Black Edge

by Sheelah Kolhatkar

  For years hedge funds existed largely separate from Wall Street’s operatic boom-bust cycles, but by the mid-2000s they’d moved to the center of the industry. Some started producing enormous profits each year. Over time, the name hedge fund lost any connection to the careful strategy that had given such funds their name and came to stand, instead, for unregulated investment firms that essentially did whatever they wanted. Though they became known for employing leverage and taking risk, the defining attribute of most hedge funds was the enormous amounts of money the people running them were taking in: The fees they charged were generous, typically a “management fee” of 2 percent of assets and a “performance fee” of 20 percent of the profits each year. Before earning anything for his or her investors, the manager of a $2 billion fund would be positioned to make $40 million in fees just to keep the place running. By 2007, hedge fund founders like Paul Tudor Jones and Ken Griffin were managing multibillion-dollar pools of money, building twenty-thousand-square-foot palaces to live in, and traveling on $50 million private jets.

  To work at a hedge fund was a liberating experience for a certain kind of trader, a chance to test one’s skills against the market and, in the process, become spectacularly rich. Hedge fund jobs became the most coveted in finance. The immense fortunes they promised made a more traditional Wall Street career—climbing the hierarchy at an established investment bank such as Bear Stearns or Morgan Stanley—look far less interesting. In 2006, the same year that Lloyd Blankfein, the CEO of Goldman Sachs, was paid $54 million—causing outrage in some circles—the lowest-paid person on the list of the twenty-five highest-paid hedge fund managers made $240 million. The top three made more than a billion dollars each. Cohen was number five that year, at $900 million. By 2015, hedge funds controlled almost $3 trillion in assets around the world and were a driving force behind the extreme wealth disequilibrium of the early twenty-first century.

  The hedge fund moguls didn’t lay railroads, build factories, or invent lifesaving medicines or technologies. They made their billions through speculation, by placing bets in the market that turned out to be right more often than wrong. And for this, they have gained not only extreme personal wealth but also formidable influence throughout society, in politics, education, the arts, professional sports—anywhere they choose to direct their attention and resources. They manage a significant amount of the money in pension and endowment funds and have so much influence in the market that CEOs of public companies have no choice but to pay attention to them, focusing on short-term stock performance to keep their hedge fund shareholders happy. Most of these hedge fund traders don’t think of themselves as “owners” of companies or even as long-term investors. They are interested in buying in, making a profit, and selling out.

  If there was one person who personified the rise of hedge funds, and the way they transformed Wall Street, it was Steven Cohen. He was an enigmatic figure, even to those in his own industry, but his average returns of 30 percent a year for twenty years were legendary. What was especially intriguing about him was that his performance wasn’t based on any well-understood strategy, unlike other prominent investors such as George Soros or Paul Tudor Jones; he wasn’t famous for betting on global economic trends or predicting the decline of the housing market. Cohen simply seemed to have an intuitive sense for how markets moved, and he entered the industry at precisely the moment when society reoriented itself to reward that skill above almost all others. He traded in and out of stocks in rapid-fire fashion, dozens of them in a single day. Young traders longed to work for him and rich investors begged to put their money in his hands. By 2012, SAC had become one of the world’s most profitable investment funds, managing $15 billion. On Wall Street, “Stevie,” as Cohen was known, was like a god.

  Word quickly spread about this new way to become wildly rich, and thousands of new hedge funds opened up, all staffed with aggressive traders looking for investments to exploit. As the competition became more intense and the potential money to be made ballooned, hedge fund traders started going to extreme lengths to gain an advantage in the market, hiring scientists, mathematicians, economists, and shrinks. They laid cable close to stock exchanges so that their trades could be executed nanoseconds faster and employed engineers and coders to make their computers as powerful as those at the Pentagon. They paid soccer moms to walk the aisles at Walmart and report back on what was selling. They studied satellite images of parking lots and took CEOs out to extravagant dinners, digging for information. They did all this because they knew how difficult it is to beat the market, day after day, week after week, year after year. Hedge funds are always trying to find what traders call “edge”—information that gives them an advantage over other investors.

