Fooled by Randomness (12 page)

There is a Yiddish saying: “If I am going to be forced to eat pork, it better be of the best kind.” If I am going to be fooled by randomness, it better be of the beautiful (and harmless) kind. This point will be made again in Part III.

Five

•

SURVIVAL OF THE LEAST FIT—CAN
EVOLUTION BE FOOLED
BY RANDOMNESS?

CARLOS THE EMERGING-MARKETS WIZARD

I
used to meet Carlos at a variety of New York parties, where he would show up impeccably dressed, though a bit shy with the ladies. I used to regularly pounce on him and try to pick his brains about what he did for a living, namely buying or selling emerging-market bonds. A nice gentleman, he complied with my requests, but tensed up; for him speaking English, in spite of his fluency, seemed to require some expenditure of physical effort that made him contract his head and neck muscles (some people are not made to speak foreign languages). What are emerging-market bonds? “Emerging market” is the politically correct euphemism to define a country that is not very developed (as a skeptic, I do not impart to their “emergence”such linguistic certainty).The bonds are financial instruments issued by these foreign governments, mostly Russia, Mexico, Brazil, Argentina, and Turkey. These bonds traded for pennies when these governments were not doing well. Suddenly investors rushed into these markets in the early 1990s and pushed the envelope further and further by acquiring increasingly more exotic securities. All these countries were building hotels where United States cable news channels were available, with health clubs equipped with treadmills and large-screen television sets that made them join the global village. They all had access to the same gurus and financial entertainers. Bankers would come to invest in their bonds and the countries would use the proceeds to build nicer hotels so more investors would visit. At some point these bonds became the vogue and went from pennies to dollars; those who knew the slightest thing about them accumulated vast fortunes.

Carlos supposedly comes from a patrician Latin-American family that was heavily impoverished by the economic troubles of the 1980s, but, again, I have rarely run into anyone from a ravaged country whose family did not at some juncture own an entire province or, say, supply the Russian czar with sets of dominoes. After brilliant undergraduate studies, he went to Harvard to pursue a Ph.D. in economics, as it was the sort of thing Latin-American patricians had gotten into the habit of doing at the time (with a view to saving their economies from the evils of non-Ph.D. hands). He was a good student but could not find a decent thesis topic for his dissertation. Nor did he gain the respect of his thesis advisor, who found him unimaginative. Carlos settled for a master’s degree and a Wall Street career.

The nascent emerging-market desk of a New York bank hired Carlos in 1992. He had the right ingredients for success; he knew where on the map to find the countries that issued “Brady bonds,” dollar-denominated debt instruments issued by Less Developed Countries. He knew what Gross Domestic Product meant. He looked serious, brainy, and well-spoken, in spite of his heavy Spanish accent. He was the kind of person banks felt comfortable putting in front of their customers. What a contrast with the other traders who lacked polish!

Carlos got there right in time to see things happening in that market. When he joined the bank, the market for emerging-market debt instruments was small and traders were located in undesirable parts of trading floors. But the activity rapidly became a large, and growing, part of the bank’s revenues.

He was generic among this community of emerging market traders; they are a collection of cosmopolitan patricians from across the emerging-market world that remind me of the international coffee hour at the Wharton School. I find it odd that rarely does a person specialize in the market of his or her birthplace. Mexicans based in London trade Russian securities, Iranians and Greeks specialize in Brazilian bonds, and Argentines trade Turkish securities. Unlike my experience with real traders, they are generally urbane, dress well, collect art, but are nonintellectual. They seem too conformist to be true traders. They are mostly between thirty and forty, owing to the youth of their market. You can expect many of them to hold season tickets to the Metropolitan Opera. True traders, I believe, dress sloppily, are often ugly, and exhibit the intellectual curiosity of someone who would be more interested in the information-revealing contents of the garbage can than the Cézanne painting on the wall.

