The Quants

by Scott Patterson

  Illustrating the international nature of the crisis, an Australian hedge fund called Basis Capital Fund Management that had invested heavily in subprime securities collapsed. From there, the falling dominoes multiplied. Sowood, the hedge fund Ken Griffin had snapped up, fell by more than 50 percent in a matter of weeks. American Home Mortgage Investment, one of the nation’s largest mortgage lenders, saw its stock plunge nearly 90 percent after it warned it was having trouble accessing cash from the capital markets and might have to shut down. A week later, American Home filed for Chapter 11 bankruptcy protection.

  In early August, Countrywide Financial, the nation’s largest mortgage lender, warned of “unprecedented disruptions” in the credit market. The company said that while it had “adequate funding liquidity … the situation is rapidly evolving and the impact on the company is unknown.”

  All the bad news made it clear that many CDOs were worth far less than most had thought. The losses proved jaw-droppingly large. Later that year, Morgan took a loss of $7.8 billion, much of it from Hubler’s desk.

  The losses in high-rated tranches of CDOs—the superseniors—devastated the balance sheets of banks in the United States and overseas and were a primary cause of the credit meltdown that swept the financial system starting that summer. The CDO machine, and the highly leveraged house of cards built upon it, cascaded into a black hole. Trading dried up, and pricing for CDOs became nearly impossible due to the complex, misused models such as the Gaussian copula.

  As the mortgage market imploded, quant funds such as AQR, Renaissance, PDT, Saba, and Citadel believed they were immune to the trouble. Renaissance and PDT, for instance, didn’t dabble in subprime mortgages or credit default swaps. They mostly traded stocks, options, or futures contracts, which had little to do with subprime. Citadel, AQR, and Saba believed they were the smart guys in the room and had either hedged against losses or were on the right side of the trade and were poised to cash in.

  Deutsche Bank, for example, was cashing in on Weinstein’s bearish bet, which eventually made about $250 million for the bank. A thirty-six-year-old colleague named Greg Lippmann had also placed a huge bet against subprime that would earn the bank nearly $1 billion. Lippmann’s colleagues could be seen wearing gray T-shirts around the trading floor that read “I Shorted Your House” in bold black letters.

  Weinstein, poised to cash in on his bets, threw a party at his Southampton digs on July 28, a warm summer Saturday night. A row of tiki torches illuminated the unassuming front of Weinstein’s two-story cottage. Guests lounged under a white tent in the expansive backyard as they sipped white wine from self-illuminated cocktail glasses. Weinstein, dressed in a jet-black button-down shirt, trim brown hair slicked back to reveal his pale, broad forehead, was relaxed and confident as he mingled with his well-heeled guests.

  Two days later, the credit crisis that had been building for years would explode with full force. With Muller back from his self-imposed exile, Asness poised to make untold millions with AQR’s IPO, Weinstein planning to break away from Deutsche to launch his own hedge fund powerhouse, and Griffin ready to vault into the highest pantheon of the investing universe, the stakes were as high as they’d ever been for the small band of quants.

  At the start of August 2007, the nation was treated to the typical midsummer news lull. The junior senator from Illinois, Barack Obama, gave a speech in Washington declaring that the United States should shift its military focus away from the Iraq war to fight Islamic extremism. More than a dozen people drowned near Minneapolis after the Mississippi River flooded. Starbucks said its quarterly profits rose 9 percent and that it planned to open another 2,600 stores in fiscal 2008. Barbie and Hot Wheels maker Mattel said it was recalling one million toys made in China, including Elmo Tub Sub and Dora the Explorer figures, because they contained lead.

  But beneath the calm surface, a cataclysm was building like magma bubbling to the surface of a volcano. All the leverage, all the trillions in derivatives and hedge funds, the carry-trade cocktails and other quant esoterica, were about to explode. Those close enough to the action could almost feel the fabric of the financial system tearing apart.

