briantheprogrammer

Sketchy Crystal Balls

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There were probably millions of people whose lives were in genuine danger at that moment, and I was not among them. But in the separate, metaphysical realm of capitalism, losing my job and my seat in the industry like this would be pretty close. My balance sheet would collapse from the losses on the house and the loss of income would leave me unable to replenish the lost dollars.

The reason I say it REALLY felt like war is because I wasn’t at risk due to my own mistakes. I was at risk merely because of my position. You might argue that I was in this position because of my past mistakes; namely buying a new construction condo in Brooklyn in 2007. But my point is that there is a special feeling that you get once the die is cast and you are waiting for the outcome, helplessly.

I knew that if I lost my job it wouldn’t be easy to find the next one. There was something called “adverse selection.” If I had gone looking for a job say 12 months earlier I would have been golden. Back then, Wall Street was still growing. But in late 2008 it was shrinking. And it was about to start shrinking at an accelerating rate.

Adverse selection is a quant concept that describes the tendency of assets purchased in response to customer demand to move against you. According to the standard thinking, it is because the customers (or whomever initiates the transaction) has information about future price moves.

It’s as if the correct prices of stocks are floating out there in the universe and the quants are all looking into these sketchy crystal balls that work, but only to limited and varying degrees. Then they send their orders to buy the stocks that are going up and sell the ones that are going down.

According to mythology, the quant’s ability to predict these future price movements was why they got the big bonuses, and also why they had the most client money. The quants with the best crystal balls would end up controlling most of the assets and most of the order flow.

Faced with my financial death, I could see reality more clearly. The concept of adverse selection could be applied to demand for jobs as well as demand for stock trades.

Back in 2005 the big investment banks had had open seats and not enough people to fill them. They had already pulled the creme-de-la-creme from the Ivy League schools and still needed more. As a result, it became much easier to get a job. But in 2008 there were suddenly few open seats and a deluge of candidates with killer resumes. 

But none of this was happening because of information obtained by a quant via a crystal ball. It was happening because some deeper, realer reality was intruding on the fantasy universe that the quants had constructed.

In the real reality, Wall Street was really dying. 

The Bank Next Door

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I had no idea of the scale of what was about to happen. But I was beginning to get really nervous about my decision to buy that apartment. First, there was the value of the property itself to worry about. Then there was my ability to pay for it.

Having some sort of original idea, along with the ability to execute on it, seemed like the ticket to the big leagues on Wall Street, or even off of it. If I could get there, then money wouldn’t be an issue. I tried to stare down my fear with visions of success. But as it became more and more clear that the bank next door was headed for bankruptcy, I was beginning to dread completing the contract.

Wall Street was about to start dropping people like sandbags from a hot air balloon. It was going to happen one way or another, and I realized too late that I had given up my parachute. My first fear of money; not having enough of it, was coming to life. I was going to become a slave to that stupid Brooklyn condo.

I felt shame because I had fallen into exactly the same trap as the “average” American homeowner. My financial intelligence had to be better than that. But it wasn’t. So much for being a budding quant/stock-trading genius on a quest for the truth about capitalism.

Those days really felt like war to me. I mean, to be honest, everything feels like war to me; I always feel like there isn’t enough time, that death is looming over me, threatening to take me back to wherever I came from in the case of even a tiny mistake. 

Protection Against Predators

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So I had to decide which one it was.

Was the uptick rule fostering unrealistic stock valuations by making it hard for speculators to take a “negative view” on the stock price? Or was it protecting shareholder investments against predatory attacks by evil hedge funds?

Do large, public corporations actually need protection against predators? If they need protection from predators then shouldn’t they just die, like animals in nature that can no longer defend themselves? Aren’t these predators performing a valuable function by culling the herd of the elderly, weak firms like ours?

Or, was natural selection perhaps not the best analogy for thinking about capitalism in general, or banking crises in particular? The idea that the basic units of production could be forced to cease operations simply because enough hedge funds (who were not the owners of the company. Remember, short sellers sell stock that is on loan from another party) had expressed a “negative view,” via financial markets, seemed totally contrary to the purpose of those markets, in my opinion.

