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In An Uncertain World: Tough Choices from Wall Street to Washington by Robert E. Rubin


Rating: (Recommended)


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Political buffs looking for a cabinet-level kiss and tell will have to look elsewhere because former Treasury Secretary Bob Rubin’s book, In An Uncertain World, is all about thinking, policies, and the reality that upsets everything. After an exciting opening chapter on a financial crisis in Mexico as Rubin became Treasury Secretary, the book proceeds at a moderate and deliberate pace to reveal a little about Rubin, the man, and a lot about his ideas. Around page 80, I was so struck by his passing comment on page 80 that “reality is always more complex than models,” that when I read it again on page 285, I took extra note of that lesson. Here’s the context for the early quote, from the middle of chapter 3, “Inside and Outside Goldman Sachs,” (pp. 78-84):

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 timehad 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 19 74 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.

Looking back at that episode, I realize that we hadn't really been reevaluating our positions as the economic and market outlook changed. Holding an existing investment is the same as making it again. When markets turn sour, you have to forget your losses to date and do a fresh expected-value analysis based on the changed facts. Even if the expected values remain attractive, the size and risk of your portfolio must be at levels you can live with for a long time if conditions remain difficult. Praying over your positions—a frequent tendency in trading rooms during bad times—isn't a sensible approach to coping with adversity.


Around the time L. Jay Tenenbaum retired from Goldman Sachs in 1976, Ray Young, who was in charge of equities sales at the firm, gave me some advice. He said that now that L. Jay was leaving, I had to make a choice. I could continue to act in the manner I had developed working in a trading environment—focusing intently on my business, being short with people, and projecting an impersonal attitude. If so, Ray predicted, I would continue as a successful arbitrageur. But as an alternative, I could start thinking more about the people in the trading room and in sales—about their concerns and views—and how to enable them to be successful. In that case, Ray said, I wouldn't be limited to arbitrage but could become more broadly involved in the life of the firm.

Ray Young's advice pointed me toward a whole new world that I hadn't thought much about. My tendency to be abrupt and peremptory—characteristic of Wall Street traders of that era—is exemplified by a typical episode: a colleague from investment banking came to ask me about the market impact of a deal she was working on. She had trouble explaining the deal to me, and I told her I was busy and didn't understand how someone could work at Goldman Sachs and not understand some basic corporate finance. I dismissively suggested she go back upstairs and return when she was properly prepared. Ray made me understand that that kind of attitude limited how far I would go at the firm and how interesting my career there would be.

My general experience in life has been that most people can change only within a narrow range, if at all. Many people can acknowledge criticism and advice, but relatively few internalize it and alter their behavior in a significant way. Sometimes someone can change in one respect but not in another. I was involved in many discussions at Goldman over the years that centered on the question of whether a person who was highly capable professionally, but limited in some way, could grow to assume broader responsibilities. Often the limitations revolved around the ability to work effectively with colleagues and subordinates.

I've often asked myself why this advice affected me so much. Perhaps I Simply responded when someone whom I respected, who clearly had my best interests at heart, raised a problem I hadn't thought about and opened up new vistas. Judy's view was that the harshness of manner Ray critiqued was a superficial attribute. Most likely, both reasons were true. In any case, my mind-set did change and I began to listen to people better, to try to understand their problems and concerns, and to more appropriately assess and value their views. And as I’ve since said to others, this not only had the effects in my business career that Ray had suggested but gave me something I hadn't expected, a new satisfaction in the accomplishments of others.

I also connected what Ray told me with a comment that Richard Menschel, another more senior colleague who took a supportive interest in my career, had made a couple of years after I arrived at Goldman. Dick said that early in your career you may be concerned about bringing strong, younger people into your world. For some, that feeling remains; they continue to think that bright, more junior people threaten to outshine them in some way. But after a certain point, Dick predicted, I would become comfortable enough in my own position to eagerly seek out extremely capable young people for the arbitrage department.

He was right. Initially I felt uneasy about bringing a strong junior associate into the arbitrage department. But soon that changed and I wanted effective, aggressive people working with me in order to get the job done better. Moreover, as I found in everything I did thereafter, sharing credit with others didn't mean less credit for me. To the contrary. I got credit not only for the results being better, but also for sharing the credit. I also enjoyed the recognition given to people I worked with. Dick was right that a lot of otherwise successful people never figure this out. They view smart junior associates as a threat rather than as a reflection of their own capabilities as managers.

I'd never given one second of thought to management as such. Once I began to think about these issues, however, I found them engrossing. How do you get people to work well with one another? How do you attract and keep strong people? How do you motivate them to do their best? How do you get a whole organization to be strategically dynamic and to act on difficult issues? I'd never been to business school or even read any books about management, but I developed views on all of this through experience.

If those questions intrigue you, continue reading In An Uncertain World and discover how Rubin approached answers.

Steve Hopkins, January 22, 2004


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The recommendation rating for this book appeared in the February 2004 issue of Executive Times

URL for this review: An Uncertain World.htm


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