The Chaos Kings on Wall Street with Scott Patterson

0:04Hello, I'm Anthony Scaramucci, and this is Open Book, where I talk with some of the brightest minds out there about everything surrounding the written word, from authors and historians to figures in entertainment, neuroscientists, political activists, and of course, Wall Street. Sorry, I can't resist. Before we get into today's episode, if you haven't already, please hit follow or subscribe wherever you get your podcasts and leave us a review. We all love a review, even the bad ones. I want to hear the parts you're enjoying or how we can do better. You know, I can roll with the punches, so let me know.

0:38Anyways, let's get to it.

0:47As my guest today, Scott Patterson, tells us, there are many chaos kings on Wall Street. I've spent my life living through the craziness, and I wouldn't change that, but there sure have been some ups and downs. The big question is whether we can see the disasters coming, and that's what Scott depicts in his latest book.

1:13Scott, I've lived your book. I think that's one of the problems. When I read your book, I'm like, oh my God, he's covered everything. He spent a lot of time on Wall Street. There's a lot of craziness on Wall Street. It's a different sort of crazy than what goes on in Washington. And unfortunately, I got my ass blasted to pieces in Washington too. But tell us why this is so important to investors, why an investor should read this book and what could they learn from reading Chaos Kings? Yeah, well, you know, the book is about Nassim Taleb and Mark Spixnagel, who founded this hedge fund. The first one was Empirica back in 1999.

1:50And the big idea that they had was that investors really need to think more about the big crashes and downturns than the daily ups and downs. And I think that's the big lesson to take away from it is that you really need to think about the 30, 40 percent declines that you could run into rather than the daily like one percent, monthly one percent gains, because that's what really matters. If you get steamrolled, it's really hard to come back. That's that's one of the big lessons that that they took away. And I think readers could take away from this book. Yeah. You have this opening scene. Bill Ackman is about to become obsessed with COVID-19.

2:32It's January of 2020. I know Bill well. He's spoken at my conferences. I actually used to cover him when I was a young salesman at Goldman Sachs when he had just gotten right out of Harvard Business School. He had something called Gotham Partners with David Berkowitz. Right. You know, you also remember he calls into CNBC to warn people about the potential threat. Tell us about that moment and why you chose to open with it, because it's such a dramatic moment. I mean, it's just such a great moment. Tell us why you picked that. Yeah, it just really fit in with the bigger themes of the book because Ackman, he calls into CNBC.

3:08He's telling them he's really worried about COVID. He's been worried about it for months, actually, since January. and he says that one of the reasons that he looks at COVID and he sees it as being something that's exponential, something that compounds and gets bigger and bigger. And that's something that I see that certain kinds of people on Wall Street like Taleb and Spitznagel look at the world that way. I think even Buffett, Warren Buffett looks at the world that way as things that compound and get bigger and bigger. Buffett looks at it as a way to make money, obviously, but it's that framework, that frame of thinking of seeing things that can hit this exponential level that, you know, he looked at COVID and saw that as the risk and it's something that's going to spread and get bigger and bigger.

3:59And he was saying like, I don't see why this doesn't go everywhere in the world. When you think about compounding, exponential compounding, that's what you've got with COVID. And that's what, you know, I mean, Taleb, the black swan, that's something that's exponential or super exponential, something that compounds and gets bigger and bigger. And I saw, you know, Ackman, it was really interesting to me that Ackman talked about that on that call, because that's, you know, I initially, you know, I went into this book with looking at what Nassim had written about and the black swan. And that's obviously a big part of it.

4:31And then I went back and listened to Bill's call and saw that's that's actually his framework of looking at the world. And that's what alerted him to the risk in ways that other people might not really have seen so early on. I guess the question I have, I just want to step back because is COVID a black swan to you? Is COVID a new development that's potentially recurring? I mean, meaning, you know, if you said to me, okay, we had a pandemic in 1919 or 1917 to 1919, and now we have a pandemic 100 years later, these are black swans. But David Quammen wrote a book about this a few years ago and said, well, you know, the population of the earth is just sort of expanding human population being what it is.