I mean, we were supposed to be creating wealth and not destroying it right? Or at least, if we weren’t creating wealth, we were supposed to be enabling wealth creation somehow, not disabling it, right?

And in any case, this means of bringing down the bank could only work because of government-imposed capital regulations and government-imposed methods of measuring capital, which incorporated the market value of the company shares as an input.

Should capitalism even provide a purely offensive vehicle for companies to attack each other? Why should we even tolerate corporations, which are supposed to be creating wealth, attempting to profit from killing each other?

“Because FREEEDDDOOOMMM!!!!” They replied.

But if we were really in a “free market” then our share price would have nothing to do with our ability to keep operating our business. It could only affect our ability to access financial markets to raise additional capital. 

Uptick Tantrum

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For better or worse, the uptick rule had been eliminated, and now hedge funds, many of which had been valued clients of ours until very recently, were dog-piling into short positions against our stock. If the stock price got low enough, the bank could be forced to seek additional capital or to go into bankruptcy. He explained all of this and said that the SEC had fallen under the spell of “academics” and wouldn’t listen to him.

More dark sorcery in other words.

To be honest, it sounded desperate to me. He seemed legitimately scared, and that made me think that there was a real reason to worry. Where was this impassioned defense of the uptick rule during the debate about eliminating it years earlier?

Of course, critics would argue that no one was victimizing the firm. It was just “The Market” adjusting its estimate of our value to more appropriate (lower) levels. Desperate or not, I wasn’t sure that he was wrong. After all, the Fortress of Quant was crumbling before our very eyes. Maybe the uptick rule was just one more thing the quants had been wrong about.

Preventing this very thing from happening was the stated reason for the uptick rule in the first place. What I learned in that meeting was that there were two points of view, and I couldn’t tell which one was correct. The world must be a better place with the uptick rule or without it.

It was the sort of question that a person wanting to discover the truth about capitalism might need to reach a position on.

But I still didn’t know enough to take one. 

A Great Deal

100/

As our stock price was plummeting in the days leading up the Lehman Brothers bankruptcy, our CEO called everyone into a “town hall” meeting at our midtown headquarters. He complained that the SEC had rejected his suggestion to reinstate the infamous “uptick rule.” This was a trading regulation mandating that short sellers can only sell stock at times when the previous sale was an “uptick”; a sale at a higher price than the one before it.

As our stock waffled back and forth in the $10-20 range, I was feeling not so great about my decision to max out the Employee Stock Purchase Plan while it was trading between $70 and $90. At a 15% discount it had seemed like a great deal.

Let’s just say I was becoming intensely interested in the question of WHY stock prices fall.

The uptick rule had been a Depression-era attempt to prevent short sellers from ganging together to attack a stock at times when there were not many buyers present.Eliminating the uptick rule had been a major coup by the quants just a couple of years before.

It goes back to what I was explaining earlier, that everyone now understood that stock prices could go down. According to the quants, “frictions” like the uptick rule facilitated price bubbles which could mislead investors and eventually pop, creating devastating losses.

They would say things like “When you make it hard to sell stocks, you make it hard to buy stocks.”

In other words, short sellers shouldn’t be demonized. That was the argument the quants had made to the regulators.

To be honest it was a pretty convincing argument. It reminded me of the transfer tax that condo developers had to pay and was therefore passed along to buyers like me. Why did the playing field of capitalism have to be littered with so many silly obstacles; these taxes and regulations? 

A Forest of Worlds

99/

Mortgage default probabilities, asset price changes, macroeconomic variables like GDP and inflation could all be reduced to immutable averages and variances with a little data “munging,” “scrubbing,” or “cleaning.” All verbs that call to mind the image of Cinderella wiping her sister’s filth off of the bathroom floor. That was my job. It wasn’t supposed to be my job. Actually, it was supposed to be beneath even me. But I was the face of the product and if the numbers were wrong then I was the face of the wrong numbers as well.