  On the afternoon of August 3, a Friday, a torrential downpour hit New York City like a fist. As the rain fell, CNBC talk-show host and onetime hedge fund jockey Jim Cramer had a televised fit of hysteria in which he accused the Federal Reserve of being asleep at the switch. “These firms are going to go out of business! They’re nuts, they’re nuts! They know nothing!” he screamed into the stunned face of his colleague, Erin Burnett. Cramer raved about calls he’d been fielding from panicked CEOs. Firms were going to go bankrupt, he predicted. “We have Armageddon in the fixed-income markets!”

  Viewers were stunned and unnerved, though most couldn’t begin to fathom what he was raving about. One of the CEOs Cramer had been talking to was Angelo Mozilo, CEO of the mortgage giant Countrywide Financial. The Dow Jones Industrial Average gave up 281 points, most of which came after Cramer’s outburst. Over a sultry August weekend, Wall Street’s legions of traders, bankers, and hedge fund titans tried to relax, hopping in their Bentleys and BMWs, their Maseratis and Mercedeses, and retreating to the soft sands of the Hamptons beaches or jetting away for quick escapes to anywhere but New York City or Greenwich. They knew trouble was coming. It struck Monday with the force of a sledgehammer.

  Cliff Asness walked to the glass partition of his corner office and frowned at the rows of cubicles that made up AQR’s Global Asset Allocation group.

  GAA was replete with hotshot traders and researchers who scoured the globe in search of quantitative riches in everything from commodity futures to currency derivatives. On the other side of the building, separated by a wall that ran down the middle of the office, AQR’s Global Stock Selection team labored away. A job at GSS could be rough. It involved the grunt work of combing through reams of data about stock returns and the grueling task of hoping to find some pattern that the thousands of other Fama-bred quants hadn’t found yet.

  That Monday afternoon, August 6, 2007, something was going wrong at GSS. The stocks its models picked to buy and sell were moving in strange directions—directions that meant huge losses to AQR.

  Asness snapped shut the blinds on the glass partition and returned to his desk. He reached out and clicked his mouse, bringing his computer screen to life. There it was in bright red digits. The P&L for AQR’s Absolute Return Fund. Sinking like a rock.

  Throughout AQR, the hedge fund’s legions of quants also were mesmerized by the sinking numbers. It was like watching a train wreck in slow motion. Work had ground to a halt that morning as everyone tried to assess the situation. Many of the fund’s employees walked about the office in a confused daze, turning to one another in hope of answers.

  “You know what’s going on?”

  The answer was always the same: “No. You?”

  Rumors of corporate collapses were making the rounds. Banks and hedge funds were reeling from their exposure to toxic subprime mortgages. Countrywide Financial, some said, was imploding and looking in desperation for a white knight, such as Warren Buffett’s Berkshire Hathaway or Bank of America. But no one wanted anything to do with the distressed mortgage lender.

  Inside his office, Asness again stared grimly at his computer screen. Red numbers washed across it. He didn’t know what to do. His greatest fear was that there was nothing he could do.

  Outside, people noticed the closed blinds on the boss’s office. It was unusual and a bit spooky. Asness always had an open-door policy, even if very few people used it. Employees figured Asness couldn’t stand the idea of his employees peeking in through the window to see how the big guy was taking it.

  The registration statements for AQR’s initial public offering were ready and waiting to be shipped off to the SEC. Indeed, Asness was set to make the big announcement about his plans later that month, making headlines in all the important papers. But now, the IPO and all the money it would have spun off were getting m
ore distant by the second, a distance measured by the tick-by-tick decline of Absolute Return, as well as a number of other funds at AQR that were getting pounded by the mysterious downturn.

  Several blocks away from AQR’s office, Michael Mendelson, head of global trading, was in line at the local Greenwich Subway sandwich shop. He glanced at his BlackBerry, which came equipped with a real-time digital readout of all of AQR’s funds. His jaw dropped. Something bad was happening. Something horrible.

  A longtime Goldman Sachs veteran, mastermind of the bank’s elite high-frequency trading outfit, Mendelson was one of the brightest thinkers at AQR, and one of the first people Asness would call when he needed answers about a trade going awry. He knew instantly that something needed to be done fast to stem the bleeding.