5:16And it's encroaching upon the animal world. And we're going to get all of these cross viruses now from other mammals. So is this something that's not a black swan in your mind? Or do you think that we're going to resolve this and this mRNA technology puts this stuff behind us? What's your thoughts? I think that definitely not a black swan. I mean, it's, you know, something I write about in the book is how Nassim and others have been predicting this as a coming risk for years. Nassim had been working with some theorists who'd been going back into the 2000s, looking at how increased transportation was causing what one researcher, one of his collaborators on a paper, Yanir Bar-Yam, called The Transition to Extinction, which is kind of a scary title for a paper.

6:04But the idea is that the most violent viruses, something that might break out in Africa or elsewhere, often die out because they kill the local population so quickly that they don't spread. But with increased transportation through vehicles, through population growth, through air transportation, that era is coming to an end. So the risk that we're reaching this point, and I think we saw with COVID, is that these very deadly viruses have a much higher likelihood of breaking out of that area and moving to the general population. So, yeah, it's something that people have been predicting for years.

6:44I think that, you know, the reaction in financial markets in early 2020 was black swanish because things, as I'm sure you saw, got extremely crazy, you know, with oil prices going negative. I mean, there was I think that, you know, talking to people in the markets back then, you know, some are saying it was even more insane than 2008. But I think we forget that because things bounce back so quickly with all the liquidity that the U.S. government and the Fed put into the system. We bounce back very quickly. But we did have an extreme financial breakdown in that area after COVID was really spreading.

7:28Yeah. I mean, my business, frankly, is still recovering from it. I mean, we got blindsided by it. I didn't take it as seriously as Bill Ackman in the beginning. I got it wrong, frankly. I left a dinner at the World Economic Forum, Scott. There were two WHO, World Health Organization guys there telling us that they had it under control. I can tell you that every hedge fund manager that was in that dinner with me got smoked in the month of March, myself included, by the way. So it's the more humbling life is, is when you realize how little that you know. Let's talk about Nassim for a second, a brilliant philosopher.

8:08Is he a great trader in your mind? I think that he came up with this idea of he and Mark together, but they both kind of came up with it separately. And then they met in 1999. And it was sort of this, you know, ideal meeting of the minds to, make these bets on extreme events that you can lose a little bit of money on, but you can't blow up. And I think that was a brilliant concept. Nobody else had ever come up with that idea as a separate strategy. It probably was part of some hedge funds as a hedge strategy. So they were the first to come up with this idea of a tail risk, singular tail risk hedge fund.

8:48And so I would say that does put Nassim in the category of a great trader, you know, coming up with what became an asset class in its own right. Many people have tried to imitate it. I'd say that where Nassim sort of falls short is that he can't take the stress of operating that strategy day to day. Too emotional. He's got the genetics of all of us on the Mediterranean. You know, I've spent my career selling and been in relationship management. We're too, too emotional. He doesn't have the cold bloodedness necessary to do this stuff. Um, let's talk about, and I'm not going to pronounce his name right, but I read about, uh, Didier Sarnat in your book.

9:28I think hopefully I'm pronouncing it right. Totally different view than Nassim Talib. Tell us about his opinion of disasters. Uh, Nassim thinking, geez, you know, big disasters you can't predict, but Didier sort of has this view that yes, you can tell us what his theory is. I, you know, pick Didier as a sort of a counterpoint to Nassim and Mark's strategy, which is Nassim and Mark basically say we can't predict anything. It's just too hard. It's a fool's errand to try to predict markets. Whereas Didier, he's a very smart guy, mathematician, physicist, came to believe that there were signals in the market that would indicate a coming extreme event.

10:12And he actually based this on some work that he'd done in the 1990s, looking at the explosion of rockets. And, you know, there were signals in what was going on with these rockets that would indicate that one might blow up. Using the same math, he applied that to markets. And, you know, it's very interesting to, you know, look at the success of that. I mean, it does seem like he's got some skill in predicting when certain asset classes or commodities or indexes or whatever are entering bubbles. It's really what seems to be the case is it's really hard to trade on that because timing is so important.

