The Quants: How a New Breed of Math Whizzes Conquered Wall Street and Nearly Destroyed It (40 page)

He knew it.

It was
an unusually warm morning in Chicago in November 2007 as Ken Griffin walked briskly toward his private jet, which was prepped for the two-hour flight to New York City. As he was boarding the plane, he got an urgent call from Joe Russell, head of Citadel’s credit investments operation.

A big Citadel holding, online broker E*Trade Financial, was getting crushed in the market, Russell told him. Its shares, having tumbled
nearly 80 percent that year already, had been cut in half yet again just that morning, a Monday.

“We need to focus on this fast,” Russell said. A savings and loan owned by E*Trade had been dabbling in subprime mortgages, and now it was paying the price. There was talk of bankruptcy for the former dot-com darling. Russell said Citadel should start buying shares of E*Trade to stabilize the market.

“Let’s go,” Griffin said, giving the plan the thumbs-up.

Within days, Griffin, along with a crack team of sixty Citadel analysts and advisors, swept into E*Trade’s New York headquarters, just a few blocks from Citadel’s New York branch, and pored over its books. Griffin racked up the miles on his Global Explorer, flying to New York in the morning and jetting back to Chicago at night three times during the talks.

On November 29, just weeks after that first call from Russell, a deal was struck. Citadel agreed to invest roughly $2.6 billion in the company. It purchased $1.75 billion worth of E*Trade shares and notes with a fat interest rate of 12.5 percent. It also snapped up a $3 billion portfolio of mortgages and other securities from the online broker for what seemed like a bargain-basement price of $800 million. The investment represented about 2.5 percent of Citadel’s investment portfolio.

Griffin was certain the market had become overly pessimistic, and he sensed a fantastic buying opportunity. He’d seen markets like this before, when panicked sellers dump good assets while the savvy investors sit back and pick them off. Like AQR, Citadel was in many ways a value investor gobbling up battered assets, expecting them to surge ahead once the smoke cleared, once the Truth was recognized by the masses.

“The market is pricing assets like things are going to get really bad,” Griffin told the
Wall Street Journal
soon after the deal. “But the more likely outcome is for the economy to slow for two or three quarters, and then strengthen.”

The E*Trade deal was the biggest in Griffin’s career, another headline-grabbing coup on top of the Amaranth trade of 2006 and the
Sowood rescue in July. Adding to the pressure, his wife, Anne Dias Griffin, was due to give birth to the first scion of the Griffin dynasty in December.

Griffin showed little sign of stress, however. The blue-eyed billionaire seemed to be hitting on all cylinders. The speed with which he completed the E*Trade deal was the envy of competitors who lacked the mental muscle and sheer guts—not to mention the cash—to pull it off. Griffin had moved into the rarefied big leagues of money managers able to shift billions at the drop of a hat to take advantage of distressed companies willing to do anything, to sell at any price, in order to survive.

Meanwhile, Citadel’s high-frequency powerhouse, Tactical Trading, run by the Russian math whiz Misha Malyshev, continued to rack up gains despite the August quant quake. It was on track to pull in $892 million in 2007, and even more the following year. The firm’s options trading business run by Matthew Andresen, Citadel Derivatives Group, was also raking in cash, having grown to become the largest options market maker in the world. Griffin, who personally owned a large chunk of each business, decided to split Tactical and the derivatives group out of his hedge-fund operations. The move helped diversify Citadel’s business lines ahead of the planned IPO.

It also helped Griffin get a bigger chunk of Tactical, which was becoming one of the most consistently profitable business lines at the fund, if not in the world. Investors in the hedge fund were given the chance to put cash into Tactical, but it had to be in addition to their current investments. About 60 percent of investors took Griffin up on the offer. The rest of the fund’s capacity was taken by Citadel head honchos—mostly Griffin.

In the fund’s annual town hall meeting for Citadel’s staff at the Chicago Symphony Orchestra that November, Griffin was riding high. Citadel was in charge of roughly $20 billion in assets. It had dominated competitors in 2007, gaining 32 percent despite the quant meltdown in August. The firm had pulled off its E*Trade coup the week before, and the Sowood deal was shaping up nicely. Citadel’s stock-options electronic market-making business had become the biggest in the world.

