The Quants

by Scott Patterson

  Because the derivative was so new, few other banks were trading it in heavy volume. To help gin up volume, Weinstein started to make trips to other trading outfits across Wall Street, such as the giant money manager BlackRock, talking up the remarkable traits of the credit default swap.

  In 1998, he was essentially shorting the credit market, buying insurance on all kinds of bonds through swaps. Because he was buying insurance—which would pay off if investors started worrying about the creditworthiness of the bond issuers—he was in a perfect position to capitalize on the turmoil that shot through the market after Russia defaulted on its debt and LTCM collapsed. He made a nice profit for Deutsche Bank, catapulting his career.

  In 1999, Deutsche Bank promoted him to vice president. In 2001, he was named a managing director at the age of twenty-seven, one of the youngest to reach the title in the history of the German bank.

  Weinstein and his fellow derivatives dealers got help from regulators, who were rapidly deregulating. In November 1999, the Glass-Steagall Act of 1933, which had cleaved the investment banking and commercial banking industry in two—separating the risk-taking side of banks from the deposit side—was repealed. Giant banks such as Citigroup had argued that the act put them at a disadvantage compared to overseas banks that didn’t have such restrictions. For Wall Street’s growing legions of proprietary traders, it meant access to more cash; also, those juicy deposits could be used as fodder for prop desk exploits. Then, in December 2000, the government passed legislation exempting derivatives from more intense federal scrutiny. The way had been cleared for the great derivatives boom of the 2000s.

  A big test of the credit default swap market came in 2000, when the California utilities crisis struck and prices soared due to rampant shortages. Suddenly there was the real possibility that a number of large power companies could default. The implosion of Enron in late 2001 was another test of the market, which demonstrated that the credit derivatives market could withstand the default of a major corporation. The telecom meltdown and the collapse of WorldCom was another trial by fire.

  The new credit derivatives market had shown that it could function properly, even under stress. Trades were settled relatively quickly. Skeptics were proven wrong. The credit default swap market would soon be one of the hottest, fastest-growing markets in the world. Few traders would be as well versed at it as Weinstein, who began putting together one of the most successful and powerful credit derivatives trading outfits on Wall Street.

  By 2002, the economy was in a ditch. With formerly blue chip companies such as Enron and WorldCom unraveling, the worry was that anything could happen. Investors started feeling anxious about the largest media company in the world at the time, AOL Time Warner. Debt holders, especially, were panicking, while the stock was down less than 20 percent.

  One day Weinstein was strolling past AOL’s headquarters near Rockefeller Center. Thinking several steps into the future, much like a chess player plotting his strategy multiple moves in advance, he realized that while the stock had fallen about 20 percent, the collapse in its bond prices was far too severe, as if the company were on the verge of bankruptcy. Such a catastrophe was unlikely for a company with so many long-standing, relatively profitable businesses, including the television networks CNN and HBO. Deciding that the company had a good chance of surviving the turmoil, he purchased AOL bonds while shorting the stock to hedge the position. The bet turned into a huge home run as the bond market, and AOL (now simply Time Warner), recovered.

  Gambling became a way of life for Weinstein’s crew. One of his first hires was Bing Wang, who went on to finish in thirty-fourth place in the World Series of Poker in 2005. Weinstein learned that several traders at Deutsche were members of MIT’s secretive blackjack team. He was soon joining them a few times a year to hit the blackjack tables in Las Vegas, deploying the skills he’d learned reading Thorp’s Beat the Dealer in college. People who know Weinstein say his name is on more than one Vegas casino’s list of players banned for card counting.

  In their downtime, Weinstein’s traders would randomly bet on just about anything in sight: a hundred on the flip of a coin, whether it would rain in the next hour, whether the Dow would close up or down. A weekly poker game with a $100 buy-in started up off Deutsche Bank’s trading floor. Every Friday after the closing bell struck, Weinstein’s traders would gather in a conference room and face off against one another for hours.