10:51If you try to short a bubble, you know it's in a bubble, but you're wrong about the timing. You can get wiped out. So I have this scene in the book where it's Nassim and Didier actually debate one another in New York in, I think, 2015 or something like that. And it's really interesting to see how Nassim is saying, like, all right, what you've got here is really interesting and smart and clever, and I like it. It's not a way to manage risk. You know, it is risky. And what Didier is doing is speculation. He's trading. He's not managing risk, which is that is actually the job of a hedge fund manager is not to be a speculator so much as it is to manage the risk of your client's assets in the most efficient way as you can.

11:36Great insights. I mean, your two other books, The Quants, which looked at the world of quantitative analysis, and then Dark Pools, which was phenomenal because it really described the rise of the bots and the machine traders. This is a different book. So, you know, that was more those books to me were more about using technology and robots and faster speeds and so forth. But this is really about human personalities. And so I want you to juxtapose for us for a second the technology books, which I would call the machines of Wall Street and the personalities. We're always going to have the personalities, aren't we, Scott?

12:15Or what do you think? Do you think the Terminator is going to take over Wall Street? Probably already has. I mean, that's one of the points I try to make in dark pools is that's the direction we're going. You know, high frequency trading and AI were moving together in a way that was going to just sort of eventually eliminate the human element in the market. And I don't see that as a good thing. We're not there yet completely, but we're getting pretty close. So, yeah, I mean, even in the quants and dark pools, there are plenty of personalities. maybe not anybody as large life as as Nassim Taleb this book was Chaos Kings the idea of it was came to me in sort of the dark days of 2020 when you know things were obviously just completely insane it's almost hard to remember how just disorienting and crazy it was and uh what I saw was Universal and so I've known Nassim and Mark for a long time uh since 2007 actually is when I first met them.

13:17And I've tracked their, you know, I first reported a lot on their hedge fund, Universa, and their early successes. And I've just stayed in touch with them for all these years. And so it emerged with press reports in early 2020, that Universa had clocked this return of 4000 % in just a few months. And this was at a time when everybody else was just blowing up, like as you talk to. People were not ready for this. And also at the same time, Nassim had written a paper in January of 2020 warning about the risks of COVID and how dangerous this thing was and the extreme measures that people need to take to protect themselves against it.

14:01And I thought there's something really interesting here. There's something about the way these guys look at the world that allows them to come out looking kind of smart and successful in a period where everybody else is just getting their ass kicked. And there's got to be, you know, what is that? What is it about their worldview that lets them get through these periods of just utter catastrophe, you know, smooth sailing, basically, as opposed to everybody else. And that's kind of what the initial idea of the book was, to try to apply that to all sorts of other risks. And I got that. And I certainly appreciate all that.

14:36I guess the question I have for you, though, is it, and maybe Talam is right about this. I mean, he writes in his first book about the Russian roulette, right? If I spin the dial, I put the gun to my head and I click it and I don't die, they're going to hand me$10 million. And all of a sudden I'm super smart. So meaning is it just a random series of monkeys sitting at the typewriter and there's just one person that hits the typewriter keys in a way that wins when the others are losing? Or is there something about their temperament where you're like, okay, that is a distinctive edge. Okay. So somebody like me, for example, you have me believing that this is about their temperament.

15:12So is it random or is it temperament? I definitely think that there's a strong element of temperament in that and being able to execute the strategy, especially with Mark. You know, we talked about how Nassim is, he's brilliant. He's, you know, had this great strategy, couldn't live with it, doing it day to day. Whereas Mark has just been training to execute the strategy ever since he was a teenager, you know, when he was learning how to trade on the Chicago Board of Trade under this veteran commodity trader who basically taught him what you have to do is love to lose. And what that meant was if a position starts moving against you, just get out of it immediately and learn to trade another day.