I do not like being the face of wrong numbers.

Once the statistical information had been prepared the quants could calculate precise values for assets and optimal weightings for portfolios. And they could do it in an ordinary spreadsheet without a lot of fancy software.

It was all because of this miracle that the quants had pulled off, which was to get rid of time (and therefore change) from their formulas. I suddenly understood why I couldn’t get anything done in Excel. I hadn’t learned the quant skill of banishing time from my mind. I was imagining evaluating millions of permutations with my models. A vast forest of possible financial worlds.

But here I was again thinking like a stupid computer programmer that just couldn’t understand the power of statistics. You see, the quants didn’t need to evaluate a whole forest of possible worlds because they were convinced it wouldn’t matter in the end.

Why were they so sure that the statistical measures were stable? I have no idea, go ask a quant. But I had a feeling they were wrong. To prove it, I only had to explore this magical forest of possibilities and bring back the evidence.

For that, all I needed was a software product like a spreadsheet in some ways, but much more powerful. It felt like my program was just around the corner from being used in this fashion.

If I just kept hacking I would get there. 

Craters

98/

The news from credit markets was getting worse and worse. Wave after wave of mortgage defaults left craters where credit desks had been just a few weeks before. Suddenly I felt smart for being in the equity division. After all, the trouble in the credit markets was a great reason to buy stocks. And for a while it seemed like the problems might stay contained where they had started.

Equity trading boomed throughout 2008. Elsewhere, the quants were getting burned by their own magic, and as far as I could tell it was well deserved. Mortgage Backed Securities, the flagship product of Quant Tower, were increasingly being considered as “toxic assets” to institutional money managers. What made them toxic was the fact that their value depended heavily on the probability that a given mortgage in a pool would default. Depending on who you asked, those values had either been calculated incorrectly, or they were changing.

In the first case the quants had merely been wrong in their calculations. But the second case would also mean that they had been wrong, but on a deeper, more philosophical level. This is something I was beginning to understand from my forays into finance textbooks; their formulas were always based on constant averages.

For an example, take Modern Portfolio Theory, which formed the theoretical foundation for the long-only portion of the asset-management business. Applying it was a simple matter of reducing each stock to a mean and a variance around that mean, and then building a spreadsheet full of mean returns and their variances. Then you would just sprinkle a little quant dust (the correlation matrix) onto your spreadsheet and BOOM!

You would get a portfolio with great returns and low risk. It works great as long as the means and variances and the correlations in your spreadsheet are both accurate and immutable.

As it turned out, the quants did something even more remarkable than making the banking system disappear. They made time itself disappear!

If that isn’t real magic, I don’t know what is. 

Mystical Stuff

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It was still fun to watch the good-looking talking heads with their witty banter and colorful, flashy graphics. I would normally watch them from the elliptical machine at the Equinox Fitness while I was trying (and failing) to lose the 20 pounds I had gained since moving to NYC. But it was complete and total fiction. More fictional than Tolkien and Castaneda combined.

The real world was one where gigantic “institutions” managed portfolios according to one of several “portfolio theories,” which would tell you which assets to buy and sell using entirely quantitative inputs. Then they would tinker around with some opinionated positions to have something to talk to their clients about besides a bunch of boring equations.

Trying to beat the market with finger-in-the-air stock picking, that was a ‘90s thing. It had since been completely discredited in the professional investing community. No one believed that an active manager could beat the market, at least not without access to inside information, which was illegal. To be sure, there were true believers in active management, but they were mostly treated as cranks.

However there was still some hope to make money in the markets, but you needed quant powers.

What you were really after was something called “systematic alpha.” The “systematic” part meant you needed to be able to fully automate the strategy. In other words, trades were selected using a system, or algorithm. You wouldn’t necessarily automate everything in reality. Many systematic desks do all of their work manually. In fact, many prefer to do this to keep the know-how out of the hands of lowly computer programmers like me. “Alpha” was quant-speak for “returns in excess of a benchmark.” The benchmark was usually the return of the S & P 500 index.