Carlos thrived as a trader-economist. He had a large network of friends in the various Latin-American countries and knew exactly what took place there. He bought bonds that he found attractive, either because they paid him a good rate of interest, or because he believed that they would become more in demand in the future, therefore appreciating in price. It would be perhaps erroneous to call him a
trader.
A trader buys and sells (he may sell what he does not own and buy it back later, hopefully making a profit in a decline; this is called “shorting”). Carlos just bought—and he bought in size. He believed that he was paid a good risk premium to hold these bonds because there was economic value in lending to these countries. Shorting, in his opinion, made no economic sense.

Within the bank Carlos was the emerging-markets reference. He could produce the latest economic figures at the drop of a hat. He had frequent lunches with the chairman. In his opinion, trading was economics, little else. It had worked so well for him. He got promotion after promotion, until he became the head trader of the emerging-market desk at the institution. Starting in 1995, Carlos did exponentially well in his new function, getting an expansion of his capital on a steady basis (i.e., the bank allocated a larger portion of its funds to his operation)—so fast that he was incapable of using up the new risk limits.

The Good Years

The reason Carlos had good years was not just because he bought emerging-market bonds and their value went up over the period. It was mostly because he also bought dips. He accumulated when prices experienced a momentary panic. The year 1997 would have been bad had he not added to his position after the dip in October that accompanied the false stock market crash that took place then. Overcoming these small reversals of fortune made him feel invincible. He could do no wrong. He believed that the economic intuition he was endowed with allowed him to make good trading decisions. After a market dip he would verify the fundamentals, and, if they remained sound, he would buy more of the security and lighten up as the market recovered. Looking back at the emerging-market bonds between the time Carlos started his involvement with these markets and his last bonus check in December 1997, one sees an upward sloping line, with occasional blips, such as the Mexican devaluation of 1995, followed by an extended rally. One can also see some occasional dips that turned out to be “excellent buying opportunities.”

It was the summer of 1998 that undid Carlos—that last dip did not translate into a rally. His track record up to that point included just one bad quarter—but bad it was. He had earned for his bank close to $80 million cumulatively in his previous years. He lost $300 million in just one summer. What happened? When the market started dipping in June, his friendly sources informed him that the sell-off was merely the result of a “liquidation” by a New Jersey hedge fund run by a former Wharton professor. That fund specialized in mortgage securities and had just received instructions to wind down the overall inventory. The inventory included some Russian bonds, mostly because
yield hogs,
as these funds are known, engage in the activity of building a “diversified” portfolio of high-yielding securities.

Averaging Down

When the market started falling, he accumulated more Russian bonds, at an average of around $52. That was Carlos’ trait, average down. The problems, he deemed, had nothing to do with Russia, and it was not some New Jersey fund run by some mad scientist that was going to decide the fate of Russia. “Read my lips: It’s a li-qui-dation!” he yelled at those who questioned his buying.

By the end of June, his trading revenues for 1998 had dropped from up $60 million to up $20 million. That made him angry. But he calculated that should the market rise back to the pre–New Jersey sell-off, then he would be up $100 million. That was unavoidable, he asserted. These bonds, he said, would never, ever trade below $48. He was risking so little, to possibly make so much.

Then came July. The market dropped a bit more. The benchmark Russian bond was now at $43. His positions were underwater, but he increased his stakes. By now he was down $30 million for the year. His bosses were starting to become nervous, but he kept telling them that, after all, Russia would not go under. He repeated the cliché that it was too big to fail. He estimated that bailing them out would cost so little and would benefit the world economy so much that it did not make sense to liquidate his inventory now. “This is the time to buy, not to sell,” he said repeatedly. “These bonds are trading very close to their possible default value.” In other words, should Russia go into default, and run out of dollars to pay the interest on its debt, these bonds would hardly budge. Where did he get this idea? From discussions with other traders and emerging-market economists (or trader-economist hybrids). Carlos put about half his net worth, then $5 million, in the Russia Principal Bond. “I will retire on these profits,” he told the stockbroker who executed the trade.

