‘Rocket Scientists’ : Wall Street: Banking on a New Breed
Meet the “rocket scientists” of Wall Street.
“Most of the people who do what I do are considered on Wall Street to be weirdos,” said Stanley Diller, who taught higher mathematics for years at Columbia University Business School before moving to the investment banking business. Now he teaches traders how mysterious concepts such as “convexity” and “duration” should affect the business of buying and selling bonds.
Kenneth H. Sullivan joined the firm of E. F. Hutton armed with a master’s degree in engineering from Rensselaer Polytechnic Institute. “When I came into this business in 1976,” he said, “it was totally declasse ever to have even brushed up against a computer.” Now the machines are indispensable in his job as head of new product development for the investment banking firm of Drexel Burnham Lambert, a job, he noted, that “didn’t even exist 20 years ago.”
Unlikely Team of Bankers
Proficient in five computer languages, Helen F. Peters heads an unlikely team of investment bankers at Security Pacific that includes a former Antarctic researcher, a software manufacturer, and an emigre Russian particle physicist. “Physicists, astronomers, mathematicians--as long as they’ve got scientific training, we can look at them,” she said.
For the layman, the affairs of Wall Street have always had an air of the unfathomable. Over the last decade, the “rocket scientists” have fostered a major change: Now much of what goes on in investment banks is so complex that even the investment professional finds it unintelligible.
Investment veterans can be excused for believing that their business has been fairly overrun by former physicists, engineering students and advanced mathematicians. These “rocket scientists,” or “quants” (for quantitative analysts), have wielded their skill with numbers and computer technology to assume some of the most visible and remunerative jobs in investment banking.
The first ones, who arrived in the mid-1970s, helped create strategies for trading futures contracts and stock options that have revolutionized the stock market. When the Dow Jones industrial average plummeted more than 120 points in two days earlier this month, a major factor was “program trading,” a computer-driven system of shifting billions of dollars between the stock market and futures exchanges based on their complex mathematical models.
They opened the door to an explosive growth in the complexity of the stock and bond markets; just as laws often seem to be written so that only lawyers can understand them, many new securities seem to be designed so that only computer experts can comprehend them.
This increasing intricacy has even created a market niche for “rocket scientists” willing to hire themselves out as consultants. After creating Merrill Lynch’s cadre of “quants,” Helen Peters jumped to Security Pacific. There, her year-old unit, Security Pacific Investment Strategies, has 45 experts available to assist investors and corporations made lightheaded by the complicated presentations of investment banks, just as an independent appraiser might be called in to help a home buyer inspect a house.
In some quarters, an engineering degree is now regarded as a better qualification for an investment-banking job than a business-school education.
Consider Dexter Senft, a managing director with a six-figure income at the leading investment bank of First Boston Corp. From 1970 to 1973, Senft was a mathematics student at the rigorously scholastic Rice University in Houston, where the cult of rocket science was lent weight by the presence of the National Aeronautics and Space Administration’s Johnson Space Center.
“I wanted to do rocket science when I graduated,” Senft, 34, said in his soft, high voice. “I liked ‘Star Trek,’ and I was one of those kids who stayed up until 3 a.m. to watch Neil Armstrong on the moon.”
Senft was hoping to land a job at TRW Corp., a principal contractor in the space program, but he ran into a minor problem: He got his degree from Rice in December, and TRW was not hiring until June or July, when the conventional school year ended.
Senft had spent an earlier summer working for First Boston, where his assignment had been to program the firm’s computers so bond yields would flash on the bond traders’ screens. In computer terms, that was the equivalent of a menial task. But he decided to return to the firm to wait out the hiatus before he could move to TRW.
“I couldn’t figure out if I’d be here for six months or 18,” he said recently. “That was 12 years ago.”
Before long, Senft and others like him were showing the investment banks what a computer could really do. Now, Senft is head of First Boston’s bond analysis department, which had a single analyst when he joined but employs more than 80 now. He also oversees the firm’s product development team.
Business Training Ranks Low
Senft said a business degree--the seemingly ubiquitous MBA--is low on his list of qualifications for recruits. “I never went to business school,” Senft said, “and remarkably few of our 80 analysts did.”
Instead, he looks for people whose “quantitative skills are totally solid: Maybe their math isn’t that great, but they can make the computer really jump the hoop.” Many of his staff members are ex-engineers and physicists whose previous jobs were in government or with government contractors.
The “rocket scientists” remain something of a class apart in the investment banks. Outwardly, they tend to resemble others, but they speak an argot outdoing even Wall Street-ese for incomprehensibility.
“You couldn’t pick them out walking down the hall,” Senft said. He smiled self-deprecatingly. “They don’t have slide rules hanging from their belts. But you might know if you were eating lunch next to them, because they’d be using computer terms like ‘directed path search.’ ”
Members of the early generation say they had a particularly tough time convincing tradition-minded Wall Street traders that they had important skills to offer. It was this period that inspired their distaste for the term rocket scientist, for, rather than being an acknowledgement of their expertise, it was the traders’ expression of derision at this bunch of overeducated computer jocks.
“People would go to the bond traders with some program to help them trade, and they’d say, ‘Come on, this is simple, you don’t need a ‘rocket scientist’ to understand it,’ ” recalled Security Pacific’s Peters. “Now there’s been a complete reversal.”