  At a certain point, this quest for edge inevitably bumps up against, and then crosses, a line: advance knowledge of a company’s earnings, word that a chipmaker will get a takeover offer next week, an early look at drug trial results. This kind of information—proprietary, nonpublic, and certain to move markets—is known on Wall Street as “black edge,” and it’s the most valuable information of all.

  Trading on it is also usually illegal.

  When one trader was asked if he knew of any fund that didn’t traffic in inside information, he said: “No, they would never survive.” In this way, black edge is like doping in elite-level cycling or steroids in professional baseball. Once the top cyclists and home-run hitters started doing it, you either went along with them or you lost.

  And just as in cycling and baseball, the reckoning on Wall Street eventually came. In 2006, the Securities and Exchange Commission, the Federal Bureau of Investigation, and the U.S. Attorney’s Office declared they were going to go after black edge, and before long their search led them to Cohen. Whatever it was that everyone was doing, they realized, he was clearly the best at it.

  This book is a detective story set in the back rooms of office parks and the trading floors of Wall Street. It’s about FBI agents who followed hunches and set up wiretaps, flipping witnesses and working their way up the hierarchy until they reached the guys in charge. It’s about idealistic government prosecutors facing slick defense lawyers making twenty-five times as much money a year. It’s about young traders smashing their hard drives with hammers, shredding files, and turning on their closest friends to stay out of jail. It’s about how hedge funds like SAC were carefully structured so that the people at the top were protected from the questionable dealings of the employees below.

  It’s also about Steve Cohen, his dizzying ride to the pinnacle of Wall Street, and his epic fight to stay there.

  CHAPTER 1

  MONEY, MONEY, MONEY

  There tend to be two types of people who seek out jobs on Wall Street. The first are those with wealthy parents who were sent to the right prep schools and Ivy League colleges and who, from their first day on the trading floor, seem destined to be there. They move through life with a sense of ease about themselves, knowing that they will soon have their own apartments on Park Avenue and summer houses in the Hamptons, a mindset that comes from posh schooling and childhood tennis lessons and an understanding of when it is appropriate for a man to wear seersucker and when it isn’t.

  The second type call to mind terms like street smart and scrappy. They might have watched their fathers struggle to support the family, toiling in sales or insurance or running a small business, working hard for relatively little, which would have had a profound effect on them. They might have been picked on as children or rejected by girls in high school. They make it because they have a burning resentment and something to prove, or because they have the ambition to be filthy rich, or both. They have little to fall back on but their determination and their willingness to do whatever it takes, including outhustling the complacent rich kids. Sometimes the drive these people have is so intense, it’s almost like rage.

  Steven Cohen came from the second group.

  As he reported for work one morning in January 1978, Cohen looked like
any other twenty-one-year-old starting his first job. He could hear the roar of the trading floor, where dozens of young men were chattering away on the phone, trying to coax money from the people on the other end of the line. The room was alive with energy. It was as if a great oak tree were shaking in the middle of an autumn forest and leaves of money were raining down. To Cohen it felt like home, and he ran right in.

  Gruntal & Co. was a small brokerage firm located around the corner from the New York Stock Exchange in the gloomy canyons of lower Manhattan. Established in 1880, Gruntal had survived the assassination of President McKinley, the crash of 1929, oil price spikes, and recessions, largely by buying up other tiny, primarily Jewish firms while also staying small enough that no one paid it much attention. From offices across the country, Gruntal brokers tried to sell stock investments to dentists and plumbers and retirees. When Cohen arrived, the firm was just starting to move more aggressively into an area called proprietary trading, trying to make profits by investing the firm’s own money.

