Down the Rabbit Hole

It's a rainy day here in Manhattan. Perfect weather to stay in and read a good post on the "Demise of the Quants" by my fellow bloggist and tetchy ranter Baruch over at Ultimi Barbarorum¹. Fire up the coffee pot, break out a dictionary, and read it. You'll learn something.

Unless he² is actually perma-deb Tinsley Mortimer playing an incredibly elaborate joke on us all³, Baruch appears to invest in equities for an unnamed Swiss financial institution which shall remain nameless. (I will give him the benefit of the doubt and credit for his obvious native intelligence to conclude that it is not my favorite Schweizerdeutsch whipping boy, UBS.) He writes in reaction to a semi-triumphalist article on the quant meltdown this August in MIT's Technology Review magazine and his own informed reflections.

Most of what he says rings true, and—best of all—unlike Your weasely little ticket-scalping middleman Faithful Correspondent, he actually appears to invest for a living and therefore presumably knows what he is talking about. Like I said, read it.

I read the same MIT article recently, too. However, my strongest reaction had less to do with the trials and travails of a bunch of overpaid ex-nerds and more to do with the apparent epistemological and ontological underpinnings of the Grand Quant Paradigm: namely, that in financial markets, math is what matters. In its strongest form, this intellectual substrate can be characterized as described in the MIT piece:

Beneath all this beats the great hope of the quants: namely, that the financial world can be understood only through math. They have tried to discover the underlying structures of financial markets, much as academics have unlocked the mysteries of the physical world. The more quants learn, however, the farther away a unified theory of finance seems. Human behavior, as manifested in the financial markets, simply resists quantification, at least for now.

"At least for now." Classic.

I find it hard to believe that anyone with an IQ over 60 could believe such shit, but I am humble enough to know that even I can be mistaken.

* * *

Gosh, where do I begin?

Stripping away the sloppy journalistic overkill ("the financial world can be understood only through math" [emphasis mine]) and the drive-by analogy to physics ("a unified theory of finance") still leaves me with the gaping howler that at least some of these knuckleheads believe the financial markets can be understood primarily through math. This, as the man said, is nonsense. Even the eminence grise and pioneering quant Emanuel Derman has figured this out, although it is not clear he has figured out why:

Quantitative finance "superficially resembles physics," he says, "but the efficacy is very different. In physics, you can do things to 10 significant figures and get the right answer. In finance, you're lucky if you can tell up from down."

Interestingly enough, the repeated references to physics in the article are instructive, since that—plus pure mathematics—happens to be the academic background of many if not most of the quants practicing today. (Über quant and sesquitillionaire James Simons of Renaissance Technologies is a world class mathematician who co-authored the Chern-Simons theory on geometric invariants, widely used in string theory. No innumerate slouch he.) Their influence shows. Perhaps the most widely known formulation in mathematical finance—and arguably one of its foundational theories—is the famous Black-Scholes theory of option pricing, which holds as its central insight the assumption that a security price propagates through time based upon geometric Brownian motion, like the molecules in a gas.

By any measure, B-S⁴, along with its numerous variants and competitors, is a phenomenally successful theory, one that describes and enforces price relationships among cash securities and their derivatives in markets trading trillions of dollars every day. If anything has the status of Holy Writ in financial markets today, it is the Black-Scholes model. But Black-Scholes did not create the derivatives market; it is a heuristic construct which describes the arbitrage relationships and conventions which market participants use to trade these securities. The equity options market, while small, predated Fischer Black's and Myron Scholes' little exercise by some years, and seemed to function quite nicely before it had a rigorous quasi-physical theoretical underpinning. (In fact, if memory serves, Black and Scholes tried their hand at trading options using the insights from their formula and got their very large heads handed to them by the unenlightened louts in the options pit.)

Write this down: Black-Scholes works not because it describes some external ontological fact about how pricing relationships between securities and their derivatives have to work; it works because everyone agrees, more or less, that that's how prices should work. It is a convention, not a physical or financial law. This is the central epistemological trap that quants fall into when they conflate the tools, techniques, and ontological assumptions of physics, which attempts to describe that which is (more or less independent of us humans), with those of mathematical finance, which attempts to descibe how human beings trade and value financial instruments and their derivatives.