  He raced back to AQR’s office and huddled with several of AQR’s top traders and researchers, including Jacques Friedman, Ronen Israel, and Lars Neilson. After determining that a huge deleveraging was taking place, directly impacting AQR’s funds, they marched to Asness’s office.

  “It’s bad, Cliff,” Mendelson said, stepping into the room. Friedman, Israel, and Neilson followed close behind. “This has the feel of a liquidation.”

  “Who is it?” Asness said.

  “We’re not sure. Maybe Global Alpha.”

  “Oh God, no.”

  Since Asness had left Goldman in 1998, Global Alpha had been run by Mark Carhart and Ray Iwanowski, alums, like Asness, of the University of Chicago’s finance program, and Fama protégés. Under their guidance, Global Alpha had expanded its reputation as one of the smartest investing outfits on Wall Street. It never had a losing year through 2005, when it posted an eye-popping return of 40 percent.

  But Global Alpha had been slipping, losing money in 2006 and the first half of 2007. The worry: to reverse its fortunes, it was juicing up its leverage. And the more leverage, the more risk. Many feared that Global Alpha and its sister fund, Global Equity Opportunity—a stock-focused fund—were doubling down on bad trades with more and more borrowed money.

  “They’re one of the few funds big enough to leave such a big footprint.” Mendelson hunched his shoulders in frustration.

  “Have you talked to anyone over there?”

  “No,” Mendelson said. “I was going to ask you.”

  “I’ll give it a shot.”

  There had been no small amount of bad blood between Asness and his old colleagues at Goldman, who were embittered after being left behind when Asness and the others bolted. Asness felt bad about it all, but he hadn’t wanted to alienate the head honchos at Goldman by leading a mass exodus. Leaving behind Carhart and Iwanowski to manage Global Alpha, he’d hoped, was a peace offering to the company that had rolled the dice on him when he was fresh meat out of Chicago. But Carhart and Iwanowski weren’t overjoyed about being the sacrificial lambs.

  The tensions had cooled over the years. Global Alpha had developed into an elite trading outfit, with $12 billion in assets and a solid record—except for a severe misstep in 2006—that could go head-to-head with the best hedge funds in the business, including AQR.

  Asness put in a few calls to Goldman, but no one was picking up the phone. That made him more worried than ever.

  Boaz Weinstein was relaxed that Monday after the weekend bash at his house in the Southhamptons. But soon after lunch, he started to fret. Something was going wrong with Saba’s quant equities desk, which he’d added to his operation to complement his bond-trading group. The news trickled in around two o’clock when Alan Benson, the trader who ran the desk, sent his second daily email with his desk’s P&L.

  Benson’s first email, sent at 10:00 A.M., showed early signs of losses. But Weinstein had shrugged it off. Benson’s desk, which managed $2 billion worth of positions in stocks and exchange-traded funds, could be highly volatile. Losses in the morning could easily turn into gains by the afternoon.

  The 2:00 P.M. update showed the losses hadn’t turned to gains. They’d gotten much worse. Benson was down tens of millions. Weinstein stood and walked one floor down to Saba’s trading operation on the second floor. Benson looked tense and was sweating.

  “What’s up, Alan?” Weinstein said, outwardly calm as always. But there was tension in his voice caused by the startling sight of millions of dollars going up in smoke, just like the GM trade back in 2005.

  “It’s weird,” Benson said. “Stocks that we’re betting against are going up, a lot. Looks like short covering on a really big scale, across a lot of industries.”

  In a short sale, an investor borrows a stock and sells it, hoping to purchase it back at a lower price sometime in the future. Say IBM is trading at $100 a share and you expect it to decline to $90. You borrow a hundred shares from another investor through a prime broker and sell them to yet another investor for $10,000. If your crystal ball was correct and IBM does in fact fall to $90, you buy the stock back for $9,000, return the shares to the broker, and pocket the $1,000.

  But what if, for instance, IBM starts to shoot higher? You’re on the hook for those shares, and every dollar it goes up is a $100 loss. To minimize your losses, you buy the stock back. That can have the effect of pushing the stock even higher. If hundreds or thousands of short sellers are doing this at once, it turns into what’s known as a short squeeze. That Monday, August 6, was beginning to look like possibly the biggest short squeeze in history.

