(..."FAILED WIZARDS OF WALL STREET" 2-2 --Marty)
WORLDWIDE PHENOMENON. The stinger is that liquidity dried up across markets. It was a worldwide phenomenon, so the geographic diversification employed by so many quant firms did them not a whit of good. Late August was actually worse for some market-neutral arbitragers than the 1987 crash, admit some quants. ''They weren't all bullish and they weren't all bearish, but they were all believers in the liquidity and continuity of markets,'' says James Grant, editor of Grant's Interest Rate Observer.
The carnage was widespread because so many people were making the same kinds of bets. ''When Russia announced default, everybody's risk appetite went down dramatically. Every position held on every dealer's books was subject to liquidation. Any concept of long-term or fundamental value disappeared,'' says William T. Winters Jr., head of Europe fixed income at J.P. Morgan & Co. in London. ''Large investors lost money on positions that became very illiquid and volatile.''
Worst hurt of all were highly leveraged hedge funds. Heavy borrowing amplified their returns on the way up, and it amplified their losses on the way down. When spreads widened in a disorganized, tumbling market, gains on short positions weren't enough to offset losses on long ones. Lenders demanded more collateral, forcing the funds either to abandon the arbitrage plays or to raise money for the margin calls by selling other holdings at fire sale prices.
Long-Term Capital responded to the crisis by shedding marginal deals, such as bets on the direction of interest rates, at losses, while keeping in place its core arbitrage bets. As its moniker suggests, the firm is able to hang tough longer than most hedge firms because its capital base is stable. The first date any investors can withdraw capital is the end of 1998, and even then the potential withdrawal is less than 12% of the fund. Borrowing arrangements are long-term as well--generally for six months or a year.
HUBRIS. If markets quickly return to their old alignments, Long-Term Capital will come out way ahead, and August will be nothing but a scary memory. Indeed, the firm is beefing up its bets by raising more capital from investors. But what if the spreads just keep getting wider? It could happen. Grant, the newsletter editor, likes to quote a play-it-safe Wall Street maxim: ''Never meet a margin call.'' In other words, if the market is going against you, concede defeat quickly and liquidate before you really lose your shirt.
Since the quants came to Wall Street, there has been no shortage of critics. Rocket science can't substitute for common sense, says Wilford, who manages a ''market-neutral'' hedge fund himself. ''I've seen too, too many of these quant geniuses that don't have a clue about how markets behave. When they get a shock like this, they're dumbfounded. They just don't have the intuition of what to do.''
The quants may have placed too much faith in their exquisitely tuned computer models. ''The hubris a bad quant can exhibit is, he thinks he has the best model of all time,'' says van Kipnis. ''Many of these models provide the illusion of certainty,'' says economist Henry Kaufman of Kaufman & Kubarych. ''There is a kind of assurance that ultimately can't be satisfied.''
In a certain sense, maybe the problem wasn't too much rocket science, but too little. Extreme, synchronized rises and falls in financial markets occur infrequently--but they do occur. The problem with the models is that they did not assign a high enough chance of occurrence to the scenario in which many things go wrong at the same time--the ''perfect storm'' scenario. Sources say Long-Term Capital's worst-case scenario was only about 60% as bad as the one that actually occurred.
On the other hand, some quant firms made out just fine. Unlike Long-Term Capital, which looked at markets around the world, these firms are niche players, and their models concentrate on specific markets. Roll & Ross, for example, employs a value approach to stocks, using the latest academic research to screen for a combination of low price-earnings and market-to-book-value ratios.
Another example of wizardry that worked is a little-known niche firm based in Radnor, Pa., owned by Banque Nationale de Paris, called BNP/Cooper Neff Inc. The only bet BNP/Cooper Neff makes is arbitrage between stocks that become overvalued or undervalued because of such things as money flows in and out of markets. It is scrupulously neutral on the attractiveness of growth stocks vs. cyclical stocks, or large capitilization stocks vs. small-cap stocks.
Although the firm's assets under management aren't huge--about $10 billion--it estimates that it accounts for about 4% of the daily trading volume on the New York Stock Exchange and 6% to 10% of the volume on the principal exchanges of France, Germany, Spain, and Italy. BNP/Cooper Neff--which is so Far not open to outside investors--needs enormous volumes oftrades because its average profit margin per trade is so small. Their research staff includes about a dozen physics PhDs. While it won't release its results, Chairman and co-founder Richard W. Cooper says: ''August was the best month in our history. In markets that become irrational, you can find greater mispricing opportunities.''
But Cooper's firm is not typical. And, after its summer setback, rocket science, whether quants bounce back or not, will be forced to change. It will have to adjust its models to account for more riskiness in global markets. The search for inefficiencies in markets that can produce profits will continue. But there's one thing to remember about being on the cutting edge: Sometimes, you bleed.
By Peter Coy and Suzanne Woolley, with Leah Nathans Spiro and William Glasgall in New York and bureau reports
Copyright 1998, by The McGraw-Hill Companies Inc. All rights reserved.
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