It is a true and remarkable fact that mathematics, in the words of physicist Eugene Wigner, is "unreasonably effective" in describing substantial swathes of the physical world. (If you do not find this fact remarkable, even disturbing, I would posit that you understand neither math nor physics. Think again.) But at least part of the reason mathematics has been so effective to date in helping us understand the physical world must be due to how well-behaved the physical world is. Math can describe the orbits of the planets and the fissioning of an atom with astonishing accuracy, but that is because the questions we are trying to answer in these particular cases are so narrow. We can ignore mountains of superfluous data (presuming, for example, that the color of an orbiting planet does not affect its orbit) in order to use math to answer what turn out to be relatively simple questions.

But this approach breaks down in the social sphere, where the interacting particles under investigation happen to be living, breathing people with opinions, conscious and unconscious biases, and adjustable rate mortgages. Financial markets are social systems, comprised of the countless interactions of conscious (and self-conscious) agents. It is Heisenberg's Uncertainty Principle—according to which the experimental observation of a small enough physical particle affects the outcome of the experiment itself—writ large. Look back at the central point of Ultimi Barbarorum's discussion of the quant strategy blow-up. By all accounts, the data seem to indicate that these clever boys and girls arbitraged away the persistent mean-reversion tendencies they so carefully identified in the first place by crowding into the same pairwise stock and sector trades as everybody else. Then, when the subprime doo-doo hit the fan, cross-sector contagion induced by market wide leverage and other connections blew those carefully researched historical relationships clean out of the water. It wasn't arbitrage or Brownian motion at work here. It was panic. Gas molecules in a box don't all rush for the exit at the same time when you open a hatch; people do.

Anyway, I'll finish my rant with an exchange from the quant conference the MIT article described which I find illuminating:

"How many [people in the room] think spreads will widen?" [conference leader Leslie Rahl] asked.

The hands of about half the smartest people on Wall Street shot up.

"And how many think they'll narrow?"

The other half—equally smart—raised their hands.

"Well," she said. "That's what makes a market."

Equally smart, indeed.

¹ Don't ask. Better yet, read the site. It has something to do with Dutch-Portugese-Jewish philosopher Baruch de Spinoza ranting about some very naughty people in the mists of time. Hey, what did you expect the guy who publishes "The Epicurean Dealmaker" to read in his spare time? Gawker?
² Come on, now, girls, don't get your panties in a twist. Surely it is a safe assumption that "Baruch" is packing the Y chromosome, isn't it? After all, UB is a finance site, on the internet. Need I say more?
³ What are the odds? Hmmm.
⁴ Sorry. Couldn't resist. By the way, aren't footnotes great?
© 2007 The Epicurean Dealmaker. All rights reserved.

Dead Man Walking

The New York Times tells us today that the Board of Directors of Merrill Lynch is placing collect calls to a number of Wall Street personalities to gauge their interest in taking over the CEO position from current tenant Stanley O'Neal. You know, Dear Readers: that same Stan O'Neal who just announced the largest quarterly loss in Wall Street history, after projecting somewhat less than half the actual amount only weeks before, and who capped it all by going hat in hand to Wachovia begging them to consider a prophylactic merger. "Wachovia?," you ask. Yes, Wachovia.

Apparently the house of Pierce, Fenner & Smith has not sunk low enough for the MER board to tolerate this. O'Neal's handpicked director poodles are so upset that great clumps of their manicured curls are coming off in their jaws, and they are baying (privately) for O'Neal's blood. Not privately enough, of course, to prevent the entire financial media from picking up the story.

I cannot speculate what will happen next at Mother Merrill, but I can guarantee you O'Neal's days at the helm are numbered. Being a CEO at an investment bank is not unlike crowd surfing at a mosh pit: it's a pretty cool way to move around quickly, you are supported entirely by other peoples' efforts, and everyone tries to get a piece of you. Unfortunately, when the crowd loses interest in supporting you, you tend to fall fast, hard, and painfully. In addition, after dropping you lots of your former investment banking subordinates—both friend and foe—have the added charming tendency to skewer you repeatedly with long knives. Et tu, Brute?

By allowing the news that they are talking to potential CEO replacements to leak into the public domain, Merrill's board have guaranteed a complete collapse of confidence in O'Neal. His enemies (legion, by all accounts) will be gunning for him, and his friends and sycophants will be running for cover. Few administrations of any stripe can stay in office after losing a public vote of no confidence, much less one in the Lord of the Flies environment of investment banking.

