In an Uncertain World (11 page)

In the 1950s, Gus was one of the inventors not only of risk arbitrage, but also of block trading for institutional clients. Before that, an institutional investor who wanted to sell 50,000 shares of Coca-Cola—a small block by today's standards—would sell them piecemeal on the open market, putting downward pressure on the price of the stock. Gus's innovation was for Goldman to buy a whole block of shares, which might cost $10 million or $20 million, with customer commitments to buy some of the block and the rest taken into inventory for subsequent resale. The firm would take more risk by actually owning some of the stock on its books for a time. Per-share profit may have turned out to be lower, but Goldman's trading volume and market share increased tremendously.

L. Jay and Gus were both men with tempers, which was pretty normal for trading rooms in those days, when most of the familiar Wall Street names were private, a large firm had a few hundred people at most, and few traders had college degrees. The environment was highly entrepreneurial and often seat-of-the-pants. For Gus, management was accomplished by yelling—all day long. The legend was that a decade earlier, he would regularly fire everyone in his office at the end of the day—but they'd all be back at work the next morning.

By the time I got to know him, Gus had calmed down somewhat, but he was still quite a challenge. He had a sliding glass window in his office that looked out onto the trading floor at the old Goldman office at 20 Broad Street. Gus would slam open the window and bark out orders—or abuse, if he found out that Salomon Brothers had done more block trades than we had that day. Then the window would slam shut again. I once started explaining something to Gus with the words “I assume . . .” “Don't assume anything!” he barked at me. “Find out!” Or he'd snap, “Do it now, you may not be able to later!” Of course, anyone might make such a comment. But coming from Gus, with his enormous intensity, such admonitions burned themselves into my soul, and I cite them to this day. Another time, soon after I'd arrived at Goldman, Gus called me into his office to discuss a memo I'd written proposing an arbitrage transaction. He dismissed it with a one-sentence remark that I didn't understand. When I asked him what he meant, he snapped back, “We don't have time for on-the-job training here.”

Gus also had enormous charm, which he would employ with the firm's clients. One of the few times I was invited to a dinner at his apartment, he was hosting the visiting chairman of a major corporation. To hear Gus talk, you would think the chairman was the greatest genius in the history of American business and Gus's best friend. But I'd heard Gus heap similar accolades on other CEOs. In a taxi on the way home, I asked Ray Young, one of the firm's senior partners, “Ray, do you think Gus will remember those comments the next time he says the same thing to another big client?” Ray answered that Gus was being absolutely sincere—he meant everything he said when he was saying it. For that evening, the CEO in question was the center of his universe. That's why Gus's charm was so effective. Many years later, I met another person who had that kind of ability to focus his attention completely on someone without being insincere. That other person, even more persuasive in such moments, was Bill Clinton.

Despite his temper, Gus was a great leader who was truly supportive when times were tough. About individual transactions he could go absolutely crazy, as he did when we lost more than half a million dollars on the Becton Dickinson–Univis deal. “Anybody could have seen that was going to happen!” he'd shout. But those of us in the trading room knew that at the end of the day he would be fair about compensation and promotions. Gus understood that we were in a risk-reward, probability-based business and that a trader would do badly at times, either because the dice came up wrong or because people make mistakes. That made Goldman Sachs an environment where you could take rational risks. With all the ranting and raving—and there was a lot of it—in the final analysis, Gus supported risk taking and assessed people fairly based on their overall performance.

Gus himself was famously superstitious. You could hear him coming on the trading floor because of the “lucky” coins jangling in his pocket. Although one of his mantras was “It's better to be lucky than smart,” Gus didn't rely on luck. He began his workday at 5:00 in the morning and got to the office before 7:30, well ahead of everyone else—a point he was kind enough to remind us of from time to time—and then went to client dinners or charitable events every night. After Gus died, I always regretted that I'd never asked him what he, driving himself all day long every day, thought life was all about. I don't know if he would have had an answer, but one answer I don't think he would have given was money. By the time I knew him, he didn't need more for practical purposes, and I don't think his sense of self resided there. In fact, he gave away much of what he made.

