TERRY GROSS, host:

This is FRESH AIR. I'm Terry Gross.

The guy who basically invented card counting to beat the house in blackjack, Ed Thorp, took his math skills to Wall Street in the 1960s, started a hedge fund, and paved the way for a new breed of mathematical traders who became known as quants.

The quants were the math whizzes who, with the help of computers, came up with the complex formulas for hedge fund investments and for designing complex investment vehicles like mortgage derivatives and credit-default swaps, things that were behind the market collapse of 2008.

My guest, Ed Thorp, is one of the people profiled in the new book "The Quants: How a New Breed of Math Whizzes Conquered Wall Street and Nearly Destroyed It." Later, we'll meet the author, Scott Patterson. He's a staff reporter at the Wall Street Journal.

Scott Patterson, Ed Thorp, welcome to FRESH AIR. Ed, let's start with your story, since you're considered the father of the quants, like, one of the first quants; and with you, it all started with mathematical formulas you came up with for counting cards in blackjack in casinos.

So let's go back to the casino days and start there. First of all, why did you even want to do it? Why did you want to come up with a mathematical formula for dealing with roulette tables and blackjack?

Mr.�ED THORP (Author, "Beat the Dealer"): Well, as a mathematician, I had been told there were certain things that were impossible to do, and one of them was to beat gambling games with any kinds of mathematical methods. And when I happened to accidentally come across a statistics paper, which told how to play blackjack rather well, but still not able to beat it, I got intrigued. And after I worked on it for a while, I saw that there was, in fact, a way that was almost certain, in my opinion, to beat it.

So then, when I went to MIT, I used the new, big computers that were just then coming available to make calculations. And from those, I was able to devise the first card-counting systems, take them out to the casinos, use them, and found they worked.

So that got me interested in applying mathematics to real-world problems, in particular ones that involve ideas from gambling and from eventually, ideas for investing.

GROSS: Did you like gambling as much as you liked math?

Mr. THORP: No, the fun of gambling for me was going out and seeing a mathematical system that I'd thought up actually work and generate real profits in the real world, instead of just being something that was an abstract collection of symbols on a piece of paper.

GROSS: Okay, so getting back to blackjack, which is a game where you have to reach 21, and if you go over 21, you lose, and the one who comes closest to 21 wins; what kind of cards did you have to count to have the edge over the house in a casino?

Mr. THORP: What I found was that each card could be assigned a weight, basically a number from one to 11, positive or negative. And with those weights, you counted cards as they fell, and you could use the total count that you had so far to figure out how good or bad the deck was for you, and I found that you could greatly simplify this.

You could, for instance, just take cards that were small two, three, four, five, six and call them plus-one when they fell, and you could take big cards like 10s and aces and call them minus-one when they fell, start with zero and just sort of keep track of the total count. And that would give you a very good indication of whether the deck was good for you or bad for you.

When the count was plus, you'd bet bigger, and when the count was negative, you'd bet as little as you could to just keep your seat.

GROSS: So when you were counting cards, could you keep all this in your head, or did you have, like, a little, hidden computer?

Mr. THORP: No, I actually sat down for a summer and had my wife and brother deal me cards and blow smoke at me and try to distract me. So I got very comfortable doing it, and I could just almost do it in my sleep. It just became automatic.

GROSS: So wait, when you decided to try this out, to try your card-counting system at casinos, you needed some money, somebody to help bankroll you, and the person you found, named Manny Kimmel - Scott Patterson, in his book, describes him as a racketeer with his fingers in everything from numbers games in Newark to East Coast horse tracks. So did you know he was connected to organized crime when he bankrolled you?

Mr. THORP: No, I discovered all this 30 years later. What happened was I gave a paper to the American Mathematical Society in Washington, D.C., and there was a huge burst of interest - national newspaper stories and so on - and many people contacted me.

And he wanted to put up $100,000 to bankroll a test of my system in the casinos in Nevada. And there had been a lot of ridicule from casinos and from the newspaper op-ed page in the Washington Post, and so I decided that the best thing to do was to prove that it actually worked. If I said it worked and never proved it, how did I know for sure?

GROSS: So how did you meet Kimmel in the first place?

Mr. THORP: He called me and kept pestering me and wanted to get together for a meeting. And then I finally got together with him, and when I told him how the system worked, he got very excited. And I used to fly down to New York and play blackjack every Wednesday with him, to prove to him that I really could count and that the system actually transferred money from his side of the table to mine at a pretty good clip.