Fortunately, O'Neal will no doubt have a plenty cushy negotiated severance package to fall back on. Plus, he always has golf. Should he still feel a little saddened by his newly straitened circumstances, however, he can always console himself with philosophy. I suggest Boethius, for a start.

"Why, O my friends, did ye so often puff me up, telling me that I was fortunate? For he that is fallen low did never firmly stand."

— Boethius, The Consolation of Philosophy

© 2007 The Epicurean Dealmaker. All rights reserved.

Recipe for Success

For your reading pleasure this weekend, O Faithful Acolytes, I have decided to pen a little riff inspired by the scandalette du jour now working its way through the twinned pythons of New York Society and the Oprah Winfrey Show audience. I do not speak of the minor éclat caused by news that un-French French President Nicolas Sarkozy and his wife of 11 years have finally divorced—"How quaint! How ... American!" No, I refer to that titillating mini-saga emerging from the seething cesspool known as childrens' cookbook publishing, what many are coming to call "L'affaire Seinfeld."

I will not bore you with the tawdry details of this dust-up, which you can read for yourselves in the Times article by Motoko Rich. (Now there's a name for you!) Suffice it to say that Jessica Seinfeld (pictured above), wife of the eponymously named comedian Jerry Seinfeld (how do they tell their bathroom towels apart?), and her publisher Harper Collins have been not-quite accused of not-quite stealing the ideas and several recipes in her book from a disturbingly similar ankle-biter cooking compendium composed by one Missy Chase Lapine. (Seriously: I'm not clever enough to make this stuff up.) It seems the basic idea of both books is to sneak healthy foods into the cotton candy dreck most children prefer, like spinach into brownies. Apparently, dastardly matriarchs have been betraying their progeny in like manner from time immemorial.

Anyway, I draw this little drama to your overextended attention not to discuss the wiles and deceptions of faithless Womankind (as I might), but rather to illustrate how similar the story of these books' publication is to the creation of an M&A deal. The parallels are striking, and the substitution of a few pinstripe suits and a few investment banking institutions for the frilly aprons and publishing houses of the original yields a story which matches several dealmaking experiences of my own and others almost exactly.

For those of you with a conference call to join or a client meeting to attend, the basic story is this: As for the dueling cookbooks described above, it is not the quality or content of the ideas that matter in a potential M&A deal, it is their timing and packaging. An essential corollary to this is that the attractiveness, broadly defined, of the promoter of the idea is important, too. Let me explain.

I do not know about cooking strategies to cope with picky eaters, but I can guarantee you from over twenty years experience that there is virtually no such thing as a completely new, original idea in M&A. Sure, investment bankers constantly wheedle their clients to allow them to pitch some "really interesting ideas," but the clients never take the meetings in the hope they will be shown something they have not already considered, and they are almost never disappointed in their expectations. Indeed, if I were a corporate executive who lives and breathes my business, and has worked in my industry for decades, I would be mighty worried if some wet-behind-the-ears Harvard Business School tyro from Goldman Sachs or Morgan Stanley showed me a good acquisition, merger, or divestiture idea that I had not already thought about exhaustively. So should my Board of Directors. Take it from me: if your idea is not completely stupid, the client has already seen it. Likewise, it is clear that neither author in our ink-stained story above came up with a tot feeding strategy not already discovered by generations of crafty mothers.

In contrast, timing is critical in M&A. The best acquisition idea in the world doesn't do you a bit of good if you can't get the attention of the object of your desire. The target has to be ready, hair washed, teeth brushed, and packing protection before she'll agree to meet you out behind the football field bleachers late at night. And she won't want to go to dinner with you if you are between paychecks and can only afford Arby's takeout. Timing is so important, in fact, it even trumps the quality of a deal idea. When the stars are aligned, even a lousy deal can—and will—get done. Think AOL-Time Warner. From the Age of Dinosaurs forward, good M&A bankers have always closed the sale not based on the Who or the Why of a deal, but on the When and the How.

Packaging is also critical, at least to the M&A banker who wants the assignment. Presentation matters to a CEO, if only to make sure the banker he or she chooses does not embarrass him or her in front of the Board of Directors. As we have discussed before, it is practically impossible for a client to evaluate the quality of a particular M&A banker's advice before a deal closes, and often quite difficult thereafter. Therefore, in order to pick an M&A banker from among the legions of identical-looking graduates from the same business schools pestering him for the assignment, a CEO must rely on reputation plus the appearance of plausible reliability. Reputation is what it is, so personal appearance, plausibility, and chemistry with the client—packaging—usually decides which banker gets the nod.

