The Quants: How a New Breed of Math Whizzes Conquered Wall Street and Nearly Destroyed It (30 page)

He didn’t let Deutsche down. Weinstein and his prop desk gun-slingers continued to ring the cash register. The prop group pulled
in $900 million in 2006, earning Weinstein a paycheck of about $30 million.

Most of his attention was focused on his prop desk, however, alienating his underlings on flow, who didn’t think they were getting enough recognition. In 2005, he’d hired Derek Smith, a star trader at Goldman Sachs, to run the flow desk, angering a number of traders who felt they deserved to run the show. The number of Weinstein’s enemies within Deutsche started to grow.

“Why do we need an outsider?” they grumbled.

Weinstein’s monetary incentives were skewed heavily toward the prop desk side. While his compensation for his flow desk job was a discretionary bonus, his prop desk business rewarded him with a healthy percentage of the profits.

There was a good reason for Weinstein’s tunnel vision: his eyes were squarely focused on launching his own hedge fund in the next few years following the tradition set by Cliff Asness years ago when he’d broken away from Goldman Sachs to launch AQR. In early 2007, Weinstein renamed his prop-trading group Saba. It encompassed about sixty people working in offices in New York, London, and Hong Kong.

The name would brand the group on the Street, making it immediately recognizable once it broke away from Deutsche Bank. Saba was increasingly known and feared as a major force with massive financial ammunition, a major player nearing the level of bond-trading powerhouses such as Citadel and Goldman Sachs.

Weinstein reveled in his success. Now a wealthy playboy, every summer he would rent a different vacation home in the Hamptons. He continued to gamble, playing high-stakes games alongside celebrities such as Matt Damon.

He also continued to gamble with his fellow quants in New York. The game, of course, was poker.

Boaz Weinstein
dealt crisply, talking a blue streak. There was no smoke in the room as the cards fell about the table. Peter Muller, the compulsive health nut who nearly passed on the BARRA job due to
his discovery of a single cigarette butt in the company’s bathroom, didn’t allow smoking Muller’s rule didn’t bother the quants. Neither Cliff Asness nor Weinstein smoked. But every now and then, a seasoned poker professional who couldn’t fathom the notion of poker separated from an endless chain of cigarettes would sit in on the quants’ game and be forced to clock an excruciating night of nicotine-free, high-stakes gambling.

On this particular night in late 2006, it was just the quants going head-to-head. Weinstein was regaling the table with tales of “correlation,” a technical term from credit trading that he was explaining in detail to his poker buddies.

“The assumptions are crazy,” he said, placing the deck on the table and picking up his hand. “The correlations are ridiculous.”

It all had to do with the explosion in housing prices. The housing market had been booming for years and looked to be losing steam in overheated regions such as southern California and Florida. Home prices had more than doubled nationwide in a matter of five years, helping prop up the economy but leading to an unsustainable bubble. A growing number of investors, including Weinstein, thought it was about to pop like an infected boil.

Weinstein had a unique view into Wall Street’s end of the bubble. Deutsche Bank was heavily involved in mortgage lending—some of it on the subprime side. In 2006, it had purchased Chapel Funding, a mortgage originator, and had teamed up with the Hispanic National Mortgage Association to make loans to Hispanic and immigrant borrowers.

Deutsche Bank was also a big player in the securitization market, buying mortgage loans from lenders, packaging those loans into securities, then slicing and dicing them into different pieces to peddle to investors around the world.

One reason why banks engage in securitization is to spread around risk like jelly on toast. Instead of lumping the jelly on one small piece of the toast, leaving all the reward (or risk that it falls off the toast) for one bite, it’s evenly distributed, making for lots more
tasty bites—and, through the quant magic of diversification (spreading the jelly), less risk.

If an investor buys a single subprime mortgage worth $250,000, that investor bears the entire risk if that mortgage goes into default, certainly possible given the fact that subprime mortgages usually go to the least creditworthy borrowers. But if a thousand subprime mortgages, each worth about $250,000, were pooled together and turned into a single security with a collective value of $250 million, the security could be divided into some number of shares. The potential loss caused by any one mortgage going into default would be offset by the fact that it represented only a tiny portion of the security’s total value.

Parts of the securities, in many cases the lowest on the food chain, were often bundled into even more esoteric monstrosities known as collateralized debt obligations, which took into account the fact that some of the underlying mortgages were more likely than others to default. The more-likely-to-default bundles obviously carried greater risk, though along with that came its corollary, greater potential reward. Between 2004 and 2007, billions in subprime home loans were stuffed into these so-called CDOs. The CDOs were then sliced into tranches. There were high-quality slices, stamped AAA by rating agencies such as Standard & Poor’s, and there were poor-quality slices, some of which were so low in quality they didn’t even get a rating.

Bizarrely, the ratings weren’t based on the relative quality of the underlying loans. The AAA tranches could hold loans of the same value and quality as those in the lowest-rated tranches. The ratings, rather, were based on who got paid first in the stack of loans. The owners of AAA tranches had the first dibs on payments. When borrowers started to default, the owners of the lowest-tier tranches got whacked first. If enough borrowers defaulted, higher-rated tranches would start to suffer.

One of the problems with the Byzantine practice of carving up CDOs into all of these slices was figuring out how to price them. Sometime around 2000, the quants came up with an answer: correlation. By getting the price of one small part of the bundle of slices, quants could figure out the “right” prices of all the other slices by looking at how correlated they were with one another. If the pool of
loans started experiencing, say, a 5 percent rate of defaults, the quants could calculate the impact on each of the slices through their computers and figure out the correlations between each slice of the pie, all the way up to the AAA slice.

It was assumed, of course, that the poor-quality slices and the AAA slices had very little in common in terms of the likelihood of defaults by the homeowners who received the original mortgages. Put another way, the correlation between them was extremely low, almost infinitesimal.

Weinstein and several other traders at Deutsche Bank (and a number of clever hedge funds) figured out that the correlations in most models were off by miles. When they peered into the underlying loans in the CDOs, they discovered that many of the loans were so shaky, and so similar, that when one slice of the pie started to go bad, that meant the entire pie would be rotten. So many low-quality loans had been stuffed into the CDOs that even owners of seemingly safe, high-rated tranches would suffer. In other words, the correlations were very
high
. But most people buying and selling the slices thought they were very
low
.

To Weinstein, that meant a trade. Through even more esoteric quant alchemy, there were ways to “short” CDO slices through Weinstein’s favorite method: credit default swaps. By purchasing a swap, or a bunch of swaps bundled together, Weinstein would effectively take out an insurance policy on the underlying subprime loans. If those loans went belly up—which Weinstein thought most likely—the policy paid out. In simple terms, Weinstein was betting that the market was underestimating the toxicity of the subprime mortgage market.

Even better for Weinstein, most traders were so enthusiastic about the housing market and the CDOs bundling all those loans that the cost of shorting the market was extremely cheap. Weinstein saw this as an almost can’t-lose bet. Huge profits could be made. And if he was wrong, he’d lose only the scant amount he’d paid for the insurance policy.

“We’re putting on the trade at Deutsche,” Weinstein said, gazing at his cards.

Asness and Muller nodded. It was typical quant shoptalk, one
trader describing a clever new bet to his peers, but they were getting bored. It was time to get down to the business at hand. The only bet on their minds at the moment involved a pile of chips worth several thousand dollars in the center of the table.

Weinstein looked at his hand and grimaced. He had nothing and folded.

“Raise a thousand,” Asness said, tossing more chips on the pile.

Muller peered at Asness, who sat back in his chair and grinned nervously, his face reddening.
Poor Cliff. It’s so easy to tell when he’s bluffing. No poker face whatsoever on the man
.

“Call,” Muller said, throwing down another winning hand to Asness’s agonized groan. Muller was on a hot streak, and he laughed as he swept the chips into the steadily rising pile in front of him.