So after a few weeks of this, he was ready, and we went out to Reno and Stateline, Nevada.

GROSS: So did you do the playing yourself, or did you communicate signals to them when they played? How did it work?

Mr. THORP: I did the playing, but Kimmel would sit down next to me sometimes and want me to tell him how to play his hands, too. And I would have preferred it if he had just let me be, because one night, when we were winning a rather large amount of money, he wouldn't quit when I got tired and felt that I had to quit. So he lost some of the money back.

Even so, the test was very successful. We more than doubled our $10,000 bankroll, which was what I thought would happen from theory, and so everything worked out the way it was supposed to.

GROSS: Now, as you started doing this more and more in the casinos, did the casino people get on to you? Did they realize that you were counting cards, that you had a method that they would prefer you did not use?

Mr. THORP: When I first started to play, they didn't understand what was happening.

GROSS: Because no one was counting cards yet, right? I mean...

Mr. THORP: No.

GROSS: You kind of invented that.

Mr. THORP: There had been a few people, a decade before, who realized that when you got down to the very end of the deck, if it was mostly 10s and aces, then you could take a whole lot of hands so that your first card would be a 10 or ace and bet a whole lot of money on those hands. So there were people who were starting to do that. But the general idea of card counting was unknown at that time. So yes, my book "Beat the Dealer" was the and the paper that I published before that was the first revelation of that to everybody.

GROSS: So before you wrote your book and revealed some of your secrets, were the dealers mystified that you were beating the house so often?

Mr. THORP: Yes, and they came up with a lot of strange theories. In one case, for example, they began to shuffle all the time because they thought that I was doing something to the cards and knew what they were. And I said, you know, why are you doing this? And they said well, we think that you can memorize every single card in the deck and know where it is.

So I said, I don't that doesn't make any sense to me. And so the pit boss walked up, and I said to the pit boss, can you memorize every single card in the deck and then tell me the order of the cards? And he said yes. So I said I don't believe you.

(Soundbite of laughter)

Mr. THORP: I've got five dollars here which says you can't do it. And he didn't answer. So I said, I've got $100 which says you can't do it. No answer. I said I've got $500 which says you can't do it.

(Soundbite of laughter)

Mr. THORP: No answer. So I said I think we've settled that.

GROSS: So did anybody ever get on to you and throw you out?

Mr. THORP: Yes, they - eventually they began to tell me they didn't want my business there anymore, and they didn't want any of my friends coming, either. But they didn't know why. They just knew that it was bad news.

GROSS: So in 19 I have, it was like, 1961, that you started successfully counting cards in blackjack at casinos, and then in '62, you published your book about card counting. So you basically outed yourself.

Mr. THORP: Well, actually, my idea wasn't to make money. It was to show that I had an idea that worked. And I figured that between the time I started doing it and the time I outed myself that I'd be able to make as much money as I needed for our rather modest needs as a little family.

I was simply, you know, teaching in a university, and university professors don't aren't used to having a lot of money. They can live rather frugally.

GROSS: My guest is Ed Thorp, one of the math whizzes profiled in the new book, "The Quants: How a New Breed of Math Whizzes Conquered Wall Street and Nearly Destroyed It." We'll meet the author, Scott Patterson, and talk more with Ed Thorp about how he took his math skills to Wall Street after a break. This is FRESH AIR.

GROSS: If you're just joining us, my guests are Ed Thorp and Scott Patterson, and Ed Thorp is a math genius who got his start, kind of, counting cards at casinos and then went on to become a quant, one of the math geniuses who figured out statistical ways of investing. And Scott Patterson has written a new book called "The Quants: How a New Breed of Math Whizzes Conquered Wall Street and Nearly Destroyed It." And Ed Thorp is one of the people who figures prominently in the book.

Scott, I guess I'll ask you first, since you wrote the book "The Quants." What is a quant?

Mr.�SCOTT PATTERSON (Author, "The Quants: How a New Breed of Math Whizzes Conquered Wall Street and Nearly Destroyed It"): A quant is somebody who uses mathematics and computers to essentially predict the future of the market, kind of like a weatherman uses computers and models to predict what the weather's going to be tomorrow or next week.

A quant on Wall Street is using very similar techniques to predict where a stock is going to go, where all sorts of other securities are going to go. They do a lot of other things, too, but essentially it comes down to using math and computers to predict the future.