The big crisis in those years was the Penn Central bankruptcy, which hit in 1970, the year after Sidney Weinberg died and Gus's first year as senior partner. Goldman had sold commercial paper—short-term debt instruments—on behalf of the Penn Central railroad. When the railroad surprised everyone by declaring bankruptcy, investors who had bought Penn Central's paper accused us of inadequate disclosure—because of negligence or intentional failure—about the company's financial condition. The bondholders sued us for an amount that exceeded our capital. The claims may have been weak but they were not frivolous, and the partners' entire net worth was at stake. I was not yet a partner, but I had ideas about how to respond to this crisis and told Gus, though this may have been presumptuous given my limited experience, that I thought we should consider whether our regular outside counsel was well suited to the rough-and-tumble of a jury trial. He decided to stay with our regular counsel, but to use a different lead litigating partner than would ordinarily have done our work, someone who was better suited to this situation. Thereafter, he used me occasionally as something of an unofficial adviser. That was my first experience dealing with a critical institutional crisis. Since then I've had to help manage through a number of these events, not just at Goldman Sachs but later in Washington and at Citigroup.

For a period of more than a year, Penn Central created immense anxiety at Goldman. As a private partnership, we faced unlimited liability, and some people worried whether the firm would survive. When the firm's outside counsel, Sullivan & Cromwell, provided a letter saying it didn't think damage payments would materially impair our capital, Gus carried it in his jacket pocket as a kind of talisman. I thought of that letter when I had to face the same concern about the firm's survival after one of our partners was charged during the insider trading scandal of the 1980s and we obtained a similar letter from Wachtell Lipton, our counsel. In the end, the Penn Central matter was settled on terms that the firm could absorb. In fact, the settlement cost Goldman Sachs less than we eventually made in risk-arbitrage trades involving claims in the Penn Central bankruptcy.

Although some people found Gus impossible—and at times he
was
impossible—he was a giant figure for all of us who worked with him, and I still think of him often. He was less difficult with me than with the trading-room partners more directly under him—possibly because I was younger. After he died, Larry Tisch, a friend of his, told me that Gus had thought I'd run the firm someday—an idea that seemed far-fetched to me at the time.

Why did the arbitrage work at Goldman suit me? I think that there is an emotional answer and an intellectual answer, though the two are connected. The emotional answer is that my temperament was simply a good fit. Arbitrage was enormously intense; people at the firm used to think the stress was overwhelming and could drive a person insane. And there was immense pressure. But I was able both to apply myself intensely and, at the same time, to maintain a reasonable degree of equanimity. In my mind was the notion that I could walk away if I had to and go back to cafés on the Left Bank and read Henry Miller. Another calming thought was that a thousand years hence, no one would care whether some deal had gone through or whether my arbitrage career had worked out. Meanwhile, I was glad that other people at Goldman Sachs thought my job was so pressured. It meant respect from my colleagues, even though we traders didn't have to work at night like the investment bankers.

The intellectual answer relates to the questioning and probabilistic mind-set I started developing at Harvard. In 1975, a colleague of mine at another firm explained an investment that he believed to be a sure bet. He was making a massive purchase of shares of Anaconda, a mining company whose shares were to be bought by Crane, another company that wanted to enter the copper business. I agreed that the proposed deal looked extremely likely to reach closure. However, not believing in certainties, only in probabilities, I made a large investment, but with a loss potential Goldman could readily absorb in the highly unlikely event the deal didn't go through. Then the unexpected did happen—antitrust issues blocked the merger, and the deal fell apart. We took a big loss. But my friend took an unacceptably large loss, which included his job.

My approach grew from my basic makeup, from Raphael Demos's approach to philosophy and my whole Harvard experience, from my debates with George Lefcoe in New Haven, and the ethos of Yale Law School. In arbitrage, as in philosophy, you analyze, look for holes in the analysis, and seek conclusions that hold together. However, while analytic rigor may be sufficient for philosophy, it's not enough for arbitrage. In arbitrage—as in policy making—you also have to be able to pull the trigger, even when your information is imperfect and your questions can't all be answered. You have to make a decision: Should I make this investment or not? You begin with probing questions and end having to accept that some of them will be imperfectly answered—or not answered at all. And you have to have the stomach for risk.