  For an eager Jewish kid from Long Island like Cohen, Wall Street didn’t extend an open invitation. Even though he was freshly out of Wharton, Cohen still had to push his way in. Gruntal wasn’t well-respected, but he didn’t care about prestige. He cared about money, and he intended to make lots of it.

  It happened that a childhood friend of Cohen’s, Ronald Aizer, had recently taken a job running the options department at Gruntal, and he was looking for help.

  Aizer was ten years older than Cohen, had an aptitude for math, and had autonomy to invest the firm’s capital however he wanted. On Cohen’s first day, Aizer pointed at a chair and told his new hire to sit there while he figured out what, exactly, he was going to do with him. Cohen sank down in front of a Quotron screen and became absorbed in the rhythm of the numbers ticking by.

  The stock market distills a basic economic principle, one that Aizer had figured out how to exploit: The more risk you take with an investment, the greater the potential reward. If there’s a chance that a single piece of news could send a stock plunging, investors expect greater possible profit for exposing themselves to those potential losses. A sure, predictable thing, like a municipal bond, meanwhile, typically returns very little. There’s no reward without risk—it is one of the central tenets of investing. Aizer, however, found an intriguing loophole in this mechanism, where the two elements had fallen out of sync. It involved stock options.

  The market for options at the time was far less crowded than regular stock trading—and in many ways, more attractive. Options are contracts that allow a person to either buy or sell shares of stock at a fixed price, before a specific date in the future. A “put” represents the right to sell shares of stock, which means that the owner of a put will benefit if the stock price drops, allowing him or her to sell the underlying shares at the agreed-upon higher price. “Calls” are the opposite, granting the holder the right to buy a particular stock at a specific price on or before the expiration date, so the owner of the call will benefit if the stock rises, as the option contract allows him or her to buy it for less than it would cost on the open market, yielding an instantaneous profit. Investors sometimes use options as a way to hedge a stock position they already have.

  At Gruntal, Aizer had implemented a strategy called “option arbitrage.” There was a precise mathematical relationship dictating how the price of the option should change relative to the price of the underlying stock. Theoretically, in a perfect market, the price of a put option, the price of a call option, and the price at which the stock was trading would be in alignment. Because options were new and communication between markets was sometimes slow, this equation occasionally fell out of line, creating a mismatch between the different prices. By buying and selling the options on one exchange and the stock on another, for example, a clever trader could pocket the difference.

  In theory, the technique involved almost no risk. There was no borrowed money and relatively little capital required, and most positions were closed out by the end of the day, which meant that you didn’t develop ulcers worrying about something that might send the market down overnight. The strategy would be rendered obsolete as technology improved, but in the early 1980s it was like plucking fistfuls of cash off of vines—and the traders at Gruntal enjoyed bountiful harvests. All day long, Aizer and his traders compared the prices of stocks to their valuations in the options market, rushing to make a trade whenever they detected an inconsistency.

  “You could have IBM trading at $100 on the New York Stock Exchange floor,” explained Helen Clarke, who worked as Aizer’s clerk in the early 1980s, “and the options that equal IBM at $100 trading at $99 in Chicago, so you’d run to Chicago and buy it and sell it at the NYSE.” If done enough times, it added up.

  Without the benefit of computer spreadsheets, the traders had to keep track of everything in their heads. Aizer set up a system that required minimal thinking. You didn’t have to be good, he liked to say, you just had to follow the formulas. It was tedious. A trained monkey could do it.

  On Cohen’s first day, he watched Aizer work with a trading assistant, scouring the market for $0.25 or $0.50 they could make on their idiot-proof options schemes. During a lull in activity, he stared at the market screens. Then Cohen announced that he was looking at a stock, ABC. “I think it’s going to open higher tomorrow,” he said. Even brand-new on the job, Cohen was confident in his abilities as a trader.

  Aizer snickered. “All right,” he said, curious to see whether the new kid with bushy brown hair and glasses had any clue what he was doing. “Go ahead, take a shot.”