GROSS: So what are some of the major changes that the entrance of quants onto the Wall Street scene made on Wall Street?

Mr.�PATTERSON: Well, the quants really started rising in the '60s. I think Ed Thorp was probably one of the first, if not the first, quant, but they really took off in the '70s with the introduction of a formula called the Black-Scholes Option Pricing Formula, and this is a mathematical model that was used to price options on stocks, and it became very, very popular.

It was applied to all sorts of other securities across Wall Street, and as more and more people started using this formula, which was coded into computers, it became a very dominant force on Wall Street. And the guys using this formula started pushing aside the old-school traders, the guys who sort of traded by the gut and, you know, used their intuition to figure out where the market was going to go. And you know, in the '70s and '80s, more and more of these guys were showing up on the trading floors on Wall Street, starting up hedge funds, and because they were able to predict the future of securities more accurately, they were making more money than the other guys.

GROSS: Ed Thorp, why did you want to take your math skills to Wall Street after kind of conquering the casinos?

Mr. THORP: Well, I thought that the ideas I had developed in card counting and roulette, and the analysis of other gambling games would carry over, in large part, to the securities markets. And the biggest casino in the world appeared to me to be Wall Street.

So I thought it would be intriguing to try these things out there and see what happened. And coincidentally, I'd come across an idea about warrant hedging that I'd thought up after reading some literature on the market.

When I came out here to University of California Irvine, where I happen to be sitting right now, talking, as a founding faculty member in 1965, I ran into another faculty member there named Sheen Kassouf, an economist, and he'd been thinking along the same lines, and he'd actually been doing some investing in these warrant hedges that made sense to me.

So we teamed up and worked on our ideas and improved them and wrote a book called "Beat the Market," and then I went on to use the ideas in that book and some further ideas to create a hedge fund, the first actually, the first market-neutral hedge fund that was ever created.

GROSS: What's a market-neutral hedge fund?

Mr. THORP: It's one which takes positions that will hopefully make you money, no matter which way the market goes. So the market risk has been eliminated by hedging, by having both long positions on one side and short positions on the other.

So if the market goes up, your long positions will make extra money to pay off the losses that your short positions will lose, and if you've got the right kind of a hedge, when the prices errors in the securities disappear, some money will come out - some extra money.

GROSS: And Scott Patterson, what was the impact on this hedge fund that Ed Thorp created on the market and the way the market thought? Did this lead to a lot of other similar hedge funds?

Mr.�PATTERSON: Absolutely. Ed's hedge fund, which he founded in 1969, had a tremendous impact on Wall Street. Not immediate, because I think in the beginning, most people didn't really understand what he was doing. He was fairly small for a while, but as more and more people started seeing the success of his hedge fund, Princeton Newport Partners, they started using similar strategies.

If you think about this idea that Ed came up with of a market-neutral hedge fund, it was a revolutionary idea. It's a way of betting money on Wall Street that can reap you huge profits, no matter which direction the market is going. And this really became the core idea of what the hedge fund industry became.

Ed's fund never lost money in a calendar year, and so he really did know what he was doing, and I think that over the years, a lot of the lessons that he tried to teach people got lost, and the bets that the hedge fund started making became bigger, wilder and more reckless. And the hedging that Ed came up with, the hedging strategies, you know, they sort of gotten left by the wayside.

GROSS: So what was the first sign, Scott Patterson, that the quants were actually making some big mistakes that were creating turbulence in the market?

Mr.�PATTERSON: I think probably the first time that people started realizing that something was amiss was Black Monday in October, 1987. A quantitative methodology called portfolio insurance, which was a method based on option pricing formulas to hedge giant portfolios of stocks, and a huge amount of money had been put into these portfolio insurance contracts. And it was a quantitative formula, and on Black Monday, they created a cascade effect because as the market started to fall, more people started selling stocks to balance out the portfolio insurance contracts, and it created a feedback loop.

GROSS: So Scott Patterson, what were the lessons learned on Wall Street by the quants after Black Monday in 1987?

Mr.�PATTERSON: That's a good question. If you look at what Ed was doing, Ed was using similar models to those that led to the blowup on Black Monday. The difference between what he was doing and what a lot of practitioners on Wall Street were doing, is that Ed actually has a common-sense feel for the market, and he's also highly risk averse.

He's always thinking about big disasters that could happen. You know, I've talked to him about, you know, things he thinks about. He worries about, you know, a nuclear bomb hitting New York City or some horrible event happening in Tokyo or all sorts of scenarios that could throw his models off-kilter, and he adjusts for that.

The lessons that Wall Street should have learned decades ago in 1987 is that the models don't incorporate these giant moves, and they also don't take into effect the fact that they change the market when you have billions of dollars flowing into these models. Everybody's doing the same thing.

If it starts to unravel, you have this giant feedback loop, and you know, we've seen it over and over again. So you, did they learn anything? I think, you know, maybe they did for a while, but they forgot it pretty quickly.

GROSS: Let's jump ahead to the mortgage meltdown crisis of 2008 and the collapse of the stock market. Ed, as one of the first quants, what role do you see the quants as having played in the development of the credit-default swaps and the securitized mortgages that got us into so much trouble in 2008, that caused the collapse of housing market and the stock market?

Mr. THORP: I think that the quants are actually, surprisingly, fairly far down the food chain here. The sell side on Wall Street is always wanting to invent new products that sound good, and they go out and make a lot of money selling them. And the quants are their experts who craft these products.

The quants on Wall Street now, in large part, don't have market sense, and they don't have a long history of experience with what's wrong with models. They simply take the math. They, themselves, are wowed by it, and they build a machine which, in their imaginary world, must work just fine and must be safe and sound. But in fact, with the securitized pools that were put together to underlie these things, terrible, unsound mortgages were put into the pools, and that's not directly the fault of the quants, except that the quants should, if they were poking around and curious, have known how unsound these things were.

It's more the fault of the sell side, who didn't care what was in there and figured they would sell it off, and they wouldn't be caught holding the bag, and of the regulators in government who simply looked the other way.

GROSS: Ed Thorp and Scott Patterson will be back in the second half of the show. Patterson is the author of the new book, "The Quants: How a New Breed of Math Whizzes Conquered Wall Street and Nearly Destroyed It." Ed Thorp is one of the first quants and is profiled in the book. I'm Terry Gross, and this is FRESH AIR.

(Soundbite of music)

GROSS: This is FRESH AIR. Im Terry Gross back with Scott Patterson, the author of the new book "The Quants: How a New Breed of Math Whizzes Conquered Wall Street and Nearly Destroyed It."

Quants are math whizzes who, with the help of computers, predict the future of securities and create complex investment vehicles like the credit default swaps and mortgage derivatives which were behind the market's collapse in 2008. Also with us is one of the first quants, Ed Thorp. Before using his math skills for investing, he used his math counting cards in casinos to beat the house in blackjack.

So Ed Thorp, as a quant, did you participate in the creation of any of these exotic vehicles that got us into trouble through the securitized mortgages and the credit default swaps and all the stuff that lead to the housing bubble and bust and the stock market collapse?

Mr. THORP: Actually, no. In 1985 when these first mortgage pools were being put together, I analyzed them as possible investments for our hedge fund and there were two things that I found unanalyzable: The first one was to determine the quality of the mortgages and the pools and that would require going out and looking at hundreds of thousands of different houses and mortgage documents to try to figure out what was going on. That was so costly and time consuming as to be unfeasible.

Another thing that was important was how fast investors would prepay and that was unpredictable. It depended upon what the future of interest rates was. If interest rates went way down, they'd prepay and they'd refinance with a new lender at a lower rate. And if interest rates went way up, they'd hang on to the low rate mortgages and they would not prepay. And this was - prepayment rate was very important in how much these securities were worth.

And the last thing was the default rate. That's where you had to go out and check all the contracts and do a lot of analysis. You couldnt predict the default rate even then because that depended on general economic conditions. If - the default rate in the 1930s was far different than the default rate in the 1920s, for example, and the same thing in the '60s versus the '70s. So these were things that could not be quantified or analyzed and yet they were pretending that you could, so we stayed away from all those.

GROSS: So Ed Thorp, were you invested in the market a lot either personally or through your own hedge fund in 2008 during the stock market collapse?

Mr. THORP: Yes. At 2008, unfortunately, I didnt have any place to hide. I did not have a hedge fund then, so I wasnt managing more than a very small part of my own money. The small part, I managed it fine. I made about 18 percent that year, but most of the money I had was in other things - other people's hedge funds and so on. I was trying to retire and live the good life.

GROSS: So you lost a lot of money with the money you had invested in other people's hedge funds?

Mr. THORP: A significant amount. We've mostly recovered but not quite all of it.

