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

by Scott Patterson

  The infusion of cash came quickly. The government stepped in with an $85 billion bailout of AIG, which soared to about $175 billion within six months. In the following weeks, the Treasury Department, led by Hank Paulson, former CEO of Goldman Sachs, unveiled a plan to pump $700 billion into the financial system to jolt the dying patient back to life. But no one knew if it would be enough.

  Andy Lo’s Doomsday Clock was nearing midnight.

  Alan Greenspan sat in the hot glare of ranks of TV cameras on Capitol Hill, sweating. On October 23, 2008, the former chairman of the Federal Reserve faced rows of angry congressmen demanding answers about the cause of a credit crisis ravaging the U.S. economy. For more than a year, Greenspan had argued time and again that he wasn’t to blame for the meltdown. Several weeks earlier, President George W. Bush had signed a $700 billion government bailout plan for a financial industry devastated by the housing market’s collapse.

  In July, Bush had delivered a blunt diagnosis for the troubles in the financial system. “Wall Street got drunk,” Bush said at a Republican fund-raiser in Houston. “It got drunk, and now it’s got a hangover. The question is, how long will it sober up and not try to do all these fancy financial instruments?”

  The credit meltdown of late 2008 had shocked the world with its intensity. The fear spread far beyond Wall Street, triggering sharp downturns in global trade and battering the world’s economic engine. On Capitol Hill, the government’s finger-pointing machinery cranked up to full throttle. Among the first called to account: Greenspan.

  Greenspan, many in Congress believed, had been the prime enabler for Wall Street’s wild ride, too slow to remove the punch bowl of low interest rates earlier in the decade. “We are in the midst of a once-in-a-century credit tsunami,” Greenspan said to Congress in his characteristic sandpaper-dry voice. To his left sat the stone-faced Christopher Cox, head of the Securities and Exchange Commission, in for his own grilling later in the day.

  Representative Henry Waxman, a Democrat from California overseeing the hearings, shifted in his seat and adjusted his glasses. A patina of sweat glistened on his egglike dome. Greenspan droned on about the causes of the crisis, the securitization of home mortgages by heedless banks on Wall Street, the poor risk management. It was nothing new. Waxman had heard it all before from countless economists and bankers who had testified before his committee that year. Then Greenspan said something truly strange to viewers unfamiliar with the quants and their minions.

  “In recent decades, a vast risk management and pricing system has evolved combining the best insights of mathematicians and finance experts supported by major advances in computer and communications technology,” he said. “A Nobel Prize was awarded for the discovery of the pricing model that underpins much of the advance in derivatives markets,” he added, referring to the Black-Scholes option model. Greenspan kept his eyes glued to the speech laid out on the long wooden table before him.

  “The modern risk management paradigm held sway for decades,” he said. “The whole intellectual edifice, however, collapsed in the summer of last year.”

  Waxman wanted to know more about this intellectual edifice. “Do you feel that your ideology pushed you to make decisions that you wish you had not made?” he asked, indignant.

  “To exist you need an ideology,” Greenspan replied in his signature monotone. “The question is whether it is accurate or not. And what I’m saying to you is, yes, I have found a flaw. I don’t know how significant or permanent it is. But I have been very distressed by that fact.”

  “You found a flaw in the reality?” Waxman asked, seeming genuinely bewildered.

  “A flaw in the model that I perceived is the critical functioning structure that defines how the world works, so to speak.”

  The model Greenspan referred to was the belief that financial markets and economies are self-correcting—a notion as old as Adam Smith’s mysterious “invisible hand” in which prices guide resources toward the most efficient outcome through the laws of supply and demand. Economic agents (traders, lenders, homeowners, consumers, etc.) acting in their own self-interest create the best of all possible worlds, as it were—guiding them inexorably to the Truth, the efficient market machine the quants put their faith in. Government intervention, as a rule, only hinders this process. Thus Greenspan had for years advocated an aggressive policy of deregulation before these very same congressmen in speech after speech. Investment banks, hedge funds, the derivatives industry—the core elements of the sprawling shadow banking system—left to their own devices, he believed, would create a more efficient and cost-effective financial system.

