The Once-Bold Mates of Morgan

How Modern Derivatives Trading Saved the World in the 1970s

The exciting era that created poker and futures markets came to an end in the 1890s, to be followed by a period of business and financial consolidation. The huge companies that would dominate twentiethcentury business-the Generals Motors, Mills, and Electric-were formed through trust acquisition, directed mostly by J.P. Morgan. Improvements in financial technology meant that much of the gambling could be squeezed out of finance. Investment was still risky, of course, but there was no need to add extra risk to bounce over capital barriers. To use an engineering analogy, the economy went from high-temperature fabrication methods to low temperature. Business management was rationalized and professionalized. Life became duller and safer, more middle-class.

By temperament, I regret the switch. I'm glad I came to adulthood after this peace had broken down. But the 75-year spiritual reign of Morgan saw the final destruction of medieval holdover monarchies and religious tyrannies in most of the world, the integration of a tremendous flow of immigrants, survival through the most brutal and destructive wars in history, and stunning progress in science and technology. I wouldn't have wanted to live through it, but despite the unparalleled horrors, the age can take pride in unparalleled accomplishments.

THE CRASH OF '79

The 1970s was a depressing decade for a lot of reasons. There were the bad clothes and music, of course, but there was worse. The signature genre of the decade was the disaster movie, in which you got introduced to a bunch of characters only to see most of them drowned, crashed, blown up, burned, or otherwise destroyed, while they whined, bickered, and sleazed the whole time.

Another set of popular movies chronicled a very painful end of the world, always brought on by human stupidity. Rent Silent Running or the Omega Man if you don't know what I mean. Carnal Knowledge passed for a sex comedy (and Art Garfunkel passed for an actor). Even the popcorn action flicks managed to be downbeat, like Death Wish and Dirty Harry. Economics best sellers, from Limits to Growth to The Crash of '79, all prophesied disaster. The actual economy gave all the support it could, with a race to the bottom between stock and bond returns. We figured it didn't matter anyway, because no currencies seemed likely to retain any value, and the banking system was going to collapse. That is, if the world didn't end first. The economic efficiency and lifetime security of the modern corporation seemed to vanish overnight. The 1960s put a man on the moon; in the 1970s not only didn't we push farther, but budget cuts and technology mistakes meant we couldn't maintain the foothold in space. Brutal, totalitarian, impoverished communist states controlled almost half the people on earth, and there was not a single example of a country emerging from communism back to freedom or prosperity. I'm not even going to mention Vietnam, Afghanistan, the killing fields, rampant terrorism, the oil embargo, polywater, stagflation, or "Ford to City: Drop Dead." You had to be there, and I hope you weren't.

When the call went out for energetic risk takers to save the world, it wasn't clear that anyone would answer. Three-quarters of a century of suppressing risk meant that few people remembered what it was like when dynamic, self-organized financial networks catalyzed economic growth. Plenty of people knew about risk, of course, but how many of them also understood finance? There wasn't much call for smart people in finance before 1970. Interest rates didn't move much, and corporate borrowers seldom defaulted, so there was not much room to distinguish yourself in bond management. Foreign exchange rates were fixed. Stock prices moved, but no one could do better than pick them at random, so that didn't take a genius. Then, suddenly, interest rates were oscillating so much that bonds became riskier than stocks. And stocks weren't so much risky in the 1970s as predictably and safely going down. After a decade of debate over whether corporations should maximize growth or shareholder wealth, boards of directors threw in the towel and embraced stakeholder capitalism, meaning the stock could go down as long as employees and the government got to share in the shrinking pie of shareholder money. President Nixon (the poker player) took the United States off the gold standard in 1971, making all the world's currencies suddenly fiat currencies, worth whatever the government said they were. Since governments had no credibility, some currencies inflated and some hyperinflated. A dollar went from being worth about a gram of gold down to about 40 milligrams, with micrograms seemingly in the near future.

BRIDGE BUMS, CHICAGO SCHOOL, AND THE PIT

Fortunately, although the financial industry did not require smart people, a group of maverick academics had been thinking hard about finance since the mid-1950s. Just as important, the Chicago Board of Trade had not forgotten what made the American economy great. Working with academics from the University of Chicago, the Board of Trade introduced trading in stock options in 1973 at the newly created Chicago Board Option Exchange. Stock trading became fun again. The price of a seat on the New York Stock Exchange had fallen below the cost of a Manhattan taxi medallion, but it would soon rebound to record levels.

