The Quants: How a New Breed of Math Whizzes Conquered Wall Street and Nearly Destroyed It (26 page)

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.

Citadel’s leverage, however, which was at roughly 8 to 1 around 2006—though some estimate it rose as high as 16 to 1—didn’t approach that of LTCM, which hovered around 30 to 1 and topped 100 to 1 during its 1998 meltdown. But Citadel was quickly becoming far bigger than the infamous hedge fund from Greenwich in terms of assets under management, turning into a multiheaded leviathan of money almost entirely unregulated by the government—exactly as Griffin liked it.

In March 2006, Griffin attended the Wall Street Poker Night, hooting down Peter Muller as the Morgan Stanley quant faced off against Cliff Asness. Several months later, in September 2006, he made one of his biggest coups yet.

A $10 billion hedge fund called Amaranth Advisors was on the verge of collapse after making a horrifically bad bet on natural gas prices. A lanky, thirty-two-year-old Canadian energy trader and Deutsche Bank alum named Brian Hunter had lost a whopping $5 billion in the course of a single week, triggering the biggest hedge fund blowup of all time, outpacing even the collapse of LTCM.

Amaranth, which had originally specialized in convertible bonds, had built up its energy-trading desk after the collapse of Enron in 2001. It brought Hunter on board soon after the trader left Deutsche Bank amid a dispute over his pay package. Hunter proved so successful at trading natural gas that the fund let him work from Calgary, where he zipped to and from work in a gray Ferrari. Hunter had a reputation as a gunslinger, doubling down on trades if they moved against him. He was preternaturally confident that he would make money on them in the long run, so why not?

But Hunter’s trigger-happy trading habit got him in trouble when natural gas prices turned highly volatile late in the summer of 2006, after Hurricane Katrina plowed into the energy-rich Gulf Coast. Hunter was deploying complex spread trades that exploited the difference between the prices of contracts for delivery in the future. He was also buying options on gas prices that were far “out of the money” but would pay off in the event of big moves. In early September, Hunter’s trades started turning south after reports showed that a natural-gas storage glut had been building up. Hunter believed prices would rebound, and boosted his positions. As he did so, prices continued to fall, and his losses piled up—soon reaching several billion. Eventually the pain proved too much and Amaranth started to implode from within.

Griffin smelled an opportunity. Citadel’s energy experts, including a few of his own Enron alumni wizards, started poring over Amaranth’s books. They were looking to see if there was a chance that Hunter’s bets would, in fact, eventually pay off. While the short-term losses could prove painful, Citadel’s vast reserves would let it ride out the storm. Griffin called Amaranth’s chief operating officer, Charlie Winkler, and started to work out a deal. Within days, Citadel agreed to take half of Amaranth’s energy book. JP Morgan took the other half.

Critics scoffed that Citadel had made a stupid move. They were wrong. The fund gained 30 percent that year.

The gutsy deal further cemented Citadel’s reputation as one of the most powerful and aggressive hedge funds in the world. The speed and size of the deal and the decisiveness, not to mention its success, reminded experts of similar quick-fire exploits pulled off by none other than Warren Buffett, the “Oracle of Omaha.” Buffett was always near the top of the list of deep-pocketed investors whom distressed sellers would speed-dial when things turned south. Now Ken Griffin, the boy-faced hedge fund titan of Chicago, had joined that list.

He continued to snatch up artwork at jaw-dropping prices. In October 2006, he purchased
False Start
by Jasper Johns, a rainbow-colored pastiche of oils stenciled with the names of various colors—“red,” “orange,” “gray,” “yellow,” and so on. The seller: Hollywood mogul David Geffen. The price: $80 million, making it the most expensive painting by a living artist ever sold. It was also a fair indicator of the boom in art prices—fueled in large part by hedge fund billionaires—having been sold to publishing magnate S. I. Newhouse less than twenty years earlier for $17 million. (Newhouse sold it to Geffen in the 1990s for an undisclosed price.) Shortly before buying the painting, Griffin and his wife donated $19 million to the Art Institute of Chicago to finance a 264,000-square-foot wing to house modern art.

The Griffins ate well, dining regularly at the ritzy Japanese mecca NoMi, which was located in the Park Hyatt Chicago building where they lived and boasted $50 plates of sushi. Griffin was also known for his junk food obsessions, wolfing down buttered popcorn on the trading floor or ordering Big Macs from the local McDonald’s on business trips.

He also indulged his passion for cars. Citadel’s garage was often filled with about half a dozen of Griffin’s Ferraris, each constantly monitored on screens inside the hedge fund’s office.

Griffin’s Napoleonic ambitions were becoming painfully evident to those around him. He was known to say that he wanted to turn Citadel into the next Goldman Sachs, a startling goal for a hedge fund. A catchphrase he seized upon: Citadel would be an “enduring financial
institution,” one that could last beyond even its mercurial leader. Rumors percolated that Citadel was mulling an initial public offering, a deal that would reap billions in personal wealth for Griffin. As a mark of its sky’s-the-limit aspirations, Citadel sold $2 billion worth of high-grade bonds in late 2006, becoming the first hedge fund to raise money on the bond market. It was widely seen as a move to lay the groundwork for an IPO.

A few other funds beat Griffin to the IPO punch bowl in early 2007. First, there was Fortress Investment Group, a New York private equity and hedge fund operator with $30 billion under management. Fortress, whose name echoed Citadel’s, stunned Wall Street in February 2007 when it floated shares at $18.50 each. On the first day of trading, the stock shot up to $35 and finished the day at $31. The five Wall Street veterans who’d created Fortress reaped an instant gain of more than $10 billion from the deal.

