The Quants: How a New Breed of Math Whizzes Conquered Wall Street and Nearly Destroyed It (20 page)

By the
late 1990s, Ken Griffin was swapping convertible bonds from a high tower in Chicago. Jim Simons was building his quant empire in East Setauket. Boaz Weinstein was scouring computer screens to trade derivatives for Deutsche Bank. Peter Muller was trading stocks at Morgan Stanley. Cliff Asness was measuring value and momentum at AQR. They were all making more money than they’d ever dreamed possible.

And each was becoming part of and helping to create a massive electronic network, a digitized, computerized money-trading machine that could shift billions around the globe in the blink of an eye, at the click of a mouse.

This machine has no name. But it is one of the most revolutionary technological developments of modern times. It is vast, its
octopuslike tentacles reaching to the farthest corners of civilization, yet it is also practically invisible. Call it the Money Grid.

Innovators such as Ed Thorp, Fischer Black, Robert Merton, Barr Rosenberg, and many others had been early architects of the Money Grid, designing computerized trading strategies that could make money in markets around the world, from Baghdad to Bombay, Shanghai to Singapore. Michael Bloomberg, a former stock trader at Salomon Brothers and eventual mayor of New York City, designed a machine that would allow users to get data on virtually any security in the world in seconds, turning its creator into a billionaire. The Nasdaq Stock Market, which provided entirely electronic transactions, as opposed to the lumbering humans at the New York Stock Exchange, made it quicker and cheaper to buy and sell stocks around the globe. The entire global financial system became synced into a push-button electronic matrix of unfathomable complexity. Money turned digital.

Few were as well placed to take advantage of the Money Grid as the Floridian boy wonder Ken Griffin.

GRIFFIN

Griffin’s fortress for money, Citadel Investment Group, started trading on November 1, 1990, with $4.6 million in capital. The fund, like Princeton/Newport Partners, specialized in using mathematical models to discover deals in the opaque market for convertible bonds.

In its first year, Citadel earned a whopping 43 percent. It raked in 41 percent in its second, and 24 percent in its third.

One of Citadel’s early trades that caught the Street’s eye concerned an electronic home security provider called ADT Security Services. The company had issued a convertible bond that contained a stipulation that if a holder converted the bond into stock, he wouldn’t be eligible for the next dividend payment. That meant that the bond traded at a slight discount to its conversion value, because the holder wouldn’t receive the next dividend.

Griffin and his small band of researchers figured out that in the
United Kingdom, the dividend was technically not a dividend but a “scrip issue”—which meant that a buyer of the bond in the United Kingdom would be paid the dividend. In other words, the bond was cheaper than it should be.

Citadel bought as many of these bonds as it could buy. It was a trade that a number of the large dealers had missed, and it was a trade that put Citadel on the map as a shop that was on top of its game.

By then Griffin, still a boy-faced whiz kid in his mid-twenties, was juggling nearly $200 million with sixty people working for him in a three-thousand-square-foot office in Chicago’s Loop district.

Then he lost money. A great deal of money. In 1994, Alan Greenspan and the Federal Reserve shocked the market with a surprise interest rate increase. The bottom fell out of the rate-sensitive convertible bond market. Citadel dropped 4.3 percent, and assets under management fell to $120 million (part of the decline came from worried investors pulling money out of the fund). Until 2008, it was the only year Citadel’s flagship Kensington fund lost money.

Used to unstinting success, Griffin was stunned, and hell-bent on making sure his financial battlements couldn’t be breached in the future.

“We’re not going to let this happen again,” he told his patron, Frank Meyer. Citadel began crafting plans to fortify its structure, instituting changes that may have saved it from a complete collapse fourteen years later. When investors had seen the bond market crumbling, they had called up Griffin in a panic and demanded a refund. Griffin knew that the market was eventually going to bounce back, but there was little he could do. The solution: lock up investors for years at a time. He slowly began negotiating the new terms with his partners, eventually getting them to agree to keep their investment in Citadel for at least two years (and at the end of each two-year period agreeing to another two-year lockup). A long lockup meant that when times got tough, Griffin could remain calm, knowing that fidgety, fleet-footed investors couldn’t cut and run at a moment’s notice. By July 1998, the new model was in place—and just in time.

