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

by Scott Patterson

  Another blow came from the federal government’s ban on short selling in the weeks following the Lehman-AIG debacle. Shares of financial firms across the board—even stalwarts such as Goldman Sachs and Morgan Stanley—were collapsing. To keep the situation from spiraling out of control, the Securities and Exchange Commission in September instituted a temporary ban on shorting about eight hundred financial stocks. Citadel, it turned out, had short positions in some of those companies as part of its convertible bond arbitrage strategy. Just as Ed Thorp had done in the 1960s, Citadel would buy corporate bonds and hedge the position by shorting the stock. With the short-selling ban, those shares surged dramatically in a vicious short squeeze that inflicted huge losses on hedge funds. Shares of Morgan Stanley, a bank squarely in the short sellers’ crosshairs, surged more than 100 percent in a matter of days from about $9 to $21 in early October when the ban was in place.

  Before the ban took effect, Griffin got SEC chairman Christopher Cox on the phone.

  “This could mean a catastrophe for us, and a lot of other funds like us,” Griffin told Cox. “The ban could also inject greater uncertainty and risk into the market,” he said.

  The chairman was unmoved. “The financial system is in crisis, Ken,” he said. “The people need to be protected from a collapse.”

  It was a quant nightmare. Markets were at the mercy of unruly forces such as panicked investors and government regulators. As the conference call proceeded, Beeson kept repeating a single word: unprecedented. Citadel’s losses, he said, were due to “the unprecedented deleveraging that took place around the world over the past several weeks.”

  To quants, unprecedented is perhaps the dirtiest word in the English language. Their models are by necessity backward-looking, based on decades of data about how markets operate in all kinds of conditions. When something is unprecedented, it falls outside the parameters of the models. In other words, the models don’t work anymore. It was as if a person flipping a coin a hundred times, expecting roughly half to turn up heads and the rest tails, experienced a dozen straight flips where the coin landed on its edge.

  Finally Griffin took charge of the call. “Again, good afternoon,” he said, quickly reminding listeners that while he might be a forty-year-old whippersnapper, he’d been in the game for a long time, having seen the crash in 1987, the debt panic of 1998, the dot-com bust. But this market was different—unprecedented.

  “I have never seen a market as full of panic as I’ve seen in the past seven or eight weeks,” he said. “The world is going to change on a going-forward basis.”

  Then the stress broke through. Griffin’s voice cracked. He seemed on the verge of tears. “I could not ask for a better team to weather the storm that we are going through,” he said in a sentimental flourish. “They are winning on a going-forward basis,” he said, sounding almost wistful even as he lapsed into the most generic corporatese.

  After just twelve minutes, the call ended. The rumors about Citadel’s collapse had been quieted, but not for long.

  Griffin was growing paranoid, convinced that rival hedge funds and take-no-prisoners investment bank traders were taking bites out of his fund, sharks smelling blood in the water and trying to swallow Citadel whole. Inside his fund, he fumed at white-knuckled bond traders who refused to keep adding positions in the market’s madness. He clashed with his right-hand man, James Yeh, a reclusive quant who’d been at Citadel since the early 1990s. Yeh thought his boss was making the wrong move. After the Bear Stearns debacle, as the crisis was heating up, Citadel had taken on huge blocks of convertible bonds. Griffin had even been eyeing pieces of Lehman Brothers before the firm collapsed. Yeh and others at Citadel, however, were far more bearish than Griffin and thought the best move was to batten down the hatches and wait for the storm to pass.

  That wasn’t how Ken Griffin played the game. In past crises, when everyone else was ducking for cover, Griffin had always been able to make money by wading into the market and scooping up bargains—the LTCM debacle of 1998, the dot-com meltdown, the Enron implosion, Amaranth, Sowood, E*Trade. Citadel always had the firepower to make hay while others cowered in fear. As the system cratered in late 2008, Griffin’s instincts were to double down.

  Griffin’s signature trade, however, worked against him this time. The market wasn’t stabilizing. Values kept sinking, bringing Citadel down with them.

  As the meltdown continued, Griffin began personally buying and selling securities. Griffin, who hadn’t personally traded in size for years, seemed to be desperately trying to save his firm from catastrophe using his own market savvy. There was one problem, traders said: The positions were often losers as the market kept spiraling lower.

