The Quants: How a New Breed of Math Whizzes Conquered Wall Street and Nearly Destroyed It (38 page)

But several members of his staff were having trouble making it to Lehman’s midtown Manhattan office on Seventh Avenue. The massive storm had knocked out the city’s subway system, and no one could find a cab. Rothman told them they had to find a way to get into the office, no matter what. Walk, run, ride a horse. Whatever. They had to get this call out.

Rothman, in constant contact with his research staff in New York, spent all day collecting data, working the Street for insight, writing, putting together complicated charts. By the time the note was finished, it was midnight local time, 3:00 a.m. Eastern. Rothman stumbled back to the Four Seasons, exhausted.

“Over the past few days, most quantitative fund managers have experienced significant abnormal performance in their returns,” he wrote with classic Wall Street analyst understatement. “It is not just that most factors are not working but rather they are working in a perverse manner, in our view.”

The report continued with the scenario Rothman had worked out
over sushi with Levin: “It is impossible to know for sure what was the catalyst for this situation. In our opinion, the most reasonable scenario is that a few large multi-strategy quantitative managers may have experienced significant losses in their credit or fixed income portfolios. In an attempt to lower the risks in their portfolios and being afraid to ‘mark to market’ their illiquid credit portfolios, these managers probably sought to raise cash and de-lever in the most liquid market—the U.S. equity market.”

The following pages of the report were a detailed examination of the specific trades that were blowing up. The oddest section, however, was its conclusion, a terse reiteration of the quant credo that at the end of the day, people—and investors—generally behave in a rational manner. The Truth, after all, is the Truth. Right?

“We like to believe in the rationality of human beings (and particularly quants) and place our faith in the strong forces and mutual incentives we all have for orderly functioning of the capital markets,” Rothman wrote. “As drivers of cars down dark roads at night, we learn to have faith that the driver approaching on the other side of the road will not swerve into our lane to hit us. In fact, he is just as afraid of our swerving to hit him as we are of his swerving to hit us. We both exhale as we pass by each other headed into the night in our respective opposite directions, successfully avoiding both of our destructions.”

The report, called “Turbulent Times in Quant Land,” was posted on Lehman’s servers early that morning. It quickly became the most highly distributed note in the history of Lehman Brothers.

As word of his report seeped out, he got a call from
Wall Street Journal
reporter Kaja Whitehouse. When asked to describe the severity of the meltdown, Rothman didn’t mince words.

“Wednesday is the type of day people will remember in quantland for a very long time,” Rothman said. “Events that models only predicted would happen once in 10,000 years happened every day for three days.”

He spoke as though the worst were over. It wasn’t.

Early Thursday
morning, August 9, PDT held a series of emergency meetings in Peter Muller’s office. The situation was dire. If the fund lost much more money, it ran the risk of getting shut down by Morgan’s risk managers—a disaster that could mean the group would have to liquidate its entire portfolio. Reed advocated even more aggressive selling. Muller agreed but wanted to wait one more day before ratcheting up. Meanwhile, the losses were piling up.

By then, the quant meltdown was affecting markets across the globe. The Dow Jones Industrial Average tumbled 387 points Thursday.

The Japanese yen, which quant funds liked to short due to extremely low interest rates in Japan, surged against the dollar and the euro—an example of more short covering by quant funds as the carry trade fell apart. But the dollar rose against most other currencies as investors snapped it up in a panicked flight to safe, liquid assets, just as they had during Black Monday in October 1987 and in August 1998 when LTCM imploded.

On Friday morning, Muller came into the office early. The plan was to deleverage like mad before everything was wiped out. But before he gave the thumbs-up on the plan, Muller wanted to see what happened at the opening bell.
You never know
, he thought.
Maybe we’ll get a break
. But he wasn’t counting on it.

There was plenty of bad news to worsen the mood. France’s largest publicly traded bank, BNP Paribas, froze the assets of three of its funds worth a combined $2.2 billion. In a refrain that would echo across financial markets repeatedly in the coming year, BNP blamed the “complete evaporation of liquidity” in securitization markets related to U.S. housing loans, which had “made it impossible to value certain assets fairly regardless of their quality or credit rating.”

Late Thursday, Jim Simons had issued a rare midmonth update on the state of one of his funds. The Renaissance Institutional Equities Fund, which managed about $26 billion in assets, was down 8.7 percent so far from the end of July—a loss of nearly $2 billion.

In a letter to investors, Simons attempted to explain what had gone wrong. “While we believe we have an excellent set of predictive signals, some of these are undoubtedly shared by a number of long/short
hedge funds,” wrote the white-bearded wizard of East Setauket. “For one reason or another many of these funds have not been doing well, and certain factors have caused them to liquidate positions. In addition to poor performance these factors may include losses in credit securities, excessive risk, margin calls and others.”

The Medallion fund, however, was doing even worse than RIEF. It had dropped a whopping 17 percent for the month, a loss of roughly $1 billion. Like Muhammad Ali getting licked by Joe Frazier in Madison Square Garden in 1971, the greatest fund of all time was on the ropes, and seemed at risk of getting knocked out.

Over at AQR, the mood was even more grim. Its traders were tense and tired. The hard, round-the-clock work was completely atypical for quants used to the rigid, structured, predictable flow of markets. Complete chaos wasn’t supposed to be part of the package.

The fun was over. AQR had reserved a movie theater that Thursday night for a showing of
The Simpsons Movie
as an employee event. The reservation was canceled.

Ken Griffin
, meanwhile, sensed blood in the water. While the quantitative Tactical Trading fund run by Misha Malyshev was getting hammered, it represented only a fraction of Citadel’s massive girth.

Late Thursday night, Griffin picked up the phone and called Cