“Bubble Logic” began by making a rather startling argument: the market of early 2000 was not like the market of the past. Of course, that was exactly what the dot-com cheerleaders were claiming. The economy was different. Inflation was low. Productivity had surged thanks to new advances in technology, such as laptops, cell phones, and the Internet. Stocks should be given higher values in such an environment, because companies would spit out more cash.
Asness, however, was turning this argument on its head. Yes, things were different this time, in a bad way. History has shown that the stock market has almost always been a good investment over the long run. Asness trotted out numbers showing that stocks beat inflation in every twenty-year period since 1926. Stocks beat bonds, and stocks beat cash. So investors should always invest in stocks, right?
Wrong. Stocks generally perform better than most other investments “not because of magic, but largely because throughout the period we study they were generally priced reasonably, or even cheaply vs. their earnings and dividends prospects,” Asness wrote. “That is not necessarily the case anymore.”
As a sample case, Asness examined the New Economy darling, Cisco Systems, which makes Internet routers. He systematically demolished the case for investing in Cisco by showing that there was no possible way that the company’s earnings prospects could match its valuation. And yet, despite the obviousness of the case, he noted, “Cisco is on almost every ‘must own’ recommended list I see. Go figure.”
In the paper’s conclusion, the agitated hedge fund manager made an argument that flew in the face of Fama’s efficient-market hypothesis. According to the EMH, it’s impossible to know when a bubble is occurring, since current prices reflect all publicly known available information. Only in retrospect, when the bubble has popped (on new information about how crappy those companies were, or how little those new homeowners could actually pay), is it clear that prices were overinflated. Asness, however, wrote that the case was already clear: the market was in a bubble. “Unless we see 20-year growth for the S&P far, far in excess of anything ever seen for 125 years starting from similar good times, long-term S&P returns become quite ugly,” he wrote.
Such a negative outcome seemed impossible to investors experiencing dot-com dipsomania in late 1999 and early 2000. Of course, Asness was right all along.
“Bubble Logic” was never published. By the time Asness finished writing it, in mid-2000, the dot-com bubble was imploding in spectacular, horrific fashion. The Nasdaq peaked in March 2000 at more than 5,000. By October 2002, it had crumbled to 1,114.
Time, and reality, had overtaken stupidity. And AQR rebounded magnificently. Investors who’d ridden out the storm were rewarded for their patience as value stocks gained a new lease on life. AQR’s flagship Absolute Return Fund would gain roughly 180 percent in the three years following its low point.
Asness would wear AQR’s horrific performance during the dotcom bubble as a bloodied badge of courage, a clear sign that supports the fund’s claims that it is completely “market neutral.” When the market crashed, AQR was still standing. Hedge funds that had plowed into Internet stocks crashed and burned.
Still, other quantitative funds such as Renaissance Technologies, D. E. Shaw, and PDT soared through the Internet bubble largely unscathed. Their models weren’t as exposed to the destruction of value stocks as were AQR’s. What’s more, their trading strategies were based on capturing extremely short-term changes in market prices and benefited from the volatility as the bubble expanded, then burst. Losses could also be limited, since such “high-frequency” funds, as they’re called, could dump assets that moved against them in rapid order. AQR’s strategies were focused on price changes that take place over the course of weeks or even months, rather than over the course of an afternoon. That meant that when the fund’s models were wrong, the pain was more intense. When the models were right, of course, the gains were massive.
The dot-com flameout was a watershed event for the hedge fund industry. Sophisticated investors started to buy into the case Asness made in “Bubble Logic” that stocks aren’t necessarily a one-way road to riches. Rock-bottom interest rates forced pension funds and endowments to find new areas to invest in. Assets under management by hedge funds surged, rising to $2 trillion by early 2007 from about $100 billion two decades earlier.
At the head of the pack were the quants. It all seemed so perfect. Their quantitative models worked. The theories describing how the market behaved had been tested and appeared to be accurate. They knew the Truth! The computers were faster, more powerful than ever. A river of money flowed in until it became a torrent, making many who bathed in it rich beyond their wildest dreams. In 2002, Asness personally pulled down $37 million. The following year, he raked in $50 million.