  Deutsche’s top managers either didn’t know about the poker game or simply winked at it. It hardly mattered. Since Deutsche was a German company, most of its upper management was based in London or Frankfurt, Germany’s financial hub. Weinstein became the seniormost member of the fixed-income side of the bank in New York. His traders had the run of the bank’s headquarters on 60 Wall Street and by many accounts were running amok. With a young, freewheeling boss who liked to gamble, and billions in funds at the tips of their fingers, Deutsche’s New York trading operation became one of the most aggressive trading outfits on the Street, the shimmering essence of cowboy capitalism.

  Weinstein was also honing his poker skills. In 2004, he attended the second annual Wall Street Poker Night at the St. Regis Hotel. He’d heard about a private poker game run by several of Wall Street’s top quant traders and hedge fund managers, including Peter Muller, Cliff Asness, and a rising star named Neil Chriss. A veteran of Goldman Sachs Asset Management, Chriss at the time was working at SAC Capital Advisors, a giant hedge fund in Stamford, Connecticut.

  At the St. Regis, Weinstein approached Chriss. He mentioned that he’d heard about the game, and that he’d love to sit in on a few hands. Chriss hesitated. There was no official “membership” in the quant poker game, but there was little doubt that the game was highly exclusive. It was a high-stakes game, with pots in the tens of thousands. One of the key qualifications for players was that losing couldn’t matter financially. Egos might be bruised. Self-esteem might slip a notch. But the hit to the wallet needed to be trivial. That required an epic bank account, eight digits minimum. Players had to be able to walk away ten, twenty grand short, and not care. Did Weinstein have the financial chops? Chriss decided to invite him, test him out—and the boy-faced Deutsche Bank credit-default-swap whiz turned out to be an instant hit. Not only was he an ace cardsharp, he was also one of the savviest investors Chriss, Muller, and Asness had ever met. Soon Weinstein was a permanent member of the quant poker group, part of the inner circle.

  All the practice paid off. In 2005, Weinstein’s boss, Anshu Jain, flew to meet with Berkshire Hathaway chairman Warren Buffett in Omaha, Nebraska, to discuss a number of the bank’s high-profile trades, including Weinstein’s. The two moguls were chatting about one of their favorite pastimes, bridge, and the conversation eventually switched to poker. Jain mentioned that Weinstein was Deutsche Bank’s poker ace. Intrigued, Buffett invited Weinstein to an upcoming poker tournament in Las Vegas run by NetJets, the private-jet company owned by Berkshire.

  Weinstein made his boss proud, winning the tournament’s grand prize: a spanking new Maserati. Still, gambling was just a pastime, a mental curiosity or warm-up for the real deal. Weinstein’s main focus, his obsession, remained trading—winning, crushing his opponents, and making money, huge money. He loved it. Soon he started expanding his operation into all kinds of markets, including stocks, currencies, and commodities—much as Ken Griffin was creating a diversified multistrategy fund at Citadel (Weinstein seemed to be modeling his group after Citadel). His signature trade was a strategy called “capital structure arbitrage,” based on gaps in pricing between various securities of a single company. For instance, if he thought its bonds were undervalued relative to its stock, he might take bullish positions on the bonds and simultaneously bet against the stock, waiting for the disparity to shrink or vanish. If his long position on the debt fell through, he’d be compensated on the other side of the trade when the stock collapsed.

  Weinstein was looking for inefficiencies in firms’ capital structure
s, their blend of debt and stock, and used credit default swaps in creative ways to arb the inefficiencies. It was the old relative-value arbitrage trade, much like that crafted by Ed Thorp in the 1960s, wrapped in fancy new derivative clothes. But it worked like clockwork. Weinstein’s group was racking up millions.

  Then it all nearly fell apart in 2005 when the market didn’t behave exactly as Weinstein’s models had predicted.

  It was May 2005. Weinstein stared in disbelief at one of several computer screens in his third-floor office. A trade was moving against him, badly.