Options add spread trading to the stock market. Instead of being able only to buy or sell a stock, you can take a long or short position in puts or calls at a number of different exercise prices and expiry dates. That opens up enormous opportunities for those who can calculate fast on their feet and take controlled amounts of risk with calm judgment.

When the options markets opened in 1973, no one knew how to trade them. Futures traders understood spread trading, but they didn't know options math. Academics knew the math, but didn't know how to trade. The markets called for people who liked risk. The call was answered by the scion of the first family of American bridge.

Since the 1950s, almost all national and international bridge championships have had a Becker competing. Mike Becker is one of the better players in his family-he and his partner, Ron Rubin, have a world and 10 national championships to their credit. Mike played pro bridge, which meant eking out a living playing high-stakes bridge at New York's famed Cavendish Club or being a paid partner for people who really, really wanted to win a bridge tournament. He also hustled some poker and backgammon and was a card-counting blackjack player. Ron had a bit more ambition and thought options trading looked easier than bridge. The first time he tried, he went bust.

Then Ron won $90,000 by coming in second in the world backgammon championship. Wiser this time, he took some optionstrading advice from an expert backgammon player, Fred Kolber, and made almost a million dollars the first year of his second attempt. Coincidentally, Mike's investment manager had lost his life savings in an interest rate bet, so Ron staked Mike to trade options on the American Stock Exchange. Mike found it just as easy to be successful. Both he and Ron could figure opportunities in their heads that other traders needed computers for. Just as important, they had years of experience weighing risk and sizing up other players. Others with the right math skills often had no heads for either risk or people.

Mike also had a talent for teaching. He offered his bridge pals a deal: three months of training, supervision when needed, and $50,000 of trading capital. In return he got 50 percent of their profits, which declined by 10 percent every time the trader made $500,000. A trader going to term would make $2.5 million, $750,000 of which would be Mike's. That's pretty good, even compared to his trading income, when you consider he trained about 100 traders over 15 years, with 20 of them going the distance. Mike recruited 50 bridge champions; the rest were poker, backgammon, chess, or go experts. At the peak, 150 of the 400 American Stock Exchange options seats were held by games players trained by Mike or Ron, or the people their trainees brought down to the floor. Only a fraction of the other 250 traders had trained in business schools or math departments. Until the advent of high-quality portable computers in the early 1990s, and some market changes, America's stock option exchanges ran on game-trained brainpower.

The effect was electrifying. Since the stock market had become tolerably honest after federal legislation in the 1930s, investors could not tell the difference between good and bad stocks. Banning insider trading and manipulation made the market fairer, but also a lot more random. Study after study showed that buying every stock was the best strategy. Corporate managers were not slow to pick up that they were on the honor system. Predictably, this brought out the best in the best people and the worst in everyone else. The most common bad reaction was not unrestrained greed, since there were still quaint social sanctions against managers paying themselves hundreds of millions of dollars while the company stock went down. Instead, the bad managers opted for an easy life and comfortable salaries with lots of perks and generous pensions, with shareholder profits allocated to buying off employees, the government, and anyone who protested anything the company did. Companies got lazy, comfortable, and cowardly.

Options trading was more than turning on the light in a roachinfested kitchen; it was like a full-body X-ray. Companies went from investors having no useful information about their stock to having the exact probability of every $5 move over every quarter constantly assessed in public. It took a decade or so, because America's risk takers were rusty at finance, but it whipped things into shape. In 1970, corporations dumped their stock on the market like thousands of farmers flooding a port with grain at the same time, half of it to spoil and the rest to sell at depressed prices due to oversupply, causing a shortage the next month. By the mid-1980s, options traders had transformed it into a smoothly running just-in-time machine, effortlessly adjusting to all types of disruptions, like Chicago in its glory years. This change kicked off the greatest stock market boom in history, along with corporate raiding, leveraged buyouts, demutualization, and other forces of creative destruction. Most of the great American corporations were destroyed or turned inside out in the process, and a generation of workers found that their cradle-to-grave security deal had been converted to a roller coaster. But a new crop of corporations sprang up. Consumers, shareholders, and entrepreneurs won big.

Options are a simple form of derivative (the option value depends mainly on the underlying stock price, while derivatives are securities whose value can be derived from the price of other securities). In the 1980s, and continuing to today, derivative markets sprang up for every imaginable financial variable, and some nonfinancial ones, such as weather derivatives, as well. These markets had the same effect on their underlying assets as stock options on stocks.

WITHERED THESE LATTER-DAYS TO LEAF-SIZE FROM LACK OF ACTION...