Try this little experiment at your next Manhattan cocktail party. When you meet someone who tells you they work in finance, try to determine whether he or she is in corporate finance or M&A before they tell you. If they are well- and expensively dressed, vaguely handsome (but not too attractive), are a smooth and persuasive conversationalist, and exude so much quiet confidence that you can't decide whether they are arrogant or not, six times out of ten that person will be a corp fin or M&A banker. (If they are disshevelled, unkempt, unattractive, slightly hostile or dismissive, and totally arrogant, on the other hand, you can bet good money that they are in a hedge fund. They are also probably worth a lot more money than the M&A banker.)

Now I do not know how Missy Chase Lapine stacks up against Jessica Seinfeld in the appearance and personality department, but I can tell from the article that she is not lacking in publishing experience, and her book idea is no worse than—in fact, is indistinguishable from—the one Ms Seinfeld pitched Harper Collins two weeks later. Nevertheless, Harper Collins chose Ms Seinfeld to do the deal, based, we can imagine, largely on the same criteria her agent used when she described her as “smart, stunning, and infinitely promotable.” Like I said, packaging matters.

There is one final wrinkle to our sorry little tale that seals its instructiveness for the student of investment banking and M&A. For, at the end of the day, a client trying to decide between two bankers for an M&A assignment is often stumped. As far as the client can tell, the finalists are completely indistinguishable, equally talented, and equally plausible—both perfectly acceptable candidates for the final nod. At that point, the client often makes the decision based on the name on each banker's card. No, not that name, silly. The name of his or her investment bank.

Not that infrequently, which firm the banker belongs to becomes the primary deciding factor, winning out over even superior talent and better personal chemistry. "Goldman Sachs" almost always trumps "NoName Capital Markets LLC," regardless of how superior the NoName banker may be. For there is an old saying circulating in the boardrooms of Corporate America and among D&O insurers everywhere:

No Director ever got sued for picking Goldman Sachs to execute his shitty, half-baked M&A deal.

I imagine the firm of Missy, Chase & Lapine lost to Seinfeld LLC for the very same reason.

© 2007 The Epicurean Dealmaker. All rights reserved.

Oxymoron

I have been much too busy, Dear Readers, raping and pillaging making hay while the sun shines these past weeks to entertain you with any pearls of wisdom, and for that I do apologize. There seems to be a mad sort of Morris Dance taking place in the capital and M&A markets right now, with the storms and alarums of August faded to but a distant memory in the minds of many market participants. Accordingly, my services as mercenary consigliere have been in high demand. I fear it will all end in tears, but as I am not paid ridiculous amounts of money to salt away Kleenex for the bleary morning after, I must soldier on and do my duty by helping various consenting adults do the nasty.

One recent bit of news has tempted me to stick my head up from my spider hole, however, if only briefly. I write, of course, of the recent management reshuffles at Citigroup. I will not rehash the endless commentary, both professional and amateur, that has been lavished on this little soap opera, but I will offer a couple of remarks, since I do have some passing acquaintance with a few of the players.

I do not know Vikram Pandit, who seems to have been anointed Chuck Prince's chief lieutenant and bodyguard, so I cannot comment on his New York Times personality profile:

A calm, dispassionate man with a professorial bent and a Ph.D. in finance from Columbia, Mr. Pandit’s selfless disposition has caused him to stand out from his banking peers.

His administrative and technical skills, plus an ability to make himself indispensable to bosses like John J. Mack and Phillip J. Purcell, fueled his career at Morgan Stanley, where he became president.

But he is also a retiring man, not prone to ruthless acts, with a natural hesitancy about taking risks, both professional and personal.

However, I will note that The Wall Street Journal's stock dot portrait of Mr. Pandit, which seems to portray him as somewhat of a genial old elf, sets my PLF¹ radar buzzing. I do not know of too many selfless, retiring, and non-ruthless individuals who have risen much beyond the level of First Year Analyst at any major investment bank, much less to President of the poisonous nest of vipers that was Morgan Stanley under Phillip Purcell. I suspect he has many hidden qualities as yet undiscovered by our redoubtable financial press.

