The Quants: How a New Breed of Math Whizzes Conquered Wall Street and Nearly Destroyed It

by Scott Patterson

  Authorities had little idea about the massive losses taking place across Wall Street. That Tuesday afternoon, the Federal Reserve said it had decided to leave short-term interest rates alone at 5.25 percent. “Financial markets have been volatile in recent weeks, credit conditions have become tighter for some households and businesses, and the housing correction is ongoing,” the Fed said in its policy statement. “Nevertheless, the economy seems likely to continue to expand at a moderate pace over coming quarters, supported by solid growth in employment and incomes and a robust global economy.”

  The crisis was mounting, and Washington’s central bankers were completely out of touch. The losses on Monday and Tuesday were among the worst ever seen by quant hedge funds, with billions of dollars evaporating into thin air. Wednesday they got far worse.

  At the headquarters of Goldman Sachs Asset Management in downtown New York, everyone was on red alert. One of the largest hedge fund managers in the world, with $30 billion in assets, GSAM was getting hit on all sides. It was seeing big losses in value, growth, small-cap stocks, mid-caps, currencies, commodities, everything. Global Alpha, the Global Equity Opportunity fund—every strategy was getting crushed. And like every other quant fund, its captains, Carhart and Iwanowski, had no idea why.

  GSAM’s risk models, highly sophisticated measures of volatility, had been spiking for all of July. It was a strange sight, because volatility had been declining for years. And the way GSAM’s risk models worked, the decline in volatility meant that it had needed to take more risk, use more leverage, to make the same amount of money. Other quant funds had followed a similar course. Now volatility wasn’t behaving anymore. Volatility was actually … volatile.

  Another disturbing trend that Goldman’s quants noticed was a rapid unwinding of the worldwide carry trade. Funds such as Global Alpha, AQR, Citadel, and others had been borrowing low-yielding yen on the cheap and investing it in higher-yielding assets, generating huge profits. The trade had been highly successful for years, helping fuel all kinds of speculative bets, but it depended on one trend remaining in place: cheap yen.

  In early August 2007, the yen started to surge. Funds that had borrowed the yen, expecting to repay the loan at a later date, were scrambling to repay as the yen leapt in value against other currencies. That triggered a self-reinforcing feedback loop: As the yen kept rising, more funds were needed to repay the loans, pushing the yen up even more.

  At GSAM, the sudden unwind meant a potential catastrophe. Many of its positions—bonds, currencies, even stocks—were based on the yen carry trade.

  The collapse of the carry trade and the spike in volatility were potentially disastrous. The first major dislocation in the market, one not seen in years, had happened the previous Friday, August 3. The dislocation turned into an earthquake on Monday. By Tuesday, the situation was critical, and GSAM had to start selling hard.

  Walking downtown on Broadway to Morgan Stanley’s office through thick, sweaty crowds, Peter Muller was growing impatient. It was Wednesday, August 8, and traffic in midtown Manhattan was jammed up like he’d never seen before. People swarmed the sidewalks, not just the usual tourists but businessmen in suits, nearly everyone jabbering frantically on their cell phones.

  He’d just left his spacious apartment in the Time-Warner Center at Columbus Circle, located at the southwest corner of Central Park and fourteen blocks north of Morgan’s headquarters. There was no time to waste. He checked his watch for the twentieth time. The market would be opening soon. And he was worried—worried the meltdown would continue. He checked his BlackBerry for news. Japan had gotten killed again. Christ. Muller didn’t know why the meltdown had started. Worse, he didn’t know when it would stop. It had to stop. If it didn’t …

  Muller elbowed through the buzzing throng in front of the old Ed Sullivan Theater in frustration. Even nature seemed to be conspiring against him. Earlier that morning, a tornado had struck the city, hitting land shortly before the morning commute in New York City began in earnest. Whipped up by winds as high as 135 miles per hour, the freak twister first hit Staten Island, then leapfrogged across the Narrows of New York Bay to Brooklyn, knocking down trees, ripping up rooftops, and damaging cars and buildings in Sunset Park and Bay Ridge. It was the first tornado to strike Brooklyn in more than fifty years, and only the sixth to strike New York City since 1950.