  But as the banking collapse of 2008 showed, unregulated banks and hedge funds with young quick-draw traders with billions at their disposal and huge incentives to swing for the fences don’t always operate in the most efficient manner possible. They might even make so many bad trades that they threaten to destabilize the system itself. Greenspan wasn’t sure how to fix the system, aside from forcing banks to hold a percentage of loans they make on their own balance sheets, giving them the incentive to actually care about whether the loans might default or not. (Of course, the banks could always hedge those loans with credit default swaps.)

  Greenspan’s confession was stunning. It marked a dramatic shift for the eighty-two-year-old banker who for so long had been hailed variously as the most powerful man on the planet and the wise central banker with a Midas touch. In a May 2005 speech he’d hailed the system he now doubted. “The growing array of derivatives and the related application of more sophisticated methods for measuring and managing risks had been key factors underlying the remarkable resilience of the banking system, which had recently shrugged off severe shocks to the economy and the financial system.”

  Now Greenspan was turning his back on the very system he had championed for decades. In congressional testimony in 2000, Vermont representative Bernie Sanders had asked Greenspan, “Aren’t you concerned with such a growing concentration of wealth that if one of these huge institutions fails it will have a horrendous impact on the national and global economy?”

  Greenspan didn’t bat an eye. “No, I’m not,” he’d replied. “I believe that the general growth in large institutions has occurred in the context of an underlying structure of markets in which many of the larger risks are dramatically—I should say fully—hedged.”

  Times had changed. Greenspan seemed befuddled by the meltdown, out of touch with the elephantine growth of a vast risk-taking apparatus on Wall Street that had taken place under his nose—and by many accounts had been encouraged by his policies.

  After his testimony ended, Greenspan stood and walked, hunched over, out of the hot glare of the television lights. He seemed shaken, and it was painfully clear that Greenspan, once hailed as the savior of the financial system after orchestrating the bailout of Long-Term Capital Management in 1998, was a fragile and elderly man whose better days were long behind him.

  Watching the telecast of the congressional hearings from his hedge fund in Greenwich, Cliff Asness couldn’t believe what he was hearing. If anyone personified the system Greenspan called into question, it was Asness. A product of the University of Chicago’s school of finance, which preached the dogma of free market libertarianism like a new religion, Asness believed with every fiber in his body and brain in the economic model Greenspan now seemed to reject. There is no flaw.

  “Traitor,” he muttered to his TV set. Greenspan was turning his back on a theory about the efficiency of free markets simply to salvage his reputation, Asness thought. “Too late, old man.”

  The way Asness saw it, Greenspan had been right about free markets; his mistake was leaving interest rates too low for too long, helping inflate the housing bubble that fed the whole mess in the first place. That’s what Greenspan should have apologized for, not his support of free markets.

  Everything Asness believed in seemed under siege. Greenspan was turning his back on a movement that, Asness thought, had generated u
nprecedented wealth and prosperity for America and much of the rest of the world. Capitalism worked. Free markets worked. Sure, there were excesses, but the economy was in the process of purging those excesses out of the system. That’s how it worked. To see Greenspan lose faith and betray the creed at its moment of weakness seemed the most extreme form of cretinism.

  Far worse for Asness, AQR itself was under siege. It had lost billions in the market meltdown. Rumors had started to crop up that AQR was close to shutting down.

  AQR wasn’t the only fund suffering such rumors in October 2008. Another major hedge fund was perched on the very edge of a death spiral: Citadel.

  Ken Griffin marched into a brightly lit conference room on the thirty-seventh floor of the Citadel Center on South Dearborn Street, sat down before a polished wooden table, and donned a headset. Beside him sat Gerald Beeson, Citadel’s green-eyed, orange-haired chief operating officer, the son of a cop who’d grown up on Chicago’s rough-and-tumble South Side. Beeson was one of Griffin’s most trusted lieutenants, a veteran of the firm since 1993. It was Friday afternoon, October 24, one day after Greenspan’s testimony on Capitol Hill. More than a thousand listeners were on the line waiting for Griffin and Beeson to explain what had become of Citadel.