15:55And as the commodity trader told Mark, this is against human nature. People want to believe in their positions. They want to hold on. You can have all sorts of research that backs up, you know, that you're right and the market's wrong when in fact the market is never wrong and you need to just be able to discipline yourself. And that's what Mark has is he's got the discipline to stick with it. It's a very hard strategy to execute, even though you may know that eventually it's going to win for you. This is a strategy that can lose money for years, year after year. And in Wall Street, the incentive structure is basically, you know, make money every year, you know, no matter what, because the incentive is the bonus for most traders and hedge funds.

16:41And if you've got year after year of negative returns, your investors are going to give you the boot. Right. No question. I mean, look, but it's also, there's a great expression on Wall Street that I grew up with called fast pay makes fast friends. And so you have to always, you're only as good as your last trade. I want to put this in historical context for a second. Diana Henriquez, she wrote a book a few years back called The First Class Catastrophe. And it was about the October 19th, 1987 stock market crash and this sort of confluence of events that led to a drop of 22.5%, worst day in market history.

17:19Now, the markets, of course, recovered. It didn't end up like the 1929 crash by any means. But I'm wondering today, is the world so different? This introduction of the quants, the dark pools, the chaos kings, is the world different or will we see this continued historical oscillation of the stock market irregardless of the new technologies and the new temperaments and the new people? Well, I think that we've seen within the past, you know, in 2000, we had the dot-com blow up. In 2008, global financial crisis. Throughout the 2010s, multiple financial crises. 2020, the COVID crash. In 2010, we had the flash crash, which was my contention is it was caused by high-frequency trading.

18:11And I actually reported on that the day it happened. So I, you know, I see us entering a phase of increasing financial volatility, you know, and exacerbated potentially by the computers, which can kind of run in these doom loops and cause things to accelerate beyond our control. It's just it's an it's an entirely new market. And it's hard to really say. I mean, the contention of the high frequency group is that they actually reduce volatility. And that's probably true on a day to day basis. But they also there also is this risk, as we saw in the flash crash and some other extreme like 2020 events, things cascading very, very rapidly.

19:00And that's what I've always been concerned about is that, you know, putting the computers in control, you remove the sort of, you know, rational human ability to intervene and slow things down. And, you know, you talked about 1987. It's kind of ironic. That's when the computers started getting put into the market. Yeah, the program training. Yeah. You remember the portfolio insurance? Yeah, that's actually what started the cascade of selling as they were trying to defend themselves. Yeah. Scott, I'm at the portion of the podcast where I present five words to the author and then you respond. You can either give me a one line sentence, a word, you can give me a paragraph.

19:44I want to get your reaction to these five words. Are you ready? Universa. Very successful. Yeah, incredible, right? So this is Spick Nagel's firm. We talked about him, but I'd like to get your summary. Summary, Didier Sarnett. Very smart, not such a good trader. He's, I think, jealous of Nassim's success, which is something I've come across a lot. Well, we have people that do that to each other, unfortunately. That's a wasteful preoccupation to be jealous of others. Quant. When I say the word quant, what do you say? Smart but dangerous. Yeah, but sometimes they think that they're smarter than everybody else, right?

20:20I mean, they get a little bit of hubristic. But what if I say the word bots? Hmm. It's funny. I've thought so much about it that my brain kind of went in a loop. Same as quants, smart, but dangerous, but also unpredictable. Yeah, it's interesting, right? I mean, we unleash these technological beasts on the society and we expect them to act differently than human beings. And so we're expecting something that invariably doesn't happen. What about if I say the overall stock market? What's your opinion there? The stock market is the essence of capitalism. And it's a it's a fascinating barometer of the day to day health of the economy.

21:04But it also can be extremely irrational and not reflective of of underlying fundamentals, which is a fascinating thing that, you know, I first started covering Wall Street in the early 2000s. You know, I came out of this tradition of like, I have a degree in English, not economics. And I came across this idea that the, you know, financial markets are rational and perfectly reflect the ongoing economic realities of the world. And I, it seemed completely counterintuitive to me. You know, I look at financial markets and I see greed and fear and not something that's totally rational. So that's, that's what I think of the stock market is greed and fear.