This quest for alpha was what everyone was talking about on Wall Street. Some said alpha wasn’t real; that investors were being “Fooled by Randomness.” It was hard for me to understand why, if picking stocks was no longer possible, that one could have more success in selecting “asset classes”, “factors”, “sectors” or other methods which were ultimately just fancy ways of picking stocks in groups.

Others argued that alpha was real, but that it was a scarce and elusive thing. According to them, there was a finite supply of alpha in the universe. You might discover a hidden source of systematic alpha. But before long, a competing band of quants would catch on to what you are doing and try to steal it from you!

So, competing groups of quants battling each other for this mystical stuff was the reason why markets were so liquid with low volatility. That was the explanation for the Great Moderation.

I’m not making this up. It’s some wizard shit. And somehow it had gone awry. Anyone could see that. But in order to know how it had gone awry I would have to understand it myself, in my own way. 

Cloak of Darkness

96/

By the summer of 2008 it was becoming clear that the halo of protection around the quant portfolios was not impenetrable. Still, their abilities were vast. They had successfully banished the regulators from the credit desks. (Not from equities however, as discussed.)

But this latest piece of magic was really impressive. They made the entire banking system disappear! From financial textbooks, from theories of economics, and even from popular media. The quants had placed an entire industry beneath a cloak of darkness. It was an awesome display of power.

Outside of Wall Street, no one was asking questions about the real banking system because they didn’t know there were any questions to be asked. They didn’t know there was anything to ask questions about.

On CNBC they would often cut to the New York Stock Exchange trading floor as if it was the center of the action. But the reign of the NYSE specialist market makers had ended years prior. By this time, the NYSE floor was in fact little more than a TV set.

On those shows they would talk about the companies and how investors allegedly felt about them, but they would never talk about the trading sectors of the financial system. They would never talk about how brokers, prop traders, or the hedge fund industry actually operates.

Sometimes they would talk about the futures markets, but that was really just a way of having something to discuss first thing in the morning before NYSE and NASDAQ opened. And you could watch CNBC around the clock without ever acquiring a hint as to what was really happening in the futures market, or its more secretive, alluring cousin; the market for options on the “volatility index” known as VIX.

The actors on CNBC were pretending that we were still living in Grandpa’s stock market. They would talk about business models and earnings and pontificate over whether those earnings would increase in the future.

They were pretending that picking stocks based on fundamentals was still a thing.

But it was all just a show. 

The Missing Book

95/

I registered for the Chartered Financial Analyst (CFA) exam. It seemed like the best way to get a straight shot of financial knowledge into my brain. I thought I would be able to use my new program to conduct all the of the calculations, and that this exercise would guide the direction of the software.

Reading the CFA materials was supposed to be my therapy. Learning about things makes me feel like I can control them, even while things are actually spinning out of control. They send you a big stack of books. If the truth about capitalism was a known thing, then it ought to be in those books, or so I thought.

In reality the CFA materials contained not one truth, but several. Or maybe they were several attempts to describe the same underlying truth. But there was the truth according to accountants, the truth according to economists, and the truth according to portfolio managers.

I suppose I could talk about each of these and their mutual incompatibilities and how it seemed to undermine the idea of, well, truth.

But the emergence of three or more truths instead of one was not my complaint until later. My problem back then was that there was no truth according to traders. The entire curriculum was developed from the point of view of a buy-side portfolio manager. It had almost nothing at all to say about the trading business. The “sell side,” which consists of banks and brokers, was a total black box to the CFA curriculum.

It was like there was a missing book. There was a whole education about how to run a hedge fund or a mutual fund, but none about how to run a bank, brokerage, or a proprietary trading firm. It really did seem like there was some dark magic keeping information about the internals of our financial system out of books, media, and the popular consciousness.

I realized I was living in a secret world. One that few authors had written about, or accurately. There was a great big blind spot at the center of the capitalist machine, and I was living inside of it. The truth about capitalism must be all around me, and I had managed to acquire privileged access to it.

All I had to do was open my eyes.

Why was I wasting time with these silly books?