Boaz Weinstein
wasn’t the only one worrying about the health of CDOs in 2007. Aaron Brown—the quant who’d beaten Liar’s Poker in the 1980s—had gotten his hands dirty in the securitization industry almost since its inception. His career had provided him with a front-row seat on its evolution and cancerous growth throughout Wall Street. For years he had watched with increasing trepidation as the CDO industry grew larger and, at the same time, more divorced from reality. By 2007, Brown was working at Morgan Stanley as a risk manager and growing uncomfortable with Morgan’s subprime exposure. He was ready to get out.

He’d already been in low-level discussions about a job with a hedge fund that was staffing up for an IPO: AQR. Cliff Asness’s firm was looking for a risk management veteran to deal with thorny issues such as international risk regulations. Brown loved the idea. He’d
never worked at a hedge fund and was eager to give it a shot. In June 2007, he signed on as AQR’s chief risk officer.

Brown was well aware of AQR’s reputation as a top-of-the-line quant shop that spoke his language. But he had little idea that AQR, like Morgan Stanley, was sitting on top of a bubbling cauldron of risk that was about to explode in spectacular fashion.

Growing up
in Seattle, Brown had always been fascinated by numbers—baseball box scores, weather charts, stock pages. He couldn’t have cared less about the events they denoted—the walk-off home runs, the hurricane-wrecked trailer parks, the mergers of corporate rivals. It was the rows of digits that caught Brown’s fancy, the idea that there was some kind of secret knowledge behind the numbers. His love of mathematics eventually led him to one of the most influential books he would ever read: Ed Thorp’s
Beat the Dealer
.

Brown devoured the book, mesmerized by the idea that he could use math to make money at a game as simple as blackjack. After mastering Thorp’s card-counting method, he moved on to poker. At fourteen, he became a regular in Seattle’s underground gambling halls. Seattle was a port town full of sailors, hard-luck transients, and been-around-the-world sharpies. Brown couldn’t match them for machismo, but they couldn’t touch his math or his intuition. He quickly realized that he was very good; he excelled not just at figuring the odds of each hand but at reading the poker faces of his opponents. He could sense a bluff a mile away.

In 1974, he graduated from high school with top grades, got perfect scores on his college board exams, and headed straight for Harvard. He studied under Harrison White, a sociologist who applied quantitative models to social networks, and also dove into Harvard’s active poker scene, which included George W. Bush as a regular in Harvard Business School’s poker circles. Indeed, Harvard’s bumper crop of spoiled rich kids seemed eager to lose money to Brown, and he was happy to oblige. But the stakes were usually too low for his taste, or the games too unprofessional. He made his way to a game future Microsoft founder Bill Gates ran at Harvard’s Currier House,
but Brown found it too regimented and uptight. A bunch of tense nerds trying to act cool, he thought.

After graduating in 1978, Brown took a job at American Management Systems, a consulting firm in northern Virginia. The job was fine, but the D.C. poker circuit was a bigger draw. It was no trouble to get in on games with the odd congressman. Once he heard about a party that had a hot backroom game. He walked into an apartment and saw a heavyset man wearing a tight T-shirt, girls who looked like dolled-up secretaries hanging from each arm. It was none other than Texas congressman Charlie Wilson, future subject of the book and movie
Charlie Wilson’s War
. Brown liked Wilson, thought he was a fun guy. Better yet, Wilson loved to play poker. He wasn’t bad at it, either.

Brown wasn’t satisfied with his job, though, and once again felt the tug of academia. In 1980, he started taking classes at the University of Chicago’s graduate school in economics. In Chicago, Brown became enthralled with the mysterious world of stock options. He picked up Thorp’s
Beat the Market
and quickly mastered the book’s technique for pricing stock warrants and convertible bonds. In short order, he was doing so well trading options that he considered dropping out of school and pursuing a full-time trading career. Instead, he decided to see through his term at Chicago, while trading on the side.