Private equity firms are akin to hedge funds in that they are largely unregulated and cater to wealthy investors and large institutions. They wield war chests of cash raised from deep-pocketed investors to take over stumbling companies, which they revamp, strip down, and sell back to the public for a tidy profit.

They also like to party. The Tuesday after the Fortress IPO, Stephen Schwarzman, cofounder and chief executive of private equity powerhouse Blackstone Group, threw himself a lavish sixtieth-birthday bash in midtown Manhattan. Blackstone had just completed its $39 billion buyout of Equity Office Properties, the largest leveraged buyout in history, and Schwarzman was in a festive mood. The celebrity-studded, paparazzi-thick blowout smacked of the grandiose robber baron excesses of the Gilded Age, and it marked the crest of a decades-long boom of vast riches on Wall Street—though few knew it at the time.

The location was the Seventh Regiment Armory on Park Avenue. New York police closed part of the fabled boulevard for the event. The five-foot-six Schwarzman didn’t need to travel far for the festivities. The elite gathering was held near his thirty-five-room Park Avenue co-op, once owned by oil tycoon John D. Rockefeller. He’d reportedly paid $37 million for the spacious pad in May 2000. (Schwarzman had
also purchased a home in the Hamptons on Long Island, previously owned by the Vanderbilts, for $34 million, and a thirteen-thousand-square-foot mansion in Florida called Four Winds, originally built for the financial advisor E. F. Hutton in 1937, which ran $21 million. He later decided the house was too small and had it wrecked and reconstructed from scratch.)

The guest list at Schwarzman’s fete included Colin Powell and New York mayor Michael Bloomberg, along with Barbara Walters and Donald Trump. Upon entering the orchid-festooned armory to a march played by a brass band, ushered by smiling children in military garb, visitors were treated to a full-length portrait of their host by the British painter Andrew Festing, president of the Royal Society of Portrait Painters. The dinner included lobster, filet mignon, and baked Alaska, topped off with potables such as a 2004 Louis Jadot Chassagne-Montrachet. Comedian Martin Short emceed. Rod Stewart performed. Patti LaBelle and the Abyssinian Baptist Church choir sang Schwarzman’s praises, along with “Happy Birthday.” On its cover,
Fortune
magazine declared Schwarzman “Wall Street’s Man of the Moment.”

High-society tongues were still wagging about the party a few months later, when Schwarzman gave himself another eye-popping gift. In June, Blackstone raised $4.6 billion in an IPO that valued the company’s stock at $31 a share. Schwarzman, who was known to shell out $3,000 a weekend on meals, including $400 on stone crabs ($40 per claw), personally pocketed nearly $1 billion. At the time of the offering, his stake in the firm was valued at $7.8 billion.

None of this was lost on Griffin. He was biding his time, waiting for the right moment to strike with his own IPO and his dream of rising to challenge Goldman Sachs.

As spring turned to summer, the subprime crisis was heating up. Griffin had been planning for this moment for years, having girded Citadel for hard times with provisions such as those long lockups for investors to keep them from bolting for the exits during market panics. With billions at his fingertips, Griffin could sense a golden opportunity was presenting itself. Weak hands would be flushed out of the market, leaving the pickings for muscle-bound powerhouses such as
Citadel. It had about thirteen hundred employees toiling away for Griffin in offices around the world. By comparison, AQR had about two hundred employees and Renaissance about ninety, almost all of them Ph.D.’s.

In July
2007, Griffin got his first chance to strike. Sowood Capital Management, a $3 billion hedge fund based in Boston run by Jeffrey Larson, a former star of Harvard University’s endowment management, was on the ropes. Earlier in the year, Larson had started to grow worried about the state of the economy and realized that a great deal of risky debt would lose value. To capitalize on those losses, he shorted a variety of junior debt that would take the first hits as other investors grew concerned. To hedge those positions, Larson purchased a chunk of higher-grade debt. Turbocharging the bets, Larson borrowed massive amounts of money, leveraging up the fund to maximize its returns.

The first losses hit Sowood in June, when its investments lost 5 percent. Larson stuck to his guns and even put $5.7 million of his own cash into the fund. Expecting his positions to rebound, he told his traders to add even more leverage to the bets, pushing the fund’s leverage ratio to twelve times its capital (it had borrowed $12 for each $1 it owned).

Larson, without realizing it, had stepped into a snake pit of risk at the worst possible time. The subprime mortgage market was collapsing, triggering shock waves throughout the financial system. In June, the ratings agency Moody’s downgraded the ratings of $5 billion worth of subprime mortgage bonds. On July 10, Standard & Poor’s, another major ratings group, warned it might downgrade $12 billion of mortgage bonds backed by subprime mortgages, prompting many holders of the bonds to dump them as quickly as possible. A number of the bonds S&P was reviewing had been issued by New Century Financial, a subprime mortgage giant based in Southern California that had filed for bankruptcy protection in April. The subprime house of cards was crumbling fast.

Other hedge funds making bets similar to Sowood’s were also under fire and started unloading everything they owned into the market,
including supposedly safe high-grade bonds owned by Sowood. The trouble was, few other investors wanted to buy. Credit markets gummed up. “S&P’s actions are going to force a lot more people to come to Jesus,” Christopher Whalen, an analyst at Institutional Risk Analytics, told Bloomberg News. “This could be one of the triggers we’ve been waiting for.”

It was the first hint of the great unwinding that would nearly destroy the global financial system in the following year. The value of Sowood’s investments cratered, and Larson started selling to raise cash as its lenders demanded more collateral, adding to the distress that was roiling the market. Larson appealed to the executives of Harvard’s endowment for more cash to carry him through what he believed was just a temporary, irrational hiccup in the market. Wisely, they turned him down.