As well as my career was going at Goldman during my first several years there, I nevertheless felt that my prospects for partnership were slight. I thought I'd make some money, learn a good deal, and take my newfound skills to a smaller place to capitalize on them. But then life took one of its unexpected twists. In 1970, I was recruited by White Weld, one of the old-line Wall Street firms. A friend from law school worked there, which led the company to interview me when the fellow who ran its arbitrage department left. I called my parents and told them about the offer, which I assumed I would take. My father was unhappy about my leaving Goldman Sachs. “Maybe they'll offer you a partnership,” my father said. “Dad,” I said, “you just don't understand. They're not going to offer me a partnership at Goldman Sachs.” Becoming a partner of the Goldman of that time was like catching the brass ring—a very low probability bet.

So I went to speak with L. Jay, who was upset that I might leave. And he went to Gus Levy. Gus wasn't happy about having to deal with this problem, but after consulting with the firm's management committee, he came back and offered to make me a partner at the end of the year. I was, to say the least, surprised. Becoming a partner at Goldman Sachs was not in what I considered the realm of realistic expectations. But on the first day of fiscal 1971, I found that I was one.

CHAPTER THREE

Inside and Outside Goldman Sachs

THE IMAGE OF my grandfather Samuel Seiderman's life was very powerful in forming my own ideas of how I wanted to live mine. My grandfather was successful professionally and financially, and he had a recognized and respected place in his community. His broad range of involvements—especially in politics—made his life more varied and interesting.

Gus Levy was another model of a multifaceted, externally engaged professional life. Gus's day job was running Goldman Sachs, but he had worlds outside the firm. Gus served as chairman of the board at Mount Sinai Medical Center, sat on the boards of cultural organizations such as Lincoln Center and the Museum of Modern Art, and was a major fund-raiser for and confidant of Republican politicians. His range of friends and contacts was enormous; Gus knew, or appeared to know, everyone who was anyone in business and politics, including President Richard Nixon and New York Governor Nelson Rockefeller. “There are really six Gus Levys,” the CEO of a major bank said. “At night they put on their tuxedos and fan out around the city.” I had no desire to emulate Gus's peripatetic social life. But I was drawn to the kind of career that enabled Gus to contribute to causes that he cared about and earned him the same sort of place in his much larger world that my grandfather had in his. The various facets of Gus's life were synergistic, with efforts in one area contributing to accomplishments in others. The variety of his involvements gave his career a meaning beyond the considerable achievements in his day job.

A third example for me was Bernard J. “Bunny” Lasker, a legendary arbitrageur of Gus's generation. Despite an almost thirty-year age gap and vastly different political and social views, Bunny and I became close friends; perhaps, in some fundamental respects, we were on the same wavelength. A self-made man who had started on Wall Street as a messenger, Bunny was a vivacious, larger-than-life figure—one of those people who fill up a room just by entering it. Some people looked askance at Bunny because he lacked a certain polish, but that didn't mean he wasn't smart. Bunny never went to college, but he had a practical sense that Harvard Business School cannot teach. I used to say that if Bunny and our best MBA simultaneously started from the same point in a race that involved complicated practicalities, Bunny would run the course, have dinner, go to bed, and get up the next morning before his credentialed competitor reached the finish line.

Like his good friend Gus, Bunny knew everybody and was deeply involved in what he called the three great passions of his life—the Republican Party, the New York Stock Exchange, and West Point, where he served as a trustee despite having been rejected in his youth. He guided the New York Stock Exchange through hazardous times as chairman in 1970, when the investing public's confidence was probably at its lowest level since the Depression. Richard Nixon publicly credited Bunny with saving his career by persuading him not to try for the presidency again in 1964, when Nixon almost certainly could not have won.

Another person I sometimes think of as a professional role model was someone I never met: Armand Erpf, a partner in the then well-established investment banking firm Loeb, Rhoades and Company, who was involved in an array of cultural and civic activities. I remember reading an article in
The New York Times
in 1967, shortly after I started at Goldman Sachs, about a chair being established in Erpf's name at Columbia Business School. “My main interest is Loeb, Rhoades,” Erpf said. “After all, everything starts from there.”