  Major roadways flooded and subway tunnels were drenched, shutting down services across the city and freezing traffic. The chaos that ensued as stranded commuters took to the streets brought to more than a few minds the horrors of six years earlier, when terrorists struck the World Trade Center’s Twin Towers on September 11.

  As quickly as the storm had rushed in, it cleared away, swirling into the Atlantic. A boiling August sun emerged, baking the city in a steamy, humid soup. Wall Street’s army of traders struggled to make it to the office before the start of trading at 9:30 A.M. Many were on edge, and that had nothing to do with the weather. The storm that was building in the world’s financial markets was bursting forth in ways no one could have ever imagined. The first bands of the tempest had already hit, and Muller was in the center of it.

  It had been a long, wild ride for Muller. PDT was an industrial electronic humming machine that spit out endless streams of money. But things had changed. It was so much more corporate now, regimented, controlled. Nothing like the group’s glory days, a decade earlier, when the money seemed to fall from the sky like manna, surprising everyone.

  There was that afternoon in—what was it, 1996, 1997?—when a band of PDTers were lounging on a beach in Grenada, the spice island. It was one of many trips to exotic ports around the world that the adventurous group of math wizards would take in those heyday years. As the tropical sunlight faded, and the warm breeze rolled off the blue waters of the Caribbean Sea, Muller decided to check in on the team back in New York. He pulled out his cell phone and hit the speed dial for PDT’s trading desk, calling one of the few traders who’d stayed behind to man PDT’s computers.

  “What’s the P&L?” he’d asked, using trader shorthand for profit and loss. Muller was in the habit of hearing a lot about the “P” side of the ledger. “L,” not so much.

  “Let’s see,” said a calm voice on the other end of the line. “Seventeen.” As in $17 million.

  “Beautiful,” Muller said, and he meant it. Everything was beautiful. He smiled and flicked a lock of sandy-blond hair from his eyes, toasting another day’s bonanza to the group of quants gathered around him in the golden Grenada sunset. Not bad for another day on the beach.

  Muller pushed urgently toward Morgan Stanley’s headquarters through the chaotic tangle of Times Square. He clenched his jaw and looked up. The storm was gone, the sun shining. The investment bank’s impressive profile loomed against the slate-blue sky.

  There it was: 1585 Broadway, world headquarters of Morgan Stanley. The skyscraper towered over Duffy Square in the heart of midtown Manhattan. Completed at the start of the go-go nineties, 1585 Broadway contained nearly 900,000 square feet of office space on forty-two floors. Several stories above a row of shops, three rows of streaming data fly across the east-facing side of the high tower. Stock prices, currencies, breaking news from around the world. The hulking skyscraper looked somewhat like a heavyset floor trader itching to bully the neon-glutted towers of Times Square cowering at its concrete feet.

  At the sight of the building, Muller still felt the old thrill. He knew, more than most who worked there, the trading power housed inside the intimidating structure. Through miles of endlessly ramifying fiber-optic cables and an array of satellite dishes mushroomed about the building, the glass-windowed tower was plugged into financial markets around the globe, mainlined into the Money Grid.

  Traders deep in the bowels of 1585 Broadway bought and sold options on Japanese corporate bonds, derivatives linked to European real estate and West Texas crude, billions in currencies from Canada to Zimbabwe to Peru, as well as the odd slice of subprime mortg
age and mortgage derivatives. And, of course, stocks. Billions of dollars’ worth of stocks.

  Muller stepped briskly into Morgan’s spacious air-conditioned lobby, escaping the mayhem outside, swiped his ID badge at the electric turnstile, and jumped onto an elevator that would take him to PDT’s high-tech trading hub.

  The elevator stopped on the sixth floor, and Muller flew into the lobby, sweeping his security pass before the locked doors of PDT’s office. He rushed past the Alphaville poster that had hung in PDT’s office for more than a decade and stepped into his private office. He flicked on his rank of computers and Bloomberg terminals with access to data on nearly every tradable security in the world. After a quick check of the market action, he checked PDT’s P&L.