  Cohen made $4,000 that afternoon, and another $4,000 overnight; in 1978, this was a meaningful profit. Watching the price oscillate like a sine wave, placing the bet, taking the risk, absorbing the payoff—his body surged with adrenaline, and Cohen was hooked. Trading was all he wanted to do.

  Aizer was stunned. How could someone so inexperienced, someone who couldn’t even be bothered to iron his shirt, be this good at predicting whether stocks would go up or down?

  “I knew he was going to be famous within a week,” Aizer said. “I never saw talent like that. It was just staring at you.”

  —

  On Sunday afternoons, inside a four-bedroom split-level house in Great Neck, a little boy stood watch by his bedroom window, waiting for the sound of tires on asphalt. As soon as the Cadillac pulled up outside, he came flying down the stairs. He wanted to beat his siblings to the door when his grandparents arrived.

  Walter and Madeline Mayer, Steven Cohen’s maternal grandparents, lived partly off an investment portfolio of inherited money, and they came to see their grandchildren once or twice a month. They led an alluring life in Manhattan, one that involved fancy restaurants and Broadway shows. They represented escape and abundance and excitement, and when Steve was growing up, their visits were his favorite moments of the week. They were always talking about money, and Cohen listened carefully to the lessons that emerged, the idea that once you had money, banks would pay interest on it, and that money could be invested and it would grow, requiring little or no work on the part of the investor, who was left to be envied and admired by others. The freedom that his grandparents enjoyed was a sharp contrast to the pinched and pedestrian existence of Cohen’s parents. When his father walked in the door after work each night, Cohen grabbed his New York Post so he could study the stock tables like his grandfather.

  Born in the summer of 1956, Cohen was the third of Jack and Patricia Cohen’s eight children. Great Neck was twenty miles from New York City, an affluent suburban enclave of progressive-minded Jewish professionals who expected their children to do well in school and go on to careers as doctors and dentists. F. Scott Fitzgerald settled there in 1922, and the area became partial inspiration for The Great Gatsby, which was set in the fictional “West Egg,” based on Kings Point, Great Neck’s northernmost tip on the Long Island Sound. Many of the fathers of Great Neck lived separate Long Island and Manhattan existe
nces, which involved a lot of drinking and long train commutes and extended hours away from home. There were synagogues and good schools and grand estates.

  In Great Neck, the Cohens were on the low end of the financial spectrum, which Steve was aware of from an early age. At a time when the Garment District still produced garments, Cohen’s father, Jack, took the train every morning to one of his showrooms in Manhattan, where he ran a business called Minerva Fashions, which made twenty-dollar dresses for chains such as Macy’s and J. C. Penney.

  Cohen’s mother, Patricia—Patsy—was a self-employed piano teacher. She advertised in the local Pennysaver for clients, mostly neighborhood children, and taught strictly popular music—“Hello, Dolly!” rather than Beethoven or Brahms. She was a harsh, uncompromising woman who dominated the family, known for a sense of humor that could cut like a blade and for periodically berating her husband: “Jackie, you gotta fuck them before they fuck you!”

  Money was a constant source of stress in the Cohen household. Cohen’s mother and father spoke openly about the inheritance they hoped was imminent from Patsy’s parents, which they planned to use to introduce more comfort into their lives. Although he was small, Cohen was a gifted athlete, pitching for the baseball team, playing point guard in basketball. But his parents didn’t have the means to help him make the most of his athletic potential—there wasn’t much money for private lessons or time to drive him around to games. The junior high soccer coach ran a lakeside summer camp in Maine where several of the neighborhood children went. Cohen attended in 1968 and loved it. Camp was an enchanted world, a great equalizer where all the kids wore the same T-shirts and slept in little pine cabins, everyone on equal footing. There were no parents around fighting about the bills and telling the kids they couldn’t do things. After that one summer, however, Steve’s parents never sent him back; his classmates believed it was because they couldn’t afford the fees.