  Weinstein had recently entered one of his signature capital structure arbitrage trades on General Motors. GM’s shares had tumbled in late 2004 and early 2005 as investors worried about a possible bankruptcy and the auto giant hemorrhaged cash. GM’s debt was also getting crushed—too much, Weinstein thought. GM’s debt had been pummeled so much that it seemed as though investors thought the automaker would go bankrupt. Weinstein knew that even if the company declared bankruptcy, debt holders would still receive at least 40¢ on the dollar, likely a lot more. The shares, however, would be worthless.

  So he decided to sell protection on GM’s debt through a credit default swap, collecting a steady fee to insure the bonds. If GM did declare bankruptcy, Deutsche Bank would be on the hook. To hedge against such a possibility, Weinstein shorted GM’s stock, which was trading for about $25 to $30 a share.

  But now, in a flash, the trade was looking like a disaster. The reason: a billionaire investor named Kirk Kerkorian had made a surprise tender offer for twenty-eight million GM shares through his investment company, Tracinda Corp., causing the stock to surge—and crushing short sellers such as Weinstein.

  If that weren’t enough, several days later, the rating agencies Standard & Poor’s and Moody’s downgraded GM’s debt to junk, forcing a number of investors to sell it.

  That meant both sides of Weinstein’s trade were going against him, hard. The debt was plunging and the stock was soaring. It was incredible, and it wasn’t how the market was supposed to work. There was little he could do about it except wait. The market is irrational, he thought, and Kerkorian is nuts. Eventually things will move back into line. The Truth will be restored. In the meantime, Weinstein needed to figure out what to do.

  Weinstein and his traders huddled at the New York apartment of one of his top lieutenants. On the table: what to do about the GM trade. Some in the room argued that it was too risky and that they should take the loss and get out. If the position kept moving against them, the losses could become unsustainable. The bank’s risk managers would only allow things to go so far.

  Others took the other side. Bing Wang, the poker expert, said that the trade was more attractive than ever. “Load the boat,” Wang said, trader lingo for doubling down.

  Weinstein decided to play it safe at first, but over the following months the group kept adding to the GM trade, expecting things to eventually move back into line.

  And they did. By the end of 2005, Weinstein’s GM trade had paid off. It did even better in 2006. GM’s stock fell back to earth, and the debt recovered much of the ground it lost in the wake of the rating agency’s downgrade.

  It was a lesson Weinstein wouldn’t soon forget. While his arbitrage trades were incredibly clever, they could spin out of control due to chance outside events. But if he could hold on long enough, they’d pay off. They had to. The market couldn’t avoid the Truth.

  Or so he thought.

  By the early 2000s, the hedge fund industry was poised for a phenomenal run that would radically change the investment landscape around the world. Pension funds and endowments were diving in, and investment banks were expanding their proprietary trading operations such as Global Alpha at Goldman Sachs, PDT at Morgan Stanley, and Boaz Weinstein’s credit-trading shop at Deutsche Bank. Hundreds of billions poured into the gunslinging trading operations that benefited from an age of easy money, globally interconnected markets on the Money Grid, and the complex quantitative strategies that had first been deployed by innovators such as Ed Thorp more than three decades before.

  Thorp, however, saw the explosion of hedge funds as a dark omen. So much money was flooding into the field that it was becoming impossible to put up solid returns without taking on too much risk. Copycats were operating everywhere in a field he’d once dominated. In October 2002, he closed shop, shutting down his stat arb fund, Ridgeline Partners.

  Other traders weren’t so inclined—especially Ken Griffin, whose Citadel Investment Group, the fund Thorp had helped start more than a decade before, was quickly becoming one of the most powerful and feared hedge funds in the world.

  GRIFFIN

  As Ken Griffin settled down into married life, Citadel kept growing like a very complex, digitized weed. The Chicago hedge fund had become one of the most technologically advanced trading machines on the street, hooked like a heroin addict into the Money Grid, with offices in Chicago, San Francisco, New York, London, Tokyo, and Hong Kong and more than a thousand employees. It had its own generator on the roof of 131 South Dearborn Street, the skyscraper it occupied, to ensure its computer systems could function in a blackout. The primary computer room was equipped with a system that could drain the room of oxygen in seconds in case of fire. Some thirty miles from the office, in a secret location in the town of Downers Grove, a redundant computer system hummed quietly. Every personal computer in the office—each one top of the line—had been partially walled off so that it could be accessible to a systemwide program that crunched the numbers of the fund’s massive mortgage positions, creating a virtual “cloud” computer that churned in cyberspace twenty-four hours a day.