21:49It's great. It's great stuff. What's next for you, Scott? What are we working on next? Are you allowed to talk about it? You know, I covered climate and climate technology for the journal. But I'm also, you know, I'm pretty interested in this Trump January 6th case. And so last year I was the lead reporter for the journal on the January 6th hearings. So I'm kind of interested in following what's going on with those cases, as you might understand why. I'd be curious to get your thoughts about what's, you know, what's the fate of the former president with these cases. Well, I can give you my editorial opinion.

22:25You know, obviously he did misdeeds. And if he were not president, anybody else would be locked up for some of the things that he did in the premeditation. And they have witness accounts of him planning this level of violence. You know, some would call it an insurrection. Some would call it a protest. Whatever it is, he was involved in it. And so there's levels of criminality there. Not that there should be a two tier justice system or anything like that, but I think it's very difficult for us. The founders didn't really figure out how to handle rogue presidents other than through the process of impeachment.

22:57You know, McCarthy and McConnell and Pelosi had him on the ropes on January 7th. They could have filed for the impeachment and vacated him from the office. And Pence would have been the president for the last 13 days and they would have had him dead to rights. But they quaked under the power of his political tribe that is ardent to him, that doesn't move no matter what he says or does. He was right. He could shoot people on Fifth Avenue. So my editorial comment and my prediction is he will not go to jail. He will be disgraced through these indictments, particularly the J6 indictment, which is compelling, as you know, because you've reported on it and damning.

23:34But he won't go to jail. They won't put the former president in jail. I think it's a slippery slope for us because it's a you then start creating jail cells for your political adversaries like they do in these other countries. And I don't think the United States wants to be known for that. And I'll say this to you, and this is a reflection from Teddy Kennedy. In September of 1974, he excoriated Jerry Ford for pardoning Nixon. He said Nixon needed to pay for the crimes by going to prison. And so the pardon, he said, was specious and quite costly. 35 years later, when he was dying, he wrote in his last memoir that Jerry Ford was right, a pronged reflection in order for the country to heal.

24:13Even though we had this rogue and this criminal actor, because of the office and the institution of the presidency, we had to find a recourse. I think that's ultimately why the Romans came up with the concept of pardoning people, Scott. So, you know, you asked me the questions, I'm answering it. He's a criminal, but he's not going to go to jail. And he'll find a way to squirm out of this thing. I guess the real question is, is he going to be the Republican nominee for the presidency? And is he going to win the presidency? And of course, so many variables before that happens. But there's a chance that that could happen.

24:44And we have to prepare the country once again for this sort of nonsense. So, yeah, well, I think definitely he's going to be the Republican nominee. Me too, by the way. I think I think it's inevitable unless unless he does, which I have said, which is a contrarian move, is that he he cuts a deal somewhere in here and he's exhausted by this. His family's not into it, fakes an illness and he bows out, but he doesn't go to jail. We'll see. There's a combination of things that could happen. And, you know, you're also in a scenario where Biden and Trump are not the nominees. You know, you know, if you told me right now that we had Gavin Newsom or Phil Murphy running against Glenn Youngkin, I'm not going to be surprised by that.

25:22I'm not saying that's in the highest level of probability, but I'm not saying that that's a zero probability either. So so we'll see that you wrote a terrific book. It's called Chaos Kings, How Wall Street Traders Make Billions in the New Age of Crisis. I'm recommending it to people. And I really appreciate you joining the show today, Scott. Thank you. Yeah, thanks for having me on, Anthony. It was great.

25:48So the reason I wanted to bring Scott Patterson on is that I thought he just had a brilliant take on how Wall Street works and where the society is today and potentially where it is going. What I love about Scott's book, and I encourage you to read it, is that he really has a good understanding of the combination of history, fear and greed, and the impulses of people as they think about investing and they think about money. And then that juxtaposed against this sort of introduction of new technologies. We have faster trading today. We have lower cost transactions, which has led to greater transactions.