Helping to drive the returns at quant funds such as AQR was a highly lucrative tactic known as the carry trade. The trade had its roots in Japan, where interest rates had been lowered to below 1 percent to help pull the country out of a debilitating deflationary spiral. A bank account in Japan would yield about half a percent a year, compared with about 5 percent in the United States or 10 percent or more in some other countries.
This dynamic meant firms with the know-how and financial dexterity could borrow yen in Japan—practically for free—and invest it in other assets with higher interest rates, such as bonds, commodities, or other currencies. And the extra cash that kicked out could be deployed into even more investments, such as commodities or subprime mortgages. Add a healthy dose of leverage, and you have a perfect recipe for a worldwide speculative binge.
Indeed, by early 2007, about $1 trillion was staked on the carry trade, according to The Economist. The tactic was especially popular at Asness’s old quant shop, Goldman’s Global Alpha fund.
The trouble was, nearly all the investors in the trade, mostly hedge funds but also banks and some mutual funds, were putting their money in similar corners of the market, including high-yielding currencies such as the Australian and New Zealand dollars. Traders talked nonstop about tidal waves of “liquidity sloshing around,” pushing up the price of stocks, gold, real estate, and oil.
But who cared? The trade was so perfect, so incredibly profitable—about as close to a free lunch in the market as possible—that there was no stopping it.
Asness, meanwhile, had been running AQR from cramped Manhattan offices, boxes full of files and computer equipment spilling out of spare rooms and lining the hallways. As the firm grew, and the partners married and started to raise families, he decided it was time for a change. He scoped out several locations in Greenwich and finally decided on Two Greenwich Plaza, a squat office building next to the town’s train station, allowing easy access to the Big City for the fund’s growing legions of twentysomething quants.
One day in 2004, he rented out a car on the Metro North railway and took AQR’s staff on a field trip to the new digs. Later that year, the move was complete. Flush with hedge fund riches, Asness purchased a 12,500-square-foot mansion on North Street in Greenwich for $9.6 million. In 2005, he was the subject of an extended article in the New York Times Magazine. When the article’s author asked him what it was like to be incredibly rich, Asness quoted Dudley Moore’s character from the movie Arthur: “It doesn’t suck.”
As his imperial ambitions soared, so did his lifestyle. The firm bought a fractional share in NetJets, giving its partners access to a fleet of private jets at their beck and call. Asness decided the North Street mansion was too constricting and purchased a twenty-two-acre property in Greenwich’s swank Conyers Farm community. A team of architects would visit Asness at AQR’s headquarters and lay out their plans for a sprawling new mansion. Estimates of the cost of the project ran as high as $30 million.
Asness and company started to think about the next big step for AQR. The IPOs of Fortress and Blackstone hadn’t gone unnoticed at Two Greenwich Plaza. Asness’s friend Ken Griffin was also mulling over an IPO at Citadel.
So was AQR. By late
July 2007, the papers were drawn up. The IPO was essentially a done deal. All AQR needed to do was mail the documents to the Securities and Exchange Commission and wait for the money to roll in.
The billions.
WEINSTEIN
One day in 2005, Boaz Weinstein was patrolling the endless, computer-swathed tables of Deutsche Bank’s fixed-income flow desk. A Russian trader on the desk had heard that Weinstein was known for his chess skills. As Weinstein paused by his terminal, the Russian said, “I hear you play a mean game of chess.” “I suppose,” Weinstein said.
“I too play chess.” The Russian smiled. “We play, you and I.”
“Let’s go,” Weinstein responded without skipping a beat.
Flustered, perhaps, by Weinstein’s calm retort, the Russian trader made a strange demand: he’d play only if Weinstein was “blindfolded.” Weinstein knew what that meant. He didn’t actually need to wear a blindfold, but he did have to sit with his back to the chessboard. Weinstein agreed.