  It was bad.

  This was the most brutal market Muller had ever seen. Quant funds everywhere were getting crushed like bugs beneath a bulldozer. Muller had been swapping ideas about what was happening with other managers, ringing up Asness and grilling him about what was going on at AQR, trying to find out if anyone knew what was happening at Goldman Sachs. Everyone had theories. No one knew the answer. They all worried that it would be fatal if the unwind lasted much longer.

  Rumors of a disaster were rife. The U.S. housing market was melting down, causing huge losses at banks such as Bear Stearns and UBS and hedge funds around the world. Stock markets were in turmoil. Panic was spreading. The subprime catastrophe was mutating through the Money Grid like some strange electronic virus. The entire system started to seize up as the delicate, finely wrought creations of the quants spun out of control.

  As the losses piled up, the root of the meltdown remained a mystery. Oddly enough, as much as the furor seized the world of finance, it went largely overlooked in the larger world beyond. Indeed, investors on Main Street had little idea that a historic blowup was occurring on Wall Street. Aaron Brown at AQR had to laugh watching commentators on CNBC discuss in bewilderment the strange moves stocks were making, with absolutely no idea about what was behind the volatility. Truth was, Brown realized, the quants themselves were still trying to figure it out.

  Brown had been spending all his time trying to get up to speed on AQR’s systems to help manage the fund’s risk. He’d decided to stay in the office that Tuesday night and sleep on a small couch he kept near his desk. He wasn’t the only one. Near midnight, he stepped out of his office, eyes bloodshot from peering at numbers on a computer screen for the past twenty hours. The office was buzzing with activity, dozens of haggard quants chugging coffee, iPods plugged into their ears as they punched frantically on keyboards, unwinding the fund’s positions in markets around the globe. It was a strange sight. The office was nearly as busy as it was during the day, but it was pitch black outside.

  And still, the outside world had no idea that a meltdown of such size was taking place. One of the first to spread word to the masses was an obscure quantitative researcher who worked at Lehman Brothers.

  Matthew Rothman was still groggy from his red-eye flight into San Francisco the night before as he walked into the office of a potential client on Tuesday morning, August 7. The chief quantitative strategist for Lehman Brothers was on a West Coast road trip, pitching the models he’d spent the last year sweating over during late nights at the office and tedious weekends. This was payoff time.

  As Rothman, a heavyset, middle-aged man with a moon face and curly brown hair, sat in the client’s waiting room with his laptop and luggage—he hadn’t had time to swing by the Four Seasons, where he was staying—he wondered about the odd activity in the market he’d seen the previous day. His quantitative models had been hit hard, and he didn’t know why.

  He bolted up from his chair, startled. The trader he was waiting to see rushed toward him, his face frantic. “Oh my God, Matthew,” he said, pulling him toward his office. “Have you seen what’s going on?”

  He showed Rothman his portfolio. It was down sharply. Something terrible was happening, something never seen before. Rothman didn’t have any answers.

  The pitch was out the window. No one wanted to hear about his whiz-bang models. Rothman visited several more quant funds that day. It was a bloodbath.

  And it made no sense. A true believer in market efficiency who’d studied under Eugene Fama at Chicago, Rothman expected the market to behave according to the strict quantitative patterns he lived to track. But the market was acting in a way that defied any pattern Rothman—or any other quant—had ever seen. Everything was losing money. Every strategy was falling apart. It was unfathomable, if not outright insane.

  That evening, Rothman dined out with his friend Asriel Levin at a sushi restaurant in downtown San Francisco. Levin had once run the flagship quant fund 32 Capital inside Barclays Global Investors in San Francisco, the largest money manager in the world. In late 2006, he’d started up his own hedge fund, Menta Capital. “Uzi,” as people called Levin, was one of the smartest quants Rothman knew. He felt lucky to be able to pick Levin’s brain during such a critical time. Over sushi and wine, the two started hashing out their ideas about what had triggered the meltdown. By the time they were through—they closed the restaurant—they had a working hypothesis that would prove prescient.