GROSS: So what are some of the ways that you feel the mathematical models that you helped create didnt foresee the housing bubble and therefore the housing collapse?

Mr. THORP: Well, the problem is that the people using these methods and models didnt use them correctly. They thought they applied to things they didnt apply to. It would be as though I were talking about gambling odds and somebody were to ask me, what's the chance of a plague of locusts? Or you know, what's the chance that seas will run red with blood? I was actually asked that once in a murder trial and my answer was: Those are one time events. They're out of the collection of assumptions you make when you make probability estimates. And so probability estimates have nothing to say about events like this. You can't stipulate the probability that one of these things will happen. And these huge tail events - that is, way out on the tails of a probability distribution -come for reasons that are kind of outside the assumptions and the experience of the models.

GROSS: Ed Thorp, as far as you can tell now, how are quants being used on Wall Street? Are these mathematical models relied on as heavily now after the stock market collapsed as they were before?

Mr. THORP: My impression is: pretty much. There is a giant industry now. Many thousands of people who otherwise would've gone into engineering and science have gone over to Wall Street to work on these things because the pay is better and it's fun. And they're still there. They have a vested interest in staying there. And I think people - a lot of people think that we're just going to go back to business as usual in this country, that this is all going to blow over and we're not going to have any significant increase in regulation. We're not going to have any significant listing of off-the-book derivatives on exchanges like the commodity futures exchanges and that we'll set ourselves up for another big fall. That's what I'm afraid will happen.

GROSS: So how's that affecting how much you want to have invested in the market?

Mr. THORP: Well, its tough. The question is, you know, where do you go? There's - we only have one world we live in. If we had a market on Mars you might think about going there. But I think its going to be very difficult. And I personally find it hard to guess exactly when some bad thing will happen and how long it will take and what will trigger it. Just like in this last crash, you know something bad is going to happen, you just dont know when or how.

GROSS: And Scott Paterson, author of the book "The Quants," what's your impression of the role quants are playing now on Wall Street?

Mr. PATTERSON: Well, it - to me, it looks like they're taking off as fast as they can, looking for new places to invest. And one area that you see the quants really, really taking off is in the world of high-frequency trading, which is super fast trading using supercomputers. It's really having a massive impact on the stock market and raising a lot of concerns with regulators. These high-frequency traders can send, buy and sell orders to stock exchanges at rates that would make your head spin, thousands of orders per second. And there are some concerns that the orders are flying so fast that they could trigger some kind of destabilizing selloff on the market.

It's actually very worrisome. I share Ed's concerns that the lessons haven't been learned. That people - the rewards on Wall Street are so phenomenal that if youre allowed to bet enough money over, say, a period of a year or so, you could be set for life. And if you lose the money, then its not your problem. It's the taxpayers' problem. And that's a huge systemic issue that we have that everybody today is trying to come to grips with.

GROSS: Now, just one more thing. Ed Thorp, I read about you that you have signed up to have your body cryogenically frozen when you die

Mr. THORP: Mm-hmm.

GROSS: in the hopes that science will have reached the point eventually that you can be unfrozen and brought back to life. Knowing you as I've come to know you during the course of this interview, I assume youve played the odds and figured out what the odds are that you will be brought back to life. So what are the odds?

Mr. THORP: I would say that the longer I live, the further along science will be, so the odds get higher and higher. But I say right now, two percent.

GROSS: That's pretty low isn't it?

Mr. THORP: I think so. But its better than zero.

GROSS: Mm-hmm. What are the odds you think you'll be happy if the two percent turns out to be true and youre brought back to life?

Mr. THORP: Maybe 50-50.

(Soundbite of laughter)

Mr. THORP: Depends on how good a job they do and what the world's like then.

GROSS: Precisely.

Mr. THORP: That's one of the uncertainties.

GROSS: Okay. I want to thank you both. Scott Patterson, Ed Thorp, thank you both for being with us.

Mr. THORP: Thank you for having us.

Mr. PATTERSON: Thank you, Terry.

GROSS: Scott Patterson is the author of the new book, "The Quants: How a New Breed of Math Whizzes Conquered Wall Street and Nearly Destroyed It." Ed Thorp was one of the first quants and is profiled in the book.

Coming up, we talk with Randi Epstein about her new book "Get Me Out: A History of Childbirth From the Garden of Eden to the Sperm Bank."

This is FRESH AIR.

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