After the closing bell, Weinstein and the Russian met in a conference room. Word about the match started to spread, and a few traders gathered to watch. As the match wore on, more and more Deutsche employees showed up. Soon there were hundreds, cheering on every move as Weinstein and the Russian went head-to-head—and making side bets on who would win. The match lasted two hours. By the time it was over, Weinstein was victorious.
Those were heady days for Weinstein. The money was rolling in. He was dating beautiful women. And it was only the beginning. As his success grew at Deutsche Bank, he started thinking about making the very same step Cliff Asness had made at Goldman Sachs in 1998: breaking away from the mother ship and launching a hedge fund.
The credit trading operation he’d created at Deutsche had become one of the elite outfits on Wall Street. Top traders would ring Weinstein on the phone to pick his brains on the latest action in credit default swaps, bonds, stocks, you name it. His group had become a true multistrategy hedge fund inside the bank, trading every kind of security imaginable and juggling upward of $30 billion in positions.
Weinstein was gaining a reputation as a multitalented savant, a Renaissance man of Wall Street. His prop trading team was also becoming known as a force to be reckoned with. Like PDT, they were also developing their own odd rituals, testing one another’s mental skills in ways only a nerdy band of hothouse quants could dream up.
Take the Maptest ritual. The Maptest website shows a layout of all fifty states in America. The trick: the states are unlabeled. Columns arrayed below the map include the state names. The task is to drag the names onto the appropriate state within a certain time. Players receive a score for how quickly the task is completed. To spice things up, the veterans, including Weinstein, would place bets on the newbies’ scores. “Look at the tiny size of his cranium,” a Deutsche Bank trader might crack as a new recruit feverishly dragged state names across the computer screen. “Bet a hundred he doesn’t know where Wyoming is.”
“You’re on.”
Weinstein tried to tone down the group’s overtly nerdy side and often claimed that he wasn’t really a quant, downplaying the complexity of his trades. His emails contained the quip “It’s not rocket surgery,” deliberately conflating the clichés of the rocket scientist quant practicing brain surgery with complex derivatives.
Quants were too careful, too worried about risk management; they had no feel for the market. No risk, no reward. But an aggressive approach holds its dangers. Deutsche Bank had its own cautionary tale in the person of Brian Hunter, who’d worked on Deutsche’s energy desk before moving on to Amaranth. Hunter had generated millions of dollars for the bank trading natural gas in the early 2000s, until losing $51 million in a single week in 2003. Hunter blamed Deutsche’s faulty software. Deutsche blamed Hunter, and the two parted ways.
Some worried that Weinstein was getting in over his head. He also helped run Deutsche Bank’s U.S. “flow” desk, which facilitated trades with clients such as hedge funds or the bond giant Pimco. The job put Weinstein atop the so-called Chinese wall that separates a bank’s trading operations from its client-facing side. There were never any allegations that Weinstein abused his position. But the fact that Deutsche Bank gave Weinstein such power was testimony to its desperation to keep him at the switch, pulling in hundreds of millions in profits. The high-stakes race for profits was transforming once-staid banks into hot-rod hedge funds fueled by leverage, derivatives, and young traders willing to risk it all to make their fortunes. Weinstein was at the center of the shift.
He didn’t let Deutsche down. Weinstein and his prop desk gun-slingers continued to ring the cash register. The prop group pulled in $900 million in 2006, earning Weinstein a paycheck of about $30 million.
Most of his attention was focused on his prop desk, however, alienating his underlings on flow, who didn’t think they were getting enough recognition. In 2005, he’d hired Derek Smith, a star trader at Goldman Sachs, to run the flow desk, angering a number of traders who felt they deserved to run the show. The number of Weinstein’s enemies within Deutsche started to grow.
“Why do we need an outsider?” they grumbled.
Weinstein’s monetary incentives were skewed heavily toward the prop desk side. While his compensation for his flow desk job was a discretionary bonus, his prop desk business rewarded him with a healthy percentage of the profits.