That's it,
I thought when I saw the story, which crystallized a thought that had previously been inchoate in my mind. And in fact, Erpf's line is not a bad description of my life over the next two decades, or at least what I tried to make it. Goldman Sachs was my fundamental and overriding involvement. From that strong base, I was able to reach out in various directions—nonprofit and charitable organizations, professional associations, politics, and, eventually, a second career in Washington.

Until the end of 1992, when I left Wall Street to join the Clinton administration, my inside and outside careers ran on parallel tracks. Inside Goldman Sachs, I was learning not only about markets, finance, and economics but also about management and human nature. Outside Goldman Sachs, I was learning about management and human nature in a variety of other contexts. These two careers developed side by side, each contributing to the other. Over many years, in a variety of disparate settings and institutions—Goldman Sachs, the White House, Treasury, Citigroup, Mount Sinai Medical Center, and the Harvard Corporation—what I learned in one place about working with people and how they think and react usually held true in another.

   

THE ANALYTIC MIND-SET I further developed doing arbitrage led me to look for inefficiencies or discrepancies elsewhere in the relative value of different related securities, and thus to the arcane business of stock options. Like arbitrage, options trading is a risk-reward, probability-based business, although more directly quantitative. At the time, even most people on Wall Street knew little about it. I read quite a bit on the topic, including a newsletter about opportunities in warrants. A warrant, similar to a “call option,” is a security that conveys the right to purchase a share of stock at a set price for some period of time, usually a certain number of years.

One article in the newsletter said that warrants in Phillips Petroleum were overpriced—based on valuation models—relative to the price of the Phillips stock. That created an opportunity in what is often called relative value arbitrage or relationship trading. Relative value arbitrage means going long one instrument—a security or a derivative—and short another related instrument, when one of these instruments is considered undervalued relative to the other. The bet you're making is that the prices of the two instruments will return to their proper relationship and provide a profit from that movement. The instruments might be a common stock or bond and a “derivative”—an option or future that is convertible into the underlying stock or bond on some basis.

Not yet a partner at that point, I wrote a complicated memo recommending that we go short the Phillips warrants and long the common stock, betting that the price of the warrants would go down relative to the price of the stock. I gave the memo to L. Jay, who agreed with the recommendation. The warrants were overpriced relative to the stock, but the short position could still lose money if the stock price rose, so that the long position was an essential hedge. With that hedge, one would make a profit regardless of what happened to the price of the stock, as long as the discrepancy in relative value disappeared. L. Jay gave my memo to Gus, and Gus called me in.

“Ahh, I don't want to do all that,” Gus said of my proposal to hedge. “Let's just go short the warrants.”

“Gus,” I said, “you know we have to be hedged.”

Gus responded with a five-word sentence conveying that he didn't care about hedging, didn't care about my memo, and didn't care about explaining the matter—because if I didn't know this stuff, I shouldn't be at the firm in the first place.

I went back to L. Jay, concerned about what to do. L. Jay said, “You better just go short the warrants, if that's what Gus wants to do.” So we went short the Phillips warrants, and fortunately the stock didn't run up while we were holding the position.

The same thinking that drew me to that transaction—and a lifelong tendency to restlessly reach into new areas—led me to other kinds of options. Stock options—instruments that allow, but do not require, an investor to buy shares at a prearranged price during a fixed period of time—had long existed but had always been extremely illiquid. To buy an option, you went to one of several small put-and-call houses, which ran ads in the newspapers and had a slightly questionable reputation. They traded options “over the counter,” which meant not listed on any exchange. Prices were nontransparent, to say the least. I thought that perhaps relative value arbitrage transactions could be done against these over-the-counter options. As I became increasingly involved, I saw that Goldman Sachs might well do what the put-and-call houses did—trade stock options directly with our clients, other brokerage firms, and the options dealers themselves.

My proposal met some resistance at the firm. During the Depression, stock options had led to vast losses on Wall Street. As a result, I was told, Sidney Weinberg had a rule against Goldman Sachs being involved with them. But by the time I first discussed this with Gus, Mr. Weinberg had died. At the end of our conversation, Gus said, in his gruff way, “If you want to get involved with options, go ahead,” and he got my proposal approved by the firm's management committee.