  A single, very large money manager had taken a serious hit from subprime assets, they theorized. That, in turn, would have triggered a margin call from its prime broker.

  Margin call: two of the most frightening words in finance. Investors often borrow money from a prime broker to buy an asset, say a boatload of subprime mortgages. They do this through margin accounts. When the value of the asset declines, the prime broker calls up the investor and asks for additional cash in the margin account. If the investor doesn’t have the cash, he needs to sell something to raise it, some liquid holding that he can get rid of quickly.

  The most liquid assets tend to be stocks. Rothman and Levin figured the money manager in trouble was a multistrategy hedge fund, one that dabbled in every kind of investing strategy known to man, from futures to currencies to subprime mortgages.

  The trigger, they realized, had to be the collapse in subprime. When Ralph Cioffi’s Bear Stearns hedge funds started to melt down, the value of all subprime CDOs started to decline at once. Ratings agencies such as Moody’s and Standard & Poor’s were also downgrading large swaths of CDOs, pushing their value down even further and prompting more forced selling. Margin calls on funds with significant subprime holdings were rolling across Wall Street.

  Funds that primarily owned mortgages were stranded, since the only way they could raise cash would be to dump the very assets that were plunging in value. Multistrat funds, however, had more options. At least one of these funds—there may have been several—had a large, highly liquid equity quant book, Rothman and Levin reasoned. The fund manager must have looked around for assets he could dump with the utmost speed to raise cash for the margin call, and quickly fingered the quant equity book.

  The effects of that sell-off would have started to ripple through other funds with similar positions. The short positions were suddenly going up, and the longs were going down.

  In other words, a large hedge fund, possibly several large hedge funds, was imploding under the weight of toxic subprime assets, taking down the others in the process, like a massive avalanche started by a single loose boulder. All the leverage that had piled up for years as quant managers crowded into trades that increasingly yielded lower and lower returns—requiring more and more leverage—was coming home to roost.

  It was impossible to know how much money was in these trades, but by any estimate the figure was massive. Since 2003, assets in market-neutral hedge funds that made long and short bets, such as AQR’s, had nearly tripled to about $225 billion by August 2007, according to the widely followed Lipper TASS Database of hedge funds. At the same time, profits in the strategies were dwindling as more and more funds divvied them up. Several quant funds were slouching toward gigantism, plowing cash into the sector. Renaissance’s RIEF fund had added $12 billi
on in just the past year, bringing its assets under management to $26 billion. AQR had bulged to $40 billion. Other Wall Street operators were jumping on the quant bandwagon as well. Among the most popular trading strategies at the time were so-called 130/30 funds, which used the smoke and mirrors of leverage and quant wizardry to amp up their long positions to 130 percent of capital under management, while shorting stocks equal to another 30 percent of capital (RIEF was a 170/70 fund, indicating the use of even more leverage). By the summer of 2007, about $100 billion had been put in such strategies, many of which were based on quantitative metrics such as Fama’s value and growth factors.

  The carnage also revealed a dangerous lack of transparency in the market. No one—not Rothman, not Muller, not Asness—knew which fund was behind the meltdown. Nervous managers traded rumors over the phone and through emails in a frantic hunt for patient zero, the sickly hedge fund that had triggered the contagion in the first place. Many were fingering Goldman Sachs’s Global Alpha. Others said it was Caxton Associates, a large New York hedge fund that had been suffering losses in July. More important, Caxton had a large quant equity portfolio called ART run by a highly secretive manager, Aaron Sosnick.

  Behind it all was leverage. Quant funds across Wall Street in the years leading up to 2007 had amped up their leverage, reaching for yield. Returns had dwindled in nearly all of their strategies as more and more money poured into the group. The fleeting inefficiencies that are the very air quants breathe—those golden opportunities that Fama’s piranhas gobble up—had turned microscopically thin, as Fama and French’s disciples spread the word about growth and value stocks and stat arb became a commoditized trade copied by guys with turbo-charged Macs in their garages.