Lines in the Sand

The market kept going through the lines in the sand. By early August, they were trading in the thirties. By the middle of August, they were in the twenties. And he was taking no action. He felt that the price on the screen was quite irrelevant in his business of buying “value.”

Signs of battle fatigue were starting to show in his behavior. Carlos was getting jumpy and losing some of his composure. He yelled at someone in a meeting: “Stop losses are for schmucks! I am not going to buy high and sell low!” During his string of successes he had learned to put down and berate traders of the non-emerging-market variety. “Had we gotten out in October 1997 after our heavy loss we would not have had those excellent 1997 results,” he was also known to repeat. He also told management: “These bonds trade at very depressed levels. Those who can invest now in these markets would realize wonderful returns.” Every morning, Carlos spent an hour discussing the situation with market economists around the globe. They all seemed to present a similar story: This sell-off is overdone.

Carlos’ desk experienced losses in other emerging markets as well. He also lost money in the domestic Russian Ruble Bond market. His losses were mounting, but he kept telling his management rumors about very large losses among other banks—larger than his. He felt justified to show that “he fared well relative to the industry.”This is a symptom of systemic troubles;it shows that there was an entire community of traders who were conducting the exact same activity. Such statements, that other traders had also gotten into trouble, are self-incriminating. A trader’s mental construction should direct him to do precisely
what other people do not do.

Toward the end of August, the bellwether Russia Principal Bonds were trading below $10. Carlos’ net worth was reduced by almost half. He was dismissed. So was his boss, the head of trading. The president of the bank was demoted to a “newly created position.” Board members could not understand why the bank had so much exposure to a government that was not paying its own employees—which, disturbingly, included armed soldiers. This was one of the small points that emerging-market economists around the globe, from talking to each other so much, forgot to take into account. Veteran trader Marty O’Connell calls this the firehouse effect. He had observed that firemen with much downtime who talk to each other for too long come to agree on many things that an outside, impartial observer would find ludicrous (they develop political ideas that are very similar). Psychologists give it a fancier name, but my friend Marty has no training in behavioral sciences.

The nerdy types at the International Monetary Fund had been taken for a ride by the Russian government, which cheated on its account. Let us remember that economists are evaluated on how intelligent they sound, not on a scientific measure of their knowledge of reality. However, the price of the bonds was not fooled. It knew more than the economists, more than the Carloses of the emerging-market departments.

Louie, a veteran trader on the neighboring desk who suffered much humiliation by these rich emerging-market traders, was there, vindicated. Louie was then a fifty-two-year-old Brooklyn-born-and-raised trader who over three decades survived every single conceivable market cycle. He calmly looked at Carlos being escorted by a security guard to the door like a captured soldier taken to the arena. He muttered in his Brooklyn accent: “
Economics Schmeconomics. It is all market dynamics.
”

Carlos is now out of the market. The possibility that history may prove him right (at some point in the future) has nothing to do with the fact that he is a bad trader. He has all of the traits of a thoughtful gentleman, and would be an ideal son-in-law. But he has most of the attributes of the bad trader. And, at any point in time, the richest traders are often the worst traders. This, I will call the
cross-sectional problem:
At a given time in the market, the most successful traders are likely to be those that are best fit to the latest cycle. This does not happen too often with dentists or pianists—because these professions are more immune to randomness.

JOHN THE HIGH-YIELD TRADER

We met John, Nero’s neighbor, in
Chapter 1
. At the age of thirty-five he had been on Wall Street as a corporate high-yield bonds trader for seven years, since his graduation from Pace University’s Lubin School of Business. He rose to head up a team of ten traders in record time—thanks to a jump between two similar Wall Street firms that afforded him a generous profit-sharing contract. The contract allowed him to be paid 20% of his profits, as they stood at the end of each calendar year. In addition, he was allowed to invest his own personal money in his trades—a great privilege.