  But Griffin, like Asness, was certain the situation would stabilize. When it did, Citadel, as always, would be on top.

  Citadel’s lenders, big Wall Street banks, weren’t so confident. Citadel depended on the banks to bankroll its trades. In the spring of 2008, its hedge funds held about $140 billion in gross assets on $15 billion in capital, or the stuff it actually owned. That translated to a 9-to-1 leverage ratio. Most of the extra positions came in the form of lines of credit or other arrangements with banks.

  Concerned about the impact a Citadel collapse would have on their balance sheets, several banks organized ad-hoc committees to strategize for the possibility. J. P. Morgan was playing hardball with Citadel’s traders regarding the financing of certain positions, according to traders at the fund. Regulators, meanwhile, pressed the banks not to make drastic changes in their dealings with Citadel, worried that if one lender blinked, the others would also flee, triggering another financial shock as the entire system teetered on the edge.

  Investors were clearly worried. “There’s a rumor a day about how Citadel is going to go out of business,” Mark Yusko, manager of Citadel investor Morgan Creek Capital Management in North Carolina, told his clients on a conference call.

  Inside the firm, as the carnage dragged on, employees were running ragged. Visitors noted dark rings around traders’ bloodshot eyes. The three-day beards, the loose, coffee-stained ties. As rumors about Citadel’s situation spread, traders were barraged by calls from outside the firm asking whether Federal Reserve examiners were scouring the premises. At one point an exasperated trader stood and shouted into his phone, “Sorry, I don’t see any Fed here.” Another quipped: “I just looked under my desk and didn’t see any Fed.”

  Beeson, meanwhile, was the front man for Citadel as the firm suffered more losses. He leapt into damage-control mode, shuttling nonstop between Chicago and New York to meet with edgy counterparties, trying to reassure them that Citadel had enough capital to make it through the storm. Traders were frantically unloading assets to raise cash and trim the firm’s leverage. At one point, as flagship fund Kensington’s net worth continued to plunge, Citadel arranged an $800 million loan from one of its own funds, the high-frequency machine Tactical Trading run by Misha Malyshev that had been spun out of the flagship fund in late 2007, according to people familiar with the fund. Investors who learned of the odd arrangement took it as a sign of desperation and realized it meant the firm was truly on the precipice—if it was lending itself its own money, that could mean it was having a hard time getting a decent loan elsewhere.

  Several days after the bond-holder’s call, Griffin distributed an email to Citadel’s employees around the world. Citadel would survive and thrive, he said, ever the optimist. The fund’s situation reminded him of Christopher Columbus’s journey across the Atlantic in 1492, he explained. When land was nowhere in sight and the situation seemed desperate, Griffin said, Columbus wrote two words in his journal: Sail on.

  It was a rallying cry for Citadel’s beleaguered employees. Just the year before, Citadel had been one of the mightiest financial forces in the world, a $20 billion powerhouse on the verge of greater things. Now it was faced with disaster. While the situation might seem bleak, Griffin said, and calamity imminent, land would eventually be found.
>
  Some reading the email thought back to their history lessons and recalled that Columbus had been lost.

  Soon after, Griffin held his fortieth-birthday party at Joe’s Seafood Prime Steak and Stone Crab in downtown Chicago, a dozen blocks from Citadel’s headquarters. Employees presented Griffin with a lifeboat-sized replica of one of Columbus’s ships. Griffin laughed and accepted the gift gracefully, but there was a sense of overhanging doom, a chill in the air, that killed any sense of festivity. Everyone could feel it: Citadel was sinking.

  At Morgan Stanley, Peter Muller and PDT were in crisis mode. The investment bank’s shares were collapsing. Many feared it was the next Lehman, destined for Wall Street’s mounting scrap heap. The market was making insane moves. The volatility was out of control, like nothing ever seen before. Muller decided to reduce a large portion of PDT’s positions, putting a hoard of its assets into cash before everyone else did.

  “The types of volatility we were seeing had no historical basis,” said one of PDT’s traders. “If your model is based on historical patterns and you’re seeing something you’ve never seen before, you can’t expect your model to perform.”