Speaking before the troops, roughly four hundred in all, Griffin was like a charged-up football coach preparing his team for the biggest game of their lives. After ticking off Citadel’s accomplishments, Griffin shifted into corporate manager cliché mode. “Success has never been measured in home runs,” he said, “it’s the singles and doubles that got us here and will take us beyond. The best times are yet to come. Yes, there will be obstacles, but obstacles are opportunities for people who know how to get the job done. If you’re up for that, you’re in the right place.”

The well-heeled crowd clapped and cheered. Griffin may be a hard driver, even a ruthless megalomaniac, but he was a winner and had made everyone in the room incredibly wealthy. Citadel seemed on the cusp of greatness. The downturn the economy was suffering from the collapse in the housing market would be short-lived, Griffin thought, a brief hiccup in the global economy’s unstoppable growth cycle. Indeed, he believed he could already see the light at the end of the tunnel. Good times were coming soon.

There’s an old Wall Street proverb about such opportunism: the light at the end of the tunnel is an oncoming train. Ken Griffin was stepping right in front of it.

“Aaargh!”

Cliff Asness leapt from the card table, grabbed the first lamp in reach, and smashed it against the wall. He stood seething before the wide hotel window. It was late 2007, and a light dusting of snow fell over New York. Christmas lights adorned a number of the apartment windows of the luxury high-rise across from the hotel.

“What the hell is wrong with you?” Peter Muller said, looking up, startled, from his seat at the table.

There he goes again. Asness had lost another hand. Bad luck. But why did he care so much? What was with the temper tantrums? Asness’s hedge fund made its money based on math, on cold-blooded rationality that ruthlessly cuts away the irrational, human element of trading. But when the chips were down at the poker table, Asness lost it.

Neil Chriss shook his head. “Cliff, you make and lose that much
in a matter of minutes every day,” he said. “I think some perspective is in order.”

Why did Asness always take losing so personally? Why did he get so angry? He’d always had a temper, and hated to lose, especially to other quants.

“Screw it,” Asness said, breathing heavily as he moved back to the card table.

In the previous year, Asness had been increasingly prone to outbursts. The pots seemed to keep rising, easily hitting five digits, sometimes more. Not that Asness couldn’t afford it. He was the richest guy in the room. But his fortunes seemed to be dwindling every day as AQR hemorrhaged cash. And Asness’s skills at the poker table seemed to track AQR’s P&L—they waned at the same time his fund started to skid. Just my luck, he thought. Or lack of luck. It was nuts.

The quant poker games were brutal marathon sessions lasting until three, four in the morning. Not that Asness would stick around for the whole affair. He had two pairs of twins, born back-to-back in 2003 and 2004, waiting for him back at his mansion in Greenwich. He liked to call the sequential birth of the twins “a gross failure of risk control,” referring to an overindulgence in fertility treatments.

Risk control seemed to get thrown out the window for the poker game, too, or so it might seem to an outsider. The buy-in was $10,000. For certain games attended by the more serious players of the group, such as Muller and Chriss, the buy-in could vault as high as fifty grand.

The players didn’t toss it all on the table on the first hand, of course. They could stuff the chips in their pockets and keep them there all night, at least until their luck ran out, if that’s how they wanted to play it. But who cared? Fifty grand was Monopoly money to them. It was all about who won and who lost. And although winners sometimes could take home winnings measured in six figures, it wasn’t going to change any of their lives.

But Asness wasn’t winning. He was losing. Just like AQR.

“Ante up,” said Muller, dealing another hand.

Asness pulled a stack of chips from his pocket and tossed them into the pot. He watched the cards as they fell around the table. He
looked up at Muller, who was staring blankly at his hand. He didn’t know how Muller could stay so calm. He’d lost more than half a billion in August over the course of a few days, yet acted like it was another day on the beach in Hawaii. But AQR had lost even more, much more. Sure, things had bounced back—a lot—but the speed of the meltdown had been unnerving. And now, as the credit crisis ground on in late 2007, AQR was facing even more losses.

Picking up his cards, Asness winced. Nothing.