He will certainly need them, given that his direct reports include the formidable Michael Klein, whom the Times describes as "a smooth investment banker ... who has shown a keen instinct for survival." Uh, yeah, that's one way to describe him. Others might point to the fact that Mr. Klein pins the Scary Investment Banker-o-Meter at "Run. Run away now," or that he is the perfect person to have with you at a knife fight on the Manila waterfront, as long as you keep him in front of you. His co-head, Equities' Jim Forese, should prove a genial Stepin Fetchit to Klein's Simon Legree, but he may yet have a trick or two of his own up his sleeve which could come around to haunt either Pandit, Klein, or both.

Meanwhile, exeunt stage right, on a cloud of fragrant encomia, the Three Musketeers of Fixed Income, Tom Maheras, Randy Barker, and Geoff Coley. Barker has taken the bullet for spearheading Citi's promiscuous lending spree, Maheras has swanned off the trading floor after refusing to report to Pandit, and Coley has been "reassigned," no doubt whither all disgraced ex-Salomon Brothers bond traders go to nurse their pride and plot revenge, equities in Dallas.

Little Tommy M. is now free to fritter away his time handicapping his chances of elevation to the pantheon of saints of Our Mother Church of Mammon while he considers the flood of employment and hedge fund offers no doubt winging their way to his inbox. Apparently, he received the same sort of standing ovation on the Citi trading floor when he left that Jamie Dimon did after Sandy Weill pulled the rug out from under him. Traders. Always the cheap and obvious gesture, then back to work until the next firm gives them a better offer. Sure, Maheras was a personable guy, and he inspired a lot of loyalty in his troops, but that and three ninety-five will buy you a latte at Starbucks. Heinrich Himmler himself could have pulled the loaves and fishes trick if he had been in charge of a universal bank's fixed income division these past few years, so making money for Citi is not proof that Maheras is God, or even "a very good banker."

* * *

Notwithstanding its justified reputation as an oxymoron worthy of inclusion with classics such as jumbo shrimp and military intelligence, there is in fact such a thing as investment banking management. (For one thing, it is a never-ending source of revenues for management consulting firms like McKinsey, in part because the problems are never fixed and arguably unfixable.) The higher up the management hierarchy a banker travels, the further removed he or she becomes from the actual making of money, and the more important it becomes for him or her to stake claims to money. This is known colloquially as politics.

Normally, or when times are good and the money is flowing, the political situation among top management of an investment bank resembles a logjam, or the Western Front: lots of strains and pressures under the surface, but very little movement on the surface. When crisis hits, however, the logjam breaks, and the long knives and artillery come out in earnest. Those are the times senior IB managers live for, since it is open season on your friends and enemies, time to settle scores and pay back prior injuries, and often your one big chance to leap to the top of the heap over the dead and falling bodies of your foes and allies. At times like these, the backbiting, backstabbing, and betrayals in the executive suite would make Machiavelli blush.

What I find interesting in the Citigroup process is that Chuck Prince apparently tried to formalize this fingerpointing exercise into a formal report on sources of the bank's problems. Usually, top management power struggles take place in the shadows, supported by whisper campaigns and off-the-record remarks, which can preserve the illusion of professionalism and statesmanship amidst the carnage. Here, causes and blame must have been assigned—and attributed—on paper, which as we all know is a very dangerous thing nowadays. Is it too much of a stretch to believe that Prince did this in part to cover his own ass, and to have a documented record of the nasty little maneuverings of his subordinates that he could use against them in the future? I think not.

So, Dear Readers, fret not. The winners and losers in this little brouhaha all look pretty much the same, notwithstanding what their publicists tell us, and the losers will no doubt land on their well-shod feet quite nicely. Besides, no-one I know gets really upset when the sharks start attacking each other in a feeding frenzy.

What I will say is that I feel for the poor junior slobs who took on the task of interviewing senior management and compiling this report. Let's hope for their sake that it was a well-written report, since their future chances of getting a job on Wall Street are probably limited to reporting for the New York Times.

¹ Poisonous Little Fuck. As opposed to, say, other hallowed senior IB management types like the GSB (Genial Son of a Bitch) or the HTB (Heartless Technocratic Bastard). Some particularly skillful inside players are adept at donning and doffing many such disguises at will, depending on the dictates of circumstance.
© 2007 The Epicurean Dealmaker. All rights reserved.