Later that year, Long-Term Capital crashed. As other hedge funds
sold indiscriminately in a broad, brutal deleveraging, Citadel snapped up bargains. Its Kensington fund gained 31 percent that year. By then, Citadel had more than $1 billion under management. The fund was diving into nearly every trading strategy known to man. In the early 1990s, it had thrived on convertible bonds and a boom in Japanese warrants. In 1994, it launched a “merger arbitrage” group that made bets on the shares of companies in merger deals. The same year, encouraged by Ed Thorp’s success at Ridgeline Partners, the statistical arbitrage fund he’d started up after shutting down Princeton/Newport, it launched its own stat arb fund. Citadel started dabbling in mortgage-backed securities in 1999, and plunged into the reinsurance business a few years later. Griffin created an internal market–making operation for stocks that would let it enter trades that flew below Wall Street’s radar, always a bonus to the secrecy-obsessed fund manager.

As Griffin’s bank account expanded to eye-watering proportions, he began to enjoy the perks of great wealth. Following a well-trodden path among the rich, he indulged his interest in owning great works of art. In 1999, he snapped up Paul Cézanne’s
Curtain Jug and Fruit Bowl
for $60.5 million. Later that year, he became enamored of an Edgar Degas sculpture called
Little Dancer, Aged
14, that he chanced upon in Sotheby’s auction house in New York. He later bought a version of the sculpture, as well as a Degas pastel called
Green Dancer
. Meanwhile, in 2000, he shelled out $6.9 million for a two-story penthouse in a ritzy art deco building on North Michigan Avenue in Chicago, an opulent stretch of properties known as the Magnificent Mile.

Citadel’s returns had become the envy of the hedge fund world, nearly matching the gains put up by Renaissance. It posted a gain of 25 percent in 1998, 40 percent in 1999, 46 percent in 2000, and 19 percent in 2001, when the dot-com bubble burst, proving it could earn money in good markets and bad. Ken Griffin, clearly, had alpha.

By then, Griffin’s fund was sitting on top of a cool $6 billion, ranking it among the six largest hedge funds in the world. Among his top lieutenants were Alec Litowitz, who ran the firm’s merger arbitrage desk, and David Bunning, head of global credit. In a few years, both Litowitz and Bunning would leave the fund. In 2005, Litowitz
launched a $2 billion hedge fund called Magnetar Capital that would play a starring role in the global credit crisis several years later. A magnetar is a neutron star with a strong magnetic field, and Litowitz’s hedge fund turned out to have a strong attraction for a fast-growing crop of subprime mortgages.

Citadel, meanwhile, was quickly becoming one of the most powerful money machines on earth, fast-moving, extremely confident, and muscle-bound with money. It had turned into a hedge fund factory, training new managers such as Litowitz who would break off and grow new funds. Ed Thorp’s progeny were spreading like weeds. And Griffin, just thirty-three years old, was still the most successful of them all.

The collapse of Enron in 2001 gave him a chance to flex his muscles. In December 2001, a day after the corrupt energy-trading firm declared bankruptcy, Griffin hopped on a plane to start recruiting energy traders from around the country. Back in Chicago, a team of quants started building commodity-pricing models to ramp up the fund’s trading operation. The fund also signed up a number of meteorologists to help keep track of supply-and-demand issues that could impact energy prices. Soon Citadel sported one of the largest energy-trading operations in the industry.

As his fund grew, Griffin’s personal wealth soared into the stratosphere. He was the youngest self-made member of the Forbes 400 in 2002. The following year, he was number ten on
Fortune’s
list of the richest people in America under forty years old, with an estimated net worth of $725 million, a hair behind Dan Snyder, owner of the Washington Redskins.

He’d reached a level of success few mortals can contemplate. To celebrate that year, he got married—at the Palace of Versailles, playground of Louis XIV, the Sun King. Griffin exchanged vows with Anne Dias, who also managed a hedge fund (though a much, much smaller one). The reception for the two-day affair was held in the Hameau de la Reine, or “Hamlet of the Queen,” where Marie Antoinette lived out Jean-Jacques Rousseau’s back-to-nature peasant idyll in an eighteenth-century faux village.

The Canadian acrobat squad Cirque du Soleil performed. Disco
diva Donna Summer sang. Guests dangled from helium balloons. The party in Paris included festivities at the Louvre and a rehearsal dinner at the Musée d’Orsay.

It was good to be Ken Griffin. Perhaps
too
good.

MULLER

Just as Griffin was starting up Citadel in Chicago, Peter Muller was hard at work at Morgan Stanley in New York trying to put together his own quantitative trading outfit using the models he’d devised at BARRA. In 1991, he pulled the trigger, flipping on the computers.

It was a nightmare. Nothing worked. The sophisticated trading models he’d developed at BARRA were brilliant in theory. But when Muller actually traded with them, he ran into all sorts of problems. The execution wasn’t fast enough. Trading costs were lethal. Small bugs in a program could screw up an order.