Many found their way to investment banking out of a vague disenchantment with their chosen fields. After Diller returned to his teaching job at Columbia University School of Business in 1973 from a brief sabbatical at the Securities and Exchange Commission, he found himself becoming increasingly dissatisfied with the academic life.
“I found it demoralizing to be on the sideline, as a voyeur, and not be involved in practical experience,” Diller, now 51, said from his office at Bear, Stearns & Co. “The pay was low, and falling. It was not a good business, economically.”
With the help of an SEC colleague who had moved to private industry, Diller joined Citicorp, the bank holding company, in 1974 and began to introduce complex economic theory to the business of buying and selling bonds in an era of rapidly changing interest rates.
“At the time, the business was primarily a subjective one,” he said. “You played the hunches: You thought interest rates were going up or going down, you liked a corporation or you didn’t like it--it was a business not burdened by any theory.”
Need for Skills Grows
As the development of new securities like futures and options enhanced the ability of institutional investors to improve their performance, Diller’s skills in using the innovative instruments came into demand. He moved from Citicorp to the firm of Goldman, Sachs & Co. and, last year, to Bear Stearns, where he runs a “highly computerized” team of 15 people analyzing securities and trying to devise new combinations to improve clients’ portfolios or protect them from interest-rate changes.
Even now, when their indispensability is recognized by every major investment bank, the “quants” still do not always fit comfortably into Wall Street’s client-oriented culture.
“Their predominant characteristic is a decided impatience with people who don’t understand their work,” said Drexel’s Sullivan, who prides himself on developing new business. “That comes across badly.”
Sullivan and others emphasize that the most successful “rocket scientists” are those who allow their clients to specify the problems they need solved--rather than those who apply their skills to creating new products for which no need exists. “There’s a proliferation of ridiculous products today, as well as the good ones,” Sullivan said.
Still, the “rocket scientists” have forced the investment banks to reconsider almost all aspects of the way they do business. They have even redefined the term “product” on Wall Street. In the old days, the investment banks all offered a similar, if not identical, inventory of stocks and bonds for corporations that came seeking capital.
They were like feed stores competing to sell from the same stock of oats. One bond might differ from another only in terms of its maturity date and the interest rate it paid; shares of stock had even less variety.
By the early 1980s, that had changed. Commodity exchanges were offering stock options, and then futures contracts on indexes based on the averaged prices of hundreds of stocks. An investment bank that could show an investor how to simultaneously trade stocks, options and stock index futures could make more money for the client, and for itself, than one that could only help a corporation issue a share.
Futures appeared in the bond market, too, allowing investors to hedge the risk that interest rates--then gyrating wildly and unpredictably--would move against them.
The notion that an investment product was a piece of paper yielded to the idea that the entire portfolio of securities, futures, options and even more exotic instruments could be considered a product. Devising these portfolios, however, demanded the most powerful computer technology, and the skill to use it.
“There are new products that wouldn’t even exist,” Senft said, “if we didn’t have computers.”
Forced to Turn Aggressive
Where a firm could once rely on its spotless reputation or sheer charm to compete with its rivals, henceforth “investment banks had to be more aggressive at coming up with new ideas to ensure they got our business,” in the words of Edward Campbell, vice president of finance at Standard Oil Co. (Sohio), a major securities issuer. The old feed stores had to change so they resembled, say, fast food restaurants, all working subtle but potentially profitable variations in which the underlying product could be detected only dimly.
One example is the innovative bond that Senft’s group at First Boston helped create for Sohio earlier this year.
As Senft and Campbell describe the process, Sohio had two desires: to borrow about $375 million at low interest rates and to hedge against the continuing depression in oil prices.
The “rocket scientists’ ” solution, developed with the assistance of Sohio and Lazard Freres, another investment bank, was a security they called an “oil index note.” This is no conventional bond. “It’s a very effective hedge to protect ourselves from the downturn,” Campbell said.
Sohio essentially sold investors a series of $1,000 short-term notes, payable in 1992. If the price of oil is $25 a barrel or less at that time, the buyers get their $1,000 back, having earned no interest at all. For every dollar that oil prices exceed $25 per barrel, however, the investor gets another $200, or 20% total interest (about 4% a year), up to a maximum price of $40 a barrel. Thus, if oil prices in 1992 are $30 per barrel, the investor will have doubled his money.
Represents a Gamble
The note thus represents a bet by the investor that oil prices will rise. At the same time, Sohio can borrow money at a rate tied to the price of oil. If prices remain low, Sohio’s interest costs on the note are minuscule. If they rise, the company will have to pay more interest--but will presumably have higher revenues to cover it.
It was a unique creation designed to serve a client’s specific problems.
Many such creations were inspired by the wild financial markets of the last five years, when the staid portfolio fashions of 40 postwar years became dangerously inadequate.
As the markets became more volatile and the welter of securities more complex, the individual investment manager became an endangered species.
“Part of the growth of quantitative analysis,” Diller said, “is a loss of faith in the ability of individual people to shine year after year. You give people rules and structures because you have no faith in individual artistry. Our job is to show them how to do well in a structured universe.”