To see why options mattered so much, consider a simplified example. Super Duper Stores operated no-frills supermarkets in semirural areas outside cities starting after World War IT. It used one huge central processing facility to receive, package, process, and ship food to 200 stores in five neighboring states. Over time, the cities and suburbs grew, so that the land occupied by the supermarkets skyrocketed in value. Super Duper acquired a dowdy but comforting brand-name image, store managers were unambitious older white males, groceries were bagged by local high school kids, and checkout was done at a manual register by part-time working wives. Everyone involved-truck drivers, butchers, produce clerks-was a full-time, union employee of the company, with a generous health and definedbenefit retirement plan. No one ever got fired.

The company stopped expanding in the late 1950s because it had reached the distribution limits of its central processing facility, and it could not operate profitably paying market prices for new locations. It used the cash thrown off by its business to pay off all its debt. When fuel prices jumped, it didn't move to distributed delivery because that would upset the routine. When South and East Asian immigrants moved into Super Duper's service areas, they were not hired-they didn't look the part. Price scanners, modern inventory, gourmet sections, generic goods-none were worth the trouble to investigate. For years, anyone with ambition or new ideas had quit; people who like things quiet and safe stayed.

The stock price stayed in one place, too. When interest rates were low and profits still high, Super Duper paid a nice dividend and was popular among conservative investors. But with higher interest rates, the dividend stream was worth less. One dollar-per-year dividend is worth $50 at a 2 percent interest rate, but only $10 at a 10 percent interest rate. Also, declining profits as a result of increasing inefficiency and competition meant the dividend was first cut, then eliminated.

Why didn't shareholders revolt? I could write a whole book on that, but for now just say that they didn't. Shareholders who got frustrated at the stock going down while management did nothing simply sold their shares to less impatient investors. Why didn't some outsider buy up the company and turn it around? In practice you needed the permission of the board of directors, and the board just said the company was not for sale at any price. Of course, none of the board members owned shares, but they did have generous salaries and pensions guaranteed by Super Duper that could be lost in a takeover.

Let's suppose that the asset value per share of Super Duper was $150. This is what it would be worth either sold to energetic managers or broken up with real estate and other assets sold individually. A rational shareholder might conclude that there was a 10 percent chance of the value being unlocked in any given year. The board or management could discover higher standards; an outsider might make a bid for the company or its assets; even a disaster could be good if it forced change. However, in none of these scenarios do shareholders expect to realize full value. A board or management change will probably be some kind of compromise, a raider will want to make a profit for herself, and a disaster will cut the value of the assets. So perhaps this stock is like a perpetual lottery ticket with a 10 percent chance of paying $100 in any given year. Since there's no cash flow until that happens, if the appropriate discount rate is 10 percent per year, each share of Super Duper has an expected net present value of $50. The only holders of Super Duper stock are people who like this kind of gamble and people who aren't paying attention. Neither of these groups is likely to trade much, so there will be low trading volume in the stock and not much attention paid to small changes in value or probability of unlocking value.

Now suppose options start trading on Super Duper. Only two things can happen to the stock: The price can stay at $50 or double to $100. The probabilities don't matter for the option price. A call option struck at $50 will pay either $0, if the stock stays at $50, or $50, if the stock goes to $100. In either case, it pays the stock price minus $50. Therefore, the option is worth the current stock price minus the present value of $50 at option expiry. Since interest rates are 10 percent per year, a one-year call option is worth $4.55.

This opens Super Duper stock up to more interesting trading. You can buy the stock and sell call options on it to earn a steady, low-risk profit. Or you can buy the options as a pure lottery ticket. If enough people do this, the market will effectively lever up the company. The stockholders are now like bondholders, earning a steady, safe return, and the options holders are like stockholders, participating in increases in the company value. This will inflate stock prices, for the same reason they went up in the 1920s, when it was easy to borrow almost all of the money to buy stocks (both the Federal Reserve and the Securities and Exchange Commission worked to curtail aggressive borrowing to buy stock after the 1929 crash; the options market provided a backdoor way to avoid regulation). Trading volume will increase and far more attention will be paid to the prices. New kinds of traders will be attracted to the market to play these games. Some of those traders will use their profits and market savvy to force actual levering up of companies or other strategies for unlocking value. The increase in stock valuations and the availability of creatively engineered finance will encourage other people to start new companies.

The economist John Kenneth Galbraith famously observed that all financial innovation consists of new ways of disguising leverage. There's a lot of truth to that, and the public options market-more broadly, increased trading in all forms of derivatives-certainly increased leverage in the economy. But Galbraith's remark is overcynical in the use of the word disguise. True financial innovation provides better ways of managing leverage. Derivatives caused disasters (Warren Buffett called them "weapons of mass destruction"), but creative destruction is still the core driver of economic development.

Going back to Super Duper stock, notice that although the oneyear $50 call is worth $4.55, the one-year $50 put is worthless. Until the crash of 1987, stock options traded at close to constant volatilities. That tends to push up the price of both the call and the put. The difference still has to be $4.55, but this trading prejudice might make the call sell at $6.50 and the put at $1.95. This inflated call price makes the stock more valuable, because you can earn a larger income holding it and selling calls. That pushes up the price and further increases the value of the call. When the market crashed, the prejudice disappeared overnight, not just in stock option markets but in all options markets. That dissipated some illusory value in the markets, but it dramatically increased the force and precision of derivatives trading in causing real economic change.

Of course, Super Duper stores and these numbers are highly simplified accounts of a very complex series of events. The point is that options trading mapped the full web of future possibilities, and game-playing traders sent capital zooming to break the bottlenecks. The extra volatility induced by the gambling was essential for two reasons: It tested links in the network, and it concentrated capital by making successful traders wealthy enough to facilitate real economic change.

HISTORY'S BEATEN THE HAZARD

Another games player who switched to finance early was Ed Thorp, the mathematics professor who invented blackjack card counting. In 1961, he wrote Beat the Dealer about how he won in casinos. Less well known is his 1967 book, Beat the Market (with Sheen Kassouf). Ed did not wait for public options trading in 1973; he began buying and selling warrants (options issued directly by corporations rather than created by exchanges) in the 1960s. He applied the same principles of careful mathematics and controlled risk taking to the market as he had to blackjack and has compiled an unequaled 40-year track record of high-return, low-risk investing.

In coming up with a trading strategy for warrants, Ed discovered a handy formula. A few years later, three finance professors independently came up with their own slight mathematical variant of the same formula. Ed Thorp, Myron Scholes, Robert Merton, and Fischer Black all had almost the same formula, but each had a different reason for believing it was true. Ed showed that it was a way to make money, Scholes that it was required for market efficiency, Merton that it had to be true or there would be arbitrage, and Black that it was required for market equilibrium. Black's insight turned out to be the most important, although it would take him 20 more years to work out its full implications. Merton and Scholes shared a Nobel Prize for their work; Black had died by that time or he certainly would have been included. Thorp missed out on the Nobel, but he got rich using the formula, while Merton and Scholes had disastrous personal financial results. Black's dislike of risk kept him from either extreme.

The four approaches to the option-pricing model led to different interpretations of the events from 1973 to 1987. Most practitioners adopted Ed Thorp's version of the model. Their attitude was that innovations in financial trading open up vast new profit opportunities, so let's get rich as fast as we can. The mainstream academic reaction in finance was in the Myron Scholes school: Options make the market more efficient, and more market efficiency is good for the economy. Underemployed physicists and mathematicians worshipped instead at the Robert Merton altar. They invented something called financial engineering, to exploit the kind of mathematical results that underlie options pricing, and structured ever more complex products and deals. For a wonderful account of one of the most prominent financial engineers, pick up My Life as a Quant by Emanuel Derman.

There is a lot of truth to all three approaches, but it was Fischer Black, who never attracted a school, who really figured things out. All four of these guys are extraordinary geniuses. Some people think Black was the smartest, but I suspect that's because he fit the antisocial, half-crazy popular image of a genius. Ed's the most fun to have dinner with, Scholes is the best lecturer, and Merton's the best if you want to sit down and work out some math. I think Black succeeded because he was the least interested in success. He liked a comfortable salary, which Goldman Sachs more than provided, but he didn't start a hedge fund like the other three. He didn't publish much in academic journals; he preferred the practitioners' publication Financial Analysts journal, edited by his friend Jack Treynor. He wrote one blazingly original paper in an area, then moved on to something else, unlike some academics who spin every idea into 10 overlapping papers interlocked in a professional subtopic. He finally put it all together in a book, which practically nobody read.

AND HE BURNED THEM AS WASTEPAPER

Consider an economic statistic like the quarterly gross domestic product for the United States, which is periodically announced by government statisticians. This is an important economic variable; it and similar statistics fit into many economic theories and models. Black realized that it was improperly aggregated to the point of being meaningless.

Most economic decisions have long time horizons. It's easy to overlook that, because most of us participate in only small parts of transactions. If a person cuts down a tree in half an hour and gets paid $20, he thinks of it as a half-hour transaction. But that tree is going to be processed in many stages, so it may be months before it is incorporated into products. Many of those products will be stages in further production-paper for a company, cross-ties for a railroad, a shelf for a retail store. There are profit-and-loss statements computed for all these businesses, which make it appear that end-to-end economic activity has taken place each quarter. But those are all based on assumptions that the future will be as planned. That's never true.

Think of all the work you've ever done that was wasted. Maybe you did something wrong and had to undo it. Maybe your work was fine, but the project was canceled. Maybe the project went fine, but it never led anywhere. You might never know that your piece went unused. And don't limit it to short-term work projects. Think of all the training you have received that is no longer useful, or never was. Think of all the time spent waiting or wasted in pointless meetings. Most of what passes for economic activity, that gets assigned a value and added up in those quarterly accounts, turns out in the end to have no value. The things that do have value are often completely unexpected and either undervalued at the time or left out of the accounts entirely. Tiny differences distinguish an iPod that is sold immediately at a premium price and a functionally identical harddisk MP3 player that is thrown away unsold and unused; a movie that grosses $100 million its first weekend and one that goes straight to the video remainder bin at Kmart; a book that tops the best-seller chart and one that the author's family won't read.

So the quarterly GDP figure combines lots of useless stuff with other undervalued stuff, and it will take years, not months, to figure out the difference. Of course, economists break GDP down into components-sometimes hundreds or thousands-and they study long time series. But, Black observed, none of this gets to the granularity that explains real economic value or the time scale at which important economic events take place.

Suppose, for example, a country decided to build a self-sufficient automobile industry from scratch. It would have to search for iron and coal; build factories to process steel, glass, and rubber; invest in research and design. It would need to build railroads to link these facilities together; those railroads would require more steel and coal or oil, as well as wood and other materials. The cars would need roads and gas stations to be useful. The whole process might take 20 years and involve a million workers at the end. Each year the progress would be valued and added in to the national accounts. People would be paid for their work; companies would be founded and would prosper; schools would be set up to train workers.

But when the first car rolls off the assembly line, it takes only one consumer to say, "I don't like it." The whole 20-year project comes to a crashing halt; all the value created for that period is written off. Maybe some assets can be salvaged. Maybe the car can be redesigned, or bicycles can be built instead. Maybe the steel can be used for buildings. But none of these restructurings are certain, and all involve significant loss in value. Almost all of the million workers will be laid off in the short term, and many of their jobs will not exist in the restructured system.

If you think of the economy as a collection of 20-year speculative projects, many of which will fail completely and none of which will turn out as planned, you see the economic need and the appeal for a gambling rather than a middle-class lifestyle. If you take the safe course, it seems as if you are entering a solid business with a longterm history and stable prospects, but it can evaporate in an instant. It's like a motel on a busy road that suddenly becomes worthless because someone built a bridge 50 miles away that changed all the traffic patterns. Even if your business is one of the successes, the entire economy can crash if too many mistakes are made in other businesses.

As an investor, you can buy a stock with a 20-year history of steadily growing profits and completely honest and transparent accounting without one penny of those profits ever being tested in the sense of contributing to something anyone actually bought. Virtually all of the economic value of things people do buy results from decisions made decades ago. A computer might have been built last week, but the research and development, the training of the workers and users, the building of the infrastructure to supply it with power and communications, the governing law, the business organization of the manufacturer and retailer, and a hundred other essentials were put in motion long before. Without all of those things, the computer either cannot be built or is worthless if built. Given all those things, the additional economic effort to build one more computer is negligible.

Disruption leads to opportunity. That deserted motel might be acquired cheap and converted to a spa resort now that the traffic noise has disappeared. The new traffic patterns from the bridge might change the commute times, hence the relative real estate values, among various suburbs. There's lots of free stuff lying around for anyone who wants it, and lots of unmet needs-unmet because the project that was supposed to meet them failed. Think how much money eBay made just acting as an intermediary to people cleaning out their attics of useless stuff. And think of how Internet search sites, such as Expedia, changed the motel business. Instead of needing a prominent location so guests could find you easily, you could compete by offering the lowest price in town, knowing that guests would find you on the Internet and get directions. What if all the owners of stranded assets bet them in a giant poker tournament? Some winners would walk away with random combinations of otherwise useless assets that just might spark someone's creativity. A lot of successful businesses were founded when someone had to find a use for something they owned.

Fischer Black had a lot more than this to say. My point is that the world he describes is more like the wide open frontier that was organized by commodity futures exchanges than the smooth equations you see in standard economics textbooks. The economic challenges of the future will be met, and the fortunes of the future made, by spread bettors acquiring capital and deploying it dynamically.

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