  “Has the feel of a big gorilla getting out of a lot of positions, fast,” Benson added.

  “Anything we can do about it?”

  “Keep an eye on it. I doubt this will last much longer. The rate this guy is unwinding his trades, it can’t go on for long. If it does …”

  “What?”

  “We’ll have to start unwinding, too.”

  At PDT that same Monday, Peter Muller was AWOL, visiting a friend just outside Boston. Mike Reed and Amy Wong manned the helm, PDT veterans from the old days when the group was nothing more than a thought experiment, its traders a small band of young math whizzes tinkering with computers like brainy teenagers in a cluttered garage.

  PDT was now a global powerhouse, with offices in London and Tokyo and about $6 billion in assets (the amount could change daily depending on how much money Morgan funneled its way). It was a well-oiled machine that did little but print money, day after day. That week, however, PDT wouldn’t print money—it would destroy it like an industrial shredder.

  The unusual behavior of stocks that PDT tracked had begun to slip sometime in mid-July and had gotten worse in the first days of August. The previous Friday, five of the biggest gainers on the Nasdaq were stocks that PDT had sold short, expecting them to decline, and five of the biggest losers were stocks PDT had bought, expecting them to rise. It was Bizarro World for quants. Up was down, down was up. The models were operating in reverse. The Truth wasn’t the Truth anymore. It was the anti-Truth.

  The losses were accelerating Monday and were especially bad in the roughly $5 billion quant fundamental book—the one PDT had increased in size after Muller returned in late 2006.

  Wong and Reed knew that if the losses got much worse, they would need to start liquidating positions in the fundamental book to bring down PDT’s leverage. Already the week before, the group had started to ease back on Midas’s engine as the market’s haphazard volatility picked up steam.

  Midas was one thing. It was a high-frequency book that bought and sold securities at a rapid pace all the time. The fundamental book was different. The securities it held, often small-cap stocks that didn’t trade very often, could be hard to get rid of, especially if a number of other traders who owned them were trying to dump them at the same time. The positions would need to be combed through and unwound piece by piece, block by block of unwanted stock. It would be hard, it would be time-consuming, and it would be very costly.

  The market moves PDT and other quant funds started to see early that week defied logic. The fine-tuned models, the bell curves and random walks, the calibrated correlations—all
the math and science that had propelled the quants to the pinnacle of Wall Street—couldn’t capture what was happening. It was utter chaos driven by pure human fear, the kind that can’t be captured in a computer model or complex algorithm. The wild, fat-tailed moves discovered by Benoit Mandelbrot in the 1950s seemed to be happening on an hourly basis. Nothing like it had ever been seen before. This wasn’t supposed to happen!

  The quants did their best to contain the damage, but they were like firefighters trying to douse a raging inferno with gasoline—the more they tried to fight the flames by selling, the worse the selling became. The downward-driving force of the deleveraging market seemed unstoppable.

  Wong and Reed kept Muller posted on the situation through emails and phone calls. It would be Muller’s decision whether to sell into the falling market to deleverage the fund, and by how much. Volatility in the market was surging, confusing PDT’s risk models. Now Muller needed to decide whether to deleverage the fundamental book, which was taking the brunt of the damage. If the losses in that book continued much longer, PDT had little choice but to start selling. It would mean cutting off branches in the hope of saving the tree.

  Quant funds everywhere were scrambling to figure out what was going on. Ken Griffin, on vacation in France, kept in touch with the traders at Citadel’s Chicago headquarters. Renaissance was also taking big hits, as were D. E. Shaw, Barclays Global Investors in San Francisco, J. P. Morgan’s quant powerhouse Highbridge Capital Management, and nearly every other quantitative fund in the world, including far-flung operations in London, Paris, and Tokyo.

  Tuesday, the downturn accelerated. AQR booked rooms at the nearby Delamar on Greenwich Harbor, a luxury hotel, so they could be available around the clock for stressed-out sleep-deprived quants. Griffin hopped in his private plane and flew back to Chicago for crisis management, and to tie up loose ends on the Sowood deal.

  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.”