There was a good reason for Weinstein’s tunnel vision: his eyes were squarely focused on launching his own hedge fund in the next few years following the tradition set by Cliff Asness years ago when he’d broken away from Goldman Sachs to launch AQR. In early 2007, Weinstein renamed his prop-trading group Saba. It encompassed about sixty people working in offices in New York, London, and Hong Kong.
The name would brand the group on the Street, making it immediately recognizable once it broke away from Deutsche Bank. Saba was increasingly known and feared as a major force with massive financial ammunition, a major player nearing the level of bond-trading powerhouses such as Citadel and Goldman Sachs.
Weinstein reveled in his success. Now a wealthy playboy, every summer he would rent a different vacation home in the Hamptons. He continued to gamble, playing high-stakes games alongside celebrities such as Matt Damon.
He also continued to gamble with his fellow quants in New York. The game, of course, was poker.
Boaz Weinstein dealt crisply, talking a blue streak. There was no smoke in the room as the cards fell about the table. Peter Muller, the compulsive health nut who nearly passed on the BARRA job due to his discovery of a single cigarette butt in the company’s bathroom, didn’t allow smoking Muller’s rule didn’t bother the quants. Neither Cliff Asness nor Weinstein smoked. But every now and then, a seasoned poker professional who couldn’t fathom the notion of poker separated from an endless chain of cigarettes would sit in on the quants’ game and be forced to clock an excruciating night of nicotine-free, high-stakes gambling.
On this particular night in late 2006, it was just the quants going head-to-head. Weinstein was regaling the table with tales of “correlation,” a technical term from credit trading that he was explaining in detail to his poker buddies.
“The assumptions are crazy,” he said, placing the deck on the table and picking up his hand. “The correlations are ridiculous.”
It all had to do with the explosion in housing prices. The housing market had been booming for years and looked to be losing steam in overheated regions such as southern California and Florida. Home prices had more than doubled nationwide in a matter of five years, helping prop up the economy but leading to an unsustainable bubble. A growing number of investors, including Weinstein, thought it was about to pop like an infected boil.
Weinstein had a unique view into Wall Street’s end of the bubble. Deutsche Bank was heavily involved in mortgage lending—some of it on the subprime side. In 2006, it had purchased Chapel Funding, a mortgage originator, and had teamed up with the Hispanic National Mortgage Association to ma
ke loans to Hispanic and immigrant borrowers.
Deutsche Bank was also a big player in the securitization market, buying mortgage loans from lenders, packaging those loans into securities, then slicing and dicing them into different pieces to peddle to investors around the world.
One reason why banks engage in securitization is to spread around risk like jelly on toast. Instead of lumping the jelly on one small piece of the toast, leaving all the reward (or risk that it falls off the toast) for one bite, it’s evenly distributed, making for lots more tasty bites—and, through the quant magic of diversification (spreading the jelly), less risk.
If an investor buys a single subprime mortgage worth $250,000, that investor bears the entire risk if that mortgage goes into default, certainly possible given the fact that subprime mortgages usually go to the least creditworthy borrowers. But if a thousand subprime mortgages, each worth about $250,000, were pooled together and turned into a single security with a collective value of $250 million, the security could be divided into some number of shares. The potential loss caused by any one mortgage going into default would be offset by the fact that it represented only a tiny portion of the security’s total value.
Parts of the securities, in many cases the lowest on the food chain, were often bundled into even more esoteric monstrosities known as collateralized debt obligations, which took into account the fact that some of the underlying mortgages were more likely than others to default. The more-likely-to-default bundles obviously carried greater risk, though along with that came its corollary, greater potential reward. Between 2004 and 2007, billions in subprime home loans were stuffed into these so-called CDOs. The CDOs were then sliced into tranches. There were high-quality slices, stamped AAA by rating agencies such as Standard & Poor’s, and there were poor-quality slices, some of which were so low in quality they didn’t even get a rating.
The Quants: How a New Breed of Math Whizzes Conquered Wall Street and Nearly Destroyed It Page 20
