presents with bows on top (all through the cybermagic of electronic transfers). The bank didn’t need to set aside much capital on its balance sheet, since it didn’t own the loans. It was simply acting as middleman, shuffling assets between buyers and sellers in the frictionless ether of securitization.
The system was extremely profitable due to all the sweet, sweet fees. Guys such as Aaron Brown either jumped on board or moved on to other things.
Brown moved on. Several top firms offered him jobs after he left Lepercq, but he turned them down, eager to get away from the Wall Street rat race. He started teaching finance and accounting courses at Fordham University and Yeshiva University in Manhattan while keeping his hand in the game by taking the odd consulting job. Consulting at J. P. Morgan, he helped design a revolutionary risk management system for a group that eventually became an independent company called RiskMetrics, a top risk management shop.
Securitization, meanwhile, took off like a freight train in the early 1990s after the savings and loan crisis, when the federal Resolution Trust Corporation took over defaulted savings and loans that once held more than $400 billion of assets. The RTC bundled up the high-yielding, risky loans and sold them in just a few years, whetting the investors’ appetites for more.
In 1998, Brown took a consulting job with Rabobank, a staid Dutch firm that had started dabbling in credit derivatives. He was introduced to the exciting world of credit default swaps and created a number of trading systems for the new derivatives. It was still the Wild West of the swap market, and there was lots of low-hanging fruit to be had with creative trading.
Credit default swaps may sound fiendishly complex, but they’re actually relatively simple instruments. Imagine a family—call it the Bonds family—moves into a beautiful new home worth $1 million recently built in your neighborhood. The local bank has given the Bondses a mortgage. Trouble is, the bank has too many loans on its books and would like to get some of them off its balance sheet. The bank approaches you and your neighbors and asks whether you would be interested in providing insurance against the chance th
at the Bonds family may one day default.
Of course, the bank will pay you a fee, but nothing extravagant. Mr. and Mrs. Bonds are hardworking. The economy is in solid shape. You think it’s a good bet. The bank starts paying you $10,000 a year. If Mr. and Mrs. Bonds default, you owe $1 million. But as long as Mr. and Mrs. Bonds keep paying their mortgage, everything is fine. It’s almost like free money. In essence, you’ve bought a credit default swap on Mr. and Mrs. Bonds’s house.
One day you notice that Mr. Bonds didn’t drive to work in the morning. Later you find out that he’s lost his job. Suddenly you’re worried that you may be on the hook for $1 million. But wait: another neighbor, who thinks he knows the family better than you, is confident that Mr. Bonds will get his job back soon. He’s willing to take over the responsibility for that debt—for a price, of course. He wants $20,000 a year to insure the Bondses’ mortgage. That’s bad news for you, since you have to pay an extra $10,000 a year—but you think it’s worth it because you really don’t want to pay for that $1 million mortgage.
Welcome to the world of credit default swaps trading.
Many CDS traders, such as Weinstein, weren’t really in the game to protect themselves against a loss on a bond or mortgage. Often these investors never actually held the debt in the first place. Instead, they were gambling on the perception of whether a company would default or not.
If all of this weren’t strange enough, things became truly surreal when the world of credit default swaps met the world of securitization. Brown had watched, with some horror, as banks started to bundle securitized loans into a product they called a collateralized debt obligation, or CDO. CDOs were similar to the CMOs (collateralized mortgage obligations) Brown had encountered in the 1980s. But they were more diverse and could be used to package any kind of debt, from mortgages to student loans to credit card debt. Some CDOs were made up of other pieces of CDOs, a Frankenstein-like beast known as CDO-squared. (Eventually there were even CDOs of CDOs of CDOs.)
The Quants: How a New Breed of Math Whizzes Conquered Wall Street and Nearly Destroyed It Page 21