Options are one type of derivative—a security, such as a warrant or a future, whose price depends on the price of an underlying instrument like a common stock or bond—and this was the beginning of Goldman Sachs's trading in derivatives on securities. That business eventually became massive at our firm and across Wall Street as ever more new instruments developed that were based on equities, debt, and foreign exchange. But at the time, the options business was still at a primitive stage. Traders grasped that prices of options should reflect the volatility of the stock but as yet had no system for calculating values. However, an unpublished paper by Fischer Black and Myron Scholes was circulating that detailed a valuation formula based on volatility. For their work on option pricing, Scholes and another colleague, Robert Merton, won a Nobel Prize in 1997. Sadly, Fischer Black died too soon to share it.

The now famous Black-Scholes formula was my first experience with the application of mathematical models to trading, and I formed both an appreciation for and a skepticism about models that I have to this day. Financial models are useful tools. But they can also be dangerous because reality is always more complex than models. Models necessarily make assumptions. The Black-Scholes model, for example, assumes that future volatility in stock prices will resemble past volatility. I later recruited Fischer away from a full professorship at MIT to Goldman, and he subsequently told me that his Goldman experience caused him to develop a more complex view of both the value and the limitation of models. But a trader could easily lose sight of the limitations. Entranced by the model, a trader could easily forget that assumptions are involved and treat it as definitive. Years later, traders at Long-Term Capital Management, whose partners included Scholes and Merton themselves, got into trouble by using models without adequately allowing for their shortcomings and getting heavily overleveraged. When reality diverged from their model, they lost billions of dollars, and the stability of the global financial system might have been threatened.

What made options trading possible on a large scale was the Chicago Board Options Exchange, the first listed market for stock options, which opened in 1973. The key was the creation of standardized terms for the listed options and a clearing system, so that options could trade in a secondary market. I remember Joe Sullivan, the first head of the CBOE, coming to Goldman to tell me about his plans. I took Joe to meet Gus, who listened to him and said, with a twinkle in his eye, that this was just a new way to lose money, and then offered his support. I joined the founding board. Joe called the day before the CBOE first opened to say that he was afraid nobody would show up to trade. In fact, 911 contracts traded the first day, on 16 different stocks. Within a relatively short period, options trading turned into a genuinely liquid market and led to the creation of larger markets in listed futures on stock indices and debt.

I began as a Goldman partner during a period of ups and downs for Wall Street. The year 1973 was the first year the firm had lost money in many years, and 1974 wasn't much better. Our chief financial officer, Hy Weinberg, told me that we junior partners would be unlikely to ever do as well financially as the older partners had because there would never be another period as good as the one that had just passed. That seemed highly plausible at the time, but turned out not to be the case.

During one particular bad stretch in 1973–74, the stock market fell 45 percent from its high. We had very large losses in risk arbitrage and block trading. We were still holding the acquiree stocks in several deals that broke up—contrary to our usual practice—because they seemed so badly undervalued. But as the market continued declining, these stocks' prices kept falling. We thought our positions would eventually come back, and so we held on.

But sometimes, even if the market has gone way down and positions seem cheap, holding on may not make sense. I remember a customer who had a big position in a commodities arbitrage transaction. He bought soybean mash and sold soybeans because the mash was cheap relative to the soybeans. He expected to profit when the inefficiency corrected and prices converged. Instead, the spread widened and he had to put up more cash margin to creditors. As the spread kept widening, he ran out of cash and couldn't put up more margin, so his positions were liquidated to meet obligations. Eventually the prices did converge. But by that time our client was bankrupt. As John Maynard Keynes once reportedly said, “Markets can remain irrational longer than you can remain solvent.” Psychological and other factors can create distortions that last a long time. You can be right in the long run and dead in the short run. Or you can be wrong in your judgments about value, for any of a whole host of possible reasons.

In that 1973–74 slump, we, like the trader with the soybean mash, were overextended relative to our staying power. In our case, the issue wasn't solvency but the limits on our tolerance for loss. I finally went to Gus. We reexamined the merits of each of our holdings and how much risk we were willing to accept going forward, and we decided to sell about half of our positions.