  Rumors of Citadel’s collapse were spreading rapidly, even hitting TV screens on the financial news network CNBC. Citadel, traders said, was circling the drain. The market turmoil after the collapse of Lehman Brothers had led to massive losses in its giant convertible bond portfolio. If Citadel went under, many feared, the ripple effects would be catastrophic, causing other funds with similar positions to tumble like so many dominoes.

  According to former senior executives at Citadel, Griffin had started to force out employees as Citadel’s fortunes grew more precarious. Joe Russell, head of Citadel’s credit trading group and the key man in the E*Trade deal, had been agitating for more power. Griffin wouldn’t give it to him, and his ruthless side emerged. The word around Citadel was that Griffin and Russell engaged in a furious shouting match that left little doubt they’d never work together again. “Throw him under the bus,” Griffin was heard to say, forcing Russell out in early September.

  But Griffin was still confident that Citadel could withstand the pressure. One major unknown kept him up at night: Goldman Sachs. Goldman’s stock had been plunging, and some feared it, too, would follow in the wake of Bear Stearns and Lehman Brothers. Goldman was a key counterparty to Citadel in numerous trades and also extended credit to the fund. Throughout the crisis, Griffin and Goldman CEO Lloyd Blankfein held numerous discussions about the state of the markets. As the system spiraled out of control, the impossible suddenly seemed all too possible. If Goldman went down, Griffin believed, Citadel would certainly follow.

  The thought of Goldman Sachs collapsing seemed incredible. Impossible. But Bear had gone down. So had Lehman. Morgan Stanley was on the ropes. AIG, Fannie Mae, Washington Mutual. Even Ken Griffin’s fortress of money was crumbling. He’d do everything in his power to keep that from happening. Even the unthinkable: hold a conference call open to the press.

  Earlier that day, James Forese, Citigroup’s head of capital markets, had called Griffin with a warning. “Ken, you guys are getting killed in the rumor mill,” Forese said. “Most of these things are just blatantly false. If you get out there and say you’re fine, it will mean a lot to the market right now.”

  And so, setting aside his penchant for secrecy, Griffin cleared his throat and prepared to explain what had happened to Citadel.

  Trouble was, everything wasn’t fine.

  In nearly two decades, Griffin had lost money in only a single year, 1994. Now his fund was on the verge of collapse. The suddenness of its downturn was head-spinning and spoke to the severity of the market’s post–Lehman Brothers turbulence.

  Citadel had been flushed into the public eye by the dramatic upheaval. The implosion of Lehman and the panic sparked by the near-collapse of AIG were like massive earthquakes rattling through the global financial system. At first the shock waves seemed manageable. Markets were dislocated in the few days following Lehman’s bankruptcy filing on September 15, but not so dramatically that Citadel would feel threatened. Griffin later described it as a huge wave that passes unfelt beneath a ship as it heads treacherously toward shore.

  Among the first to feel the crushing impact of the wave once it hit shore were credit-trading powerhouses Citadel and Boaz Weinstein’s Saba, which dabbled heavily in corporate bonds and credit default swaps. Citadel’s flagship fund, Kensington, lost a staggering 20 percent in September. By late October, it was down 35 percent for the year. Saba was also gravely wounded, losing hundreds of millions in positions in companies such as General Motors and Washington Mutual, the Seattle thrift and subprime-mortgage giant seized by federal regulators and sold to J. P. Morgan shotgun-wedding-style for $1.9 billion in late September. Weinstein had been making bets that financial firms deemed systemically important would survive the crisis, but the relentless violence of the credit meltdown crushed his optimistic forecasts.

  Now Citadel and Saba were in the crosshairs. The rumors of Citadel’s collapse were adding to the market’s already volcanic volatility, triggering big downturns and wild swings. One of the most damaging rumors, popping up on message boards and financial blogs, was that Federal Reserve officials had swooped into Citadel’s Chicago headquarters and were combing through its positions to determine whether it needed a bailout—bad memories of LTCM’s 1998 bailout a decade ago still lingered among many Wall Street veterans.

  Citadel denied it was in trouble, but the Fed rumors were partially true. Officials from the central bank were privately worried about the prospects of a collapse by Citadel. The fund sat on nearly $15 billion worth of corporate bonds in its convertible-bond arbitrage book, which was the most highly leveraged portion of the fund, according to people familiar with the fund. While the amount of leverage was a closely guarded secret, one bank’s assessment put it north of 30 to 1 in 2007, though the leverage had been reduced to 18 to 1 by the summer of 2008.

  The convertible-bond arbitrage book, whose roots went all the way back to Ed Thorp’s breakthrough insights in the 1960s, was Citadel’s hot zone. If the fund failed and started dumping bonds on the market, the system would sustain yet another brutal shock. It was already on the very cusp of doom. To gauge the risk, regulators from the Fed’s New York branch started questioning the fund’s major counterparties such as Deutsche Bank and Goldman Sachs about their exposure to Citadel, worried that Citadel’s collapse could threaten yet another bank.

  Inside Citadel’s Chicago office, the mood was grim but professional. Traders went to work as they did every day, showing up early, staying late—often much later than usual. Inside, many were quietly terrified by the huge losses they saw on their screens.

  Griffin knew he had to stop the bleeding. Egged on by Wall Street bankers such as Forese, he made a snap decision that late October Friday to hold a conference call with Citadel bondholders to quell the rumors. It was set to begin at about 3:30 P.M. Eastern time. In keeping with the nerve-wracking tenor of the moment, nothing was working the way it was supposed to. The lines were such hot commodities that many listeners couldn’t get through. A technical glitch created by the demand led to a twenty-five-minute delay, an embarrassing gaffe for a fund that prided itself on its military-style precision.

  By the time the call started, Beeson seemed flustered by the huge turnout, stumbling on his opening lines. “Today we’d like to thank you for taking …” He started again, his voice flat: “Today we’d like to thank you for taking the time to join us on this conference call on short notice.”

  Griffin chimed in, curtly thanking his team for its hard work, then turned the call back over to Beeson, who sounded almost in awe of the destructive powers of the market meltdown.

  “To call this a dislocation doesn’t go anywhere near the enormity of what we’ve seen,” he said. “What have we seen here? We have seen
the near-collapse of the world’s banking system.”

  Beeson described the impact the powerful deleveraging was having on Citadel’s positions. Just as investors plowed into cash or Treasury bonds during Black Monday in 1987 and the collapse of Long-Term Capital in 1998, a torrent of money had flowed into highly liquid assets following Lehman’s collapse. At the same time, investors dumped less-safe assets such as corporate bonds like a panicked mob fleeing a burning building.

  Normally Citadel wouldn’t have even been singed too severely by such a move. Like any good quant fund, it had hedged its bets with credit default swaps. The swaps were supposed to gain in value if the price of the bonds declined. If a GM bond fell 10 percent, the credit default swap insuring the bond would gain 10 percent. Simple. As Boaz Weinstein liked to say, it wasn’t rocket surgery.

  But in the financial tsunami of late 2008, the swaps were dysfunctional. The deleveraging had grown so powerful that most banks and hedge funds weren’t willing to buy insurance from anyone; that meant the swaps that were supposed to protect investors weren’t working as promised. Many were afraid the seller of the insurance might not be around much longer to pay up if the underlying bond defaulted. Banks essentially stopped lending, or clamped down on lending terms tighter than a cinch knot, making it extremely hard for many investors, including hedge funds such as Citadel, to fund their trades—which were almost entirely conducted with leverage. No leverage, no trading, no profits.

  It was the same problem that always occurred during financial crises: when the shit hit the fan, the fine-tuned quant models didn’t work as panicked investors rushed for the exits. Liquidity evaporated, and billions were lost. Like frightened children in a haunted house, investors had grown so skittish that they were running from their own shadows. The entire global credit market suffered a massive panic attack, threatening to bring down trading powerhouses such as Saba and Citadel in its wake.