  It was a tumultuous time for Muller on other fronts. Ever the restless globetrotter, he’d decided to pull up stakes again. His girlfriend was pregnant, and he wanted to put down roots in a place he truly loved. He purchased a luxurious house with a three-car garage and a pool in Santa Barbara, California. Still manning the helm of PDT from afar, he was making trips to New York one or two weeks a month, where he would meet up with his poker pals.

  Morgan Stanley, meanwhile, was under heavy fire. Hedge funds that traded through Morgan tried to pull out more than $100 billion in assets. Its clearing bank, the Bank of New York Mellon, asked for an extra $4 billion in capital. It was a move from the same playbook that had taken down Bear Stearns and Lehman Brothers.

  In late September, Morgan and Goldman Sachs scrapped their investment banking business model and converted into traditional bank holding companies. Effectively, Wall Street as it had long been known ceased to exist. The move meant the banks would be far more beholden to bank regulators and would be subject to more restrictive capital requirements. The glory days of massive leverage, profits, and risk taking were a thing of the past—or so it seemed.

  Days later, Morgan CEO John Mack orchestrated a $9 billion cash infusion from Japan’s Mitsubishi UFJ Financial Group. Goldman negotiated a $5 billion investment from Warren Buffett’s Berkshire Hathaway.

  Catastrophe seemed to have been averted. But the financial mayhem continued to churn through the system. PDT was riding it out on a much-diminished cushion of cash while Muller set up house in sunny Santa Barbara and played the odd gig in Greenwich Village. Seemingly little had changed for Muller, although behind the scenes he was drafting major changes for PDT that would come to light several months later. The same couldn’t be said for Boaz Weinstein.

  By outward appearances, Boaz Weinstein was sailing through the credit meltdown unfazed. Internally, he was deeply worried. Saba was taking massive hits from the credit market. The Deutsche Bank trader watched in disbelief as his carefully designed trades came unglued.

  Weinstein had rolled into 2008 at the top of his game. He and a colleague in London, Colin Fan, were overseeing all global credit trading for Deutsche. Saba was in control of nearly $30 billion in assets, a monster-sized sum for the thirty-five-year-old trader. Weinstein’s boss, Anshu Jain, had offered him the powerful position of head of all global credit trading. But Weinstein turned him down flat. He’d already drawn up plans to break away from Deutsche in 2009 and launch his own hedge fund (to be called Saba, naturally).

  After the collapse of Bear Stearns in March 2008, Weinstein believed the worst of the credit crisis was in the rearview mirror. He wasn’t alone. Griffin thought the economy was stabilizing. Morgan’s John Mack told shareholders that the subprime crisis was in the eighth or ninth inning. Goldman Sachs CEO Lloyd Blankfein was somewhat less optimistic, saying, “We’re probably in the third or fourth inning.”

  To capitalize on depressed prices, Weinstein scooped up the distressed bonds of companies such as Ford, General Motors, General Electric, and Tribune Co., publisher of the Chicago Tribune. And, of course, he hedged those bets with credit default swaps. At first the bets paid off as corporate bonds rallied, giving Saba a tidy profit. Weinstein continued to plow cash into bonds through the summer, and Saba cruised into September 2008 in the black for the year.

  Then everything fell apart. The government took over the mortgage giants Fannie Mae and Freddie Mac. Lehman declared bankruptcy. AIG teetered on a cliff, threatening to pull the entire global financial system over with it.

  Just like Citadel, Saba was getting mauled. As the losses mounted, the flow of information among Saba’s traders ground to a halt. Normally junior traders on the group’s desks would compile profit-and-loss reports summarizing the day’s trading activities. With no warning or explanation, the reports stopped circulating. Rumors of huge losses were bandied about around the water cooler. Some feared the group was about to be shut down. The weekly $100 poker games held off Saba’s trading floor came to a halt.

  Weinstein’s hands were tied. He watched in horror as investors avoided risky corporate bonds like three-day-old fish, causing prices to crater. Like Citadel, its positions were hedged with credit default swaps. But investors, worried about whether the counterparties to the traders would be around to fulfill their obligations, wanted nothing to do with the swaps. Typically, the price of the swaps, which are traded every day on over-the-counter markets between banks, hedge funds, and the like, fluctuate according to market conditions. If the value of the swaps Saba held increased in value, it could mark those positions higher on its books, even if it didn’t actually trade the swaps itself.

