The Quants: How a New Breed of Math Whizzes Conquered Wall Street and Nearly Destroyed It (24 page)

Asness and a select group from Global Alpha, as well as Kabiller, started meeting at Rungsit, a Thai restaurant on the East Side of Manhattan. Over steaming bowls of tom yum soup and satay chicken they weighed the pluses and minuses of striking out on their own. Goldman paid well and offered long-term security. Asness had recently been made a partner. There were rumors of an IPO on the horizon, and all the money that would mean. But it still wouldn’t be their company.

At the end of the day, it seemed the choice was clear. Much of the conversation centered on what to call the new firm: Greek god? Mythical beast? True to their nerd roots, they settled on a name more blandly descriptive than colorful: Applied Quantitative Research Capital Management, AQR for short.

For a brief period Asness got cold feet. Goldman’s bigwigs were pressing him to stay. Goldman was his home. Kabiller was crushed, but there was nothing he could do to change Asness’s mind.

Then, one night in late 1997, Kabiller got a phone call.

“It’s Cliff.”

Kabiller knew something was up. Asness never made personal phone calls.

“How you doing?” Kabiller asked. He was smiling so hard his face hurt. There was a long pause. Kabiller could hear Asness breathing on the other end of the line. “You ready to do this now?”

“Yeah,” Asness said.

And that was it. In December 1997, just a few days after the bank handed out its bonuses, Cliff Asness, Robert Krail, David Kabiller, and John Liew turned in their resignations to Goldman’s management. Asness listened to the soundtrack from the Broadway play
Les Misérables
to psych himself up for the task. He didn’t want to change his mind again.

Less than a year later, on August 3, 1998, AQR was up and running with $1 billion in start-up capital—one of the largest hedge fund launches on record at that point, and three times as much as they’d originally projected they could raise. Indeed, Asness and company turned down more than $1 billion in
extra
cash because they weren’t sure their strategies could handle so much capital. Investors were desperate to get in. The charismatic French fund of funds manager Arpad “Arki” Busson, future beau of the supermodel Elle Macpherson and the actress Uma Thurman, offered the use of his Swiss chalet in exchange for capacity. AQR turned him down flat.

Indeed, AQR had the ideal hedge fund pedigree: University of Chicago quant geniuses, a plethora of pension fund and endowment clients through Kabiller, sterling Goldman Sachs credentials, mind-boggling returns …

“It was a total labor of love,” recalled Kabiller. “We knew our shit, we were prepared. We had the right blend of skills, we were the real deal.”

In its first month, AQR Capital, once described as a dream-team blend of Long-Term Capital Management and Julian Robertson’s Tiger
Management, scored a small gain. From there, it fell off a cliff. It was a disaster. The reason for AQR’s downturn was in many ways more unlikely than the chain of events that destroyed LTCM. Luck, it seemed, had abandoned Cliff Asness.

WEINSTEIN

A pair of black limos raced out of Las Vegas into the desert night. It was the fall of 2003, and Boaz Weinstein’s credit traders were celebrating at an off-site bonding session. The plan was to discuss the changing landscape of the credit markets, but this was Vegas. Weinstein’s traders were itching to cut loose.

“It was a lot of betting, a lot of drinking, a lot of blackjack,” said a former Deutsche Bank trader who worked under Weinstein.

After hitting the blackjack tables, where Weinstein won over and over again using the card-counting techniques he’d learned from
Beat the Dealer
, and playing hand after hand of high-stakes poker and roulette, they piled into rented stretch limos, popped open bottles of chilled champagne, and told the drivers to step on it. Their destination: that classic quant pastime, paintball.

At the paintball facility outside the city, the teams squared off. “Prop” traders, the gunslingers who did nothing but trade all day to earn money for the bank (and themselves), faced the “flow” traders, who had the less glamorous job of acting as go-betweens for clients of Deutsche Bank, matching up buy and sell orders that “flowed” through the firm. Flow traders were allowed to make side bets, making their lives somewhat worth living, but they were never able to put the real money on the line, the colossal billion-dollar balls-to-the-walls positions that could make a year or break it.

Weinstein led the prop paintballers. One of his top lieutenants, Chip Stevens, led the flow squad. Clad in T-shirts that read “Credit Derivatives Offsite Las Vegas 2003,” the Deutsche Bank credit quants donned their goggles and fanned out across the paintball obstacle course.

Naturally, the gunslingers were victorious. But it was all in good fun. Everyone piled back into their limos, guzzled more champagne,
and convened at Weinstein’s huge luxury suite at the Wynn Las Vegas, where the festivities—including a magician and mentalist recommended by Bear Stearns chairman Ace Greenberg—really began. If there was one thing Weinstein’s credit traders knew, it was that they understood how the game was played—and they played it better than anybody else. Blackjack was a joke. The real casino, the biggest in the world, was the booming global credit derivatives market. And they were playing it like a fiddle. The money was huge, the women were beautiful, and everyone was brilliant and inside the secret. Deutsche Bank had just been named Derivatives House of the Year by
Risk
magazine, topping the previous champ, J. P. Morgan, which started referring to Deutsche as “enemy number one.”

To Weinstein, ascending to the top wasn’t a surprise. They had developed an aggressive, no-holds-barred approach that the rest of the Street couldn’t match. And that was the real point of the Vegas trips, some of those attending thought. At Deutsche Bank, risk wasn’t fucking
managed
. Risk was bitch-slapped, risk was tamed and told what to do.

The traders lapped it up.

It was all happening. Weinstein’s dream of becoming an elite Wall Street trader, nurtured ever since he watched Louis Rukeyser on TV as a precocious chess prodigy on the Upper East Side, was coming true.

And it had been so very easy.

Just as AQR
was starting to trade in 1998, Weinstein had set up shop at Deutsche Bank’s fledgling credit derivatives desk. A mere twenty-four years old, he seemed nervous and a bit frightened by the frantic action of a trading floor. But he absorbed knowledge like a sponge and was soon able to spit out information about all kinds of stocks and bonds at will from his steel-trap photographic memory.

Weinstein’s expertise at his previous job had been in trading floating rate notes, bonds that trade with variable interest rates. It wasn’t much of a leap from there to credit default swaps, which act much like bonds with interest rates that swing up and down.

As Ron Tanemura had explained to Weinstein, traders can use the
swap to essentially bet on whether a company is going to default or not. Thus, an entirely new dimension had been introduced into the vast world of credit: the ability to short a loan or a bond. Buying protection on a bond through a credit default swap was, in essence, a short position. In a flash, the sleepy bond market became the hottest casino in the world—and Weinstein was right at home.

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.