He wasn’t ready to give up yet, not even close. AQR held its traditional Christmas party at Nobu 57, a swank Japanese restaurant in midtown Manhattan. But there were signs that the bloom was off the rose. Spouses and guests weren’t allowed, unlike previous years. The stressed Greenwich quants let loose, swilling sake and Japanese beer by the gallon. “It turned into a drunkfest,” said one attendee.

The quants were also haunted by another fear: systemic risk. The August 2007 meltdown showed that the quants’ presence in the market wasn’t nearly as benign as they had believed. As with a delicate spiderweb, a tear in one part of the financial system, in this case subprime mortgages, could trigger a tear in another part—and even bring down the web itself. The market was apparently far more intertwined than they had ever realized.

MIT finance professor Andrew Lo, and his student Amir Khandani, published a definitive study of the meltdown in October 2007 called “What Happened to the Quants?” Ominously, they evoked an apocryphal Doomsday Clock for the global financial system. In August 2007, the clock ticked nearer to midnight, perhaps the closest it had come to financial Armageddon since Long-Term Capital’s implosion in 1998.

“If we were to develop a Doomsday Clock for the hedge-fund industry’s impact on the global financial system,” they wrote, “calibrated to five minutes to midnight in August 1998, and fifteen minutes to midnight in January 1999, then our current outlook for the state of systemic risk in the hedge-fund industry is about 11:51
P.M
. For the moment, markets seem to have stabilized, but the clock is ticking.”

One of the central concerns, Lo and Khandani explained, was the weblike interconnectedness of the system. “The fact that the ultimate
origins of this dislocation were apparently outside the long-short equity sector—most likely in a completely unrelated set of markets and instruments—suggests that systemic risk in the hedge-fund industry has increased significantly in recent years,” they wrote.

There was also the worry about what happened if high-frequency quant funds, which had become a central cog of the market, helping transfer risk at lightning speeds, were forced to shut down by extreme market volatility. “Hedge funds can decide to withdraw liquidity at a moment’s notice,” they wrote, “and while this may be benign if it occurs rarely and randomly, a coordinated withdrawal of liquidity among an entire sector of hedge funds could have disastrous consequences for the viability of the financial system if it occurs at the wrong time and in the wrong sector.”

It wasn’t supposed to be this way. The quants had always thought of themselves as financial helpers, greasing the churning wheels of the Money Grid. Now it seemed that they posed significant systemic risk—pushing the world closer to doomsday. Sitting at the poker table, holding another dud hand, Asness shut his eyes and thought back to his days as the most brilliant student at the University of Chicago.

Where had it all gone wrong?

One quant
gadfly had been predicting a crackup in the financial system for years: Nassim Nicholas Taleb, the former hedge fund trader and author who’d squared off against Peter Muller at Neil Chriss’s wedding several years back. In January 2008, Taleb arrived at AQR’s office in Greenwich to give a lecture. Aaron Brown had asked him to explain his theories about why quantitative models work fine in the physical world but are dangerous wizardry in the world of finance (a view Brown didn’t necessarily share).

Taleb’s audience was sparse. Asness, drained, passed. Aaron Brown had been a friend of Taleb’s for years—Taleb had provided a blurb for Brown’s book,
The Poker Face of Wall Street
—and was interested in what he had to say, even if he didn’t agree with it.

“Hey, Nassim, how goes it?”

“Not bad, my friend,” Taleb said, stroking his beard. “I hear you have been having a bad time of it.”

“You wouldn’t believe it,” Brown replied. “Or maybe you would, I don’t know. I’d say we’ve definitely seen one of the blackest swans of all time. But things seem to be cooling off.”

Taleb quickly set up his PowerPoint demonstration and began to talk. One of the first slides in the talk showed a clip from a
Wall Street Journal
article from August 11 about Matthew Rothman’s description of the quant meltdown.

“Matthew Rothman is used to working with people who pride themselves on their rationality,” the article said. “He’s a ‘quant,’ after all, one of a legion of Ph.D.’s on Wall Street who use emotionless rules of mathematics to pick trading positions. But this week, he caught a whiff of panic.”

Taleb’s slide was titled “Fallacy of Probability.” Rothman had described the quant meltdown as something models predicted would happen once in ten thousand years—but it had taken place every day for several days in a row. To Taleb, that meant something was wrong with the models.