  Griffin was quietly building a high-frequency trading machine that would one day become one of Citadel’s crown jewels and a rival to PDT and Renaissance’s Medallion fund. In 2003, he’d hired a Russian math genius named Misha Malyshev to work on a secretive stat arb project. At first, the going was tough, and profits were hard to come by. But on July 25, 2004, the operation, which came to be named Tactical Trading, kicked into gear, posting gains that went up all day. After that, it almost never stopped going up, spitting out consistent returns with very little volatility. Malyshev focused on speed, leveraging Citadel’s peerless computer power to beat competitors to the punch in the race to capture fleeting arbitrage opportunities in the stock market.

  The same year that Tactical started turning a profit, Griffin hired Matthew Andresen, a whiz kid who’d launched an electronic trading platform called Island ECN, to turbocharge Citadel’s technology and trading systems. Under Andresen, the hedge fund’s options market–making business, known as Citadel Derivatives Group Investors, would soon become a cash cow, the largest listed options dealer in the world.

  Griffin was steadily turning Citadel into far more than a hedge fund—it was becoming a sprawling financial juggernaut controlling the flow of billions in securities. Griffin’s ambitions were expanding right along with Citadel’s assets, which had neared $15 billion.

  Like any power broker, Griffin was making his share of enemies. Citadel was scooping up more and more talented traders and researchers from other hedge funds. That infuriated one notoriously testy and outspoken competitor, Daniel Loeb, manager of Third Point Partners, a New York hedge fund. In 2005, Citadel hired Andrew Rechtschaffen, a star researcher for Greenlight Capital, the fast-rising fund managed by David Einhorn, one of the regulars, along with Griffin, at the Wall Street Poker Night. Loeb, a friend of Einhorn’s, shot off an email to Griffin packed with a seething rage that indicated more was going on than just the filching of a star researcher.

  “I find the disconnect between your self-proclaimed ‘good to great, Jim Collins–esque’ organization and the reality of the gulag you created quite laughable,” Loeb wrote, referring to the popular management guru. “You are surrounded by sycophants, but even you must know that the people who work for you despise and resent you. I assume you know this because I have read the employment agreements that you
make people sign.”

  Griffin was unfazed. Great men were bound to make enemies. Why sweat it?

  But there was the cutting edge of truth to Loeb’s attack. Turnover at Citadel was high. Griffin was grinding up employees and spitting them out like a meat factory. The pressure to succeed was intense, the abuse over failure dramatic. Departures from the fund were often bitter, dripping with bad blood.

  Worse, returns for the fund weren’t what they used to be. In 2002, Citadel’s flagship Kensington Fund gained 13 percent, and annual gains slipped below 10 percent the next three years. Part of the reason, Griffin suspected, was an explosion of money flowing into hedge fund strategies—the same strategies Citadel used. Indeed, it was that very factor that had influenced Ed Thorp’s decision to close up shop. Imitation may be the sincerest form of flattery, but it doesn’t do much for the bottom line in hedge fund land.

  That’s not to say that work at Citadel turned into a life sentence in a gulag, as Loeb would have it (though some ex-employees might dispute that). The fund tossed lavish parties. A movie buff, Griffin frequently rented out theaters at Chicago’s AMC River 24 for premieres of films such as The Dark Knight and Star Wars Episode III: Revenge of the Sith. The money was head-spinning. Employees may have left Citadel bitter; they also left rich.

  Concern was also mounting about an issue far more serious than interindustry squabbles: whether Citadel posed a risk to the financial system. Researchers at a firm called Dresdner Kleinwort wrote a report posing questions about the elephantine growth of Citadel and arguing that its heavy-handed use of leverage could destabilize the system. “At face value, and without being able to look into the black box, the balance sheet of today’s Citadel hedge fund looks quite similar to LTCM,” the report stated ominously.