  But as the financial markets imploded and leverage evaporated, the swaps market became dysfunctional. The trades that would indicate the new value for the swaps simply weren’t happening. Increasingly, Weinstein’s favorite investing vehicle, which he’d helped spread across Wall Street since the late 1990s, was seen as the fuse to the powder keg that blew up the financial system.

  Weinstein remained outwardly calm, quietly brooding in his office overlooking Wall Street. But the losses were piling up rapidly and soon topped $1 billion. He pleaded with Deutsche’s risk managers to let him purchase more swaps so he could better hedge his positions, but the word had come down from on high: buying wasn’t allowed, only selling. Perversely, the bank’s risk models, such as the notorious VAR used by all Wall Street banks, instructed traders to exit short positions, including credit default swaps.

  Weinstein knew that was crazy, but the quants in charge of risk couldn’t be argued with. “Step away from the model,” he begged. “The only way for me to get out of this is to be short. If the market is falling and you’re losing money, that means you are long the market—and you need to short it, as fast as possible.”

  He explained that the bank’s ability to see around the subprime model in 2007 had earned it a fortune. Now the right move was the same—think outside the quant box.

  It didn’t work. Risk management was on autopilot. The losses piled up, soon reaching nearly two billion. Saba’s stock trading desk was instructed to sell nearly every holding, effectively closing the unit down.

  Weinstein was rarely seen on Saba’s trading floors as his losses ballooned. The trader was holed up in his office for long periods of time, often late into the night, conferring with top lieutenants about how to stop the bleeding. No one had answers. There was little they could do.

  Paranoia took hold. It seemed as if the group could be shut down at any moment. Several of the group’s top traders, including the equity trader Alan Benson, were laid off. In late November, a trader was conducting a tour of Saba’s second-floor operation. “If you come back two weeks from now, this space will be empty,” he said.

  He was a little early, but not by much.

 
; A month after Greenspan’s testimony, in mid-November, Waxman’s committee grilled another group of suspects in the credit crisis: hedge fund managers.

  And not just any hedge fund managers. Waxman had summoned the top five earners of 2007 for a televised grilling about the risks the shadowy industry posed to the economy. The lineup, men whose take-home pay averaged $1 billion in 2007, included famed tycoon George Soros. Also on the hot seat was Philip Falcone, whose hedge fund, Harbinger Capital, boasted a 125 percent return in 2007 from a big bet against subprime. His gains paled beside those of fellow witness John Paulson, whose Paulson & Co. posted returns as high as nearly 600 percent from a massive wager against subprime, earning him a one-year bonanza of more than $3 billion, possibly the biggest annual return for an investor ever.

  The other two managers arrayed before Waxman’s House Committee on Oversight and Government Reform were Jim Simons and Ken Griffin. The quants had come to Capitol Hill.

  Griffin, for one, had prepared for his appearance with Citadel’s typical discipline. Having flown to Washington from Chicago on his private jet just that morning, he was coached by a battery of lawyers, as well as Washington power broker Robert Barnett. In 1992, Barnett had helped Bill Clinton prepare for the presidential debates, acting as the stand-in for George H. W. Bush. He’d acted as a literary agent for Barack Obama, former British prime minister Tony Blair, Washington Post reporter Bob Woodward, and George W. Bush’s defense secretary Donald Rumsfeld.

  The move was classic Ken Griffin. Money was no object. When he inevitably veered off script during his testimony, lecturing the congressmen on the value of unregulated free markets, that was also classic Ken Griffin.

  But for the most part, the hedge fund kingpins made nice, agreeing that the financial system needed an overhaul but shying away from calling for direct oversight of their industry. Soros expressed outright scorn for the hedge fund industry, made up of copycats and trend followers destined for extinction. “The bubble has now burst and hedge funds will be decimated,” Soros said in his gruff Hungarian accent, a gleeful prophet of doom. “I would guess that the amount of money they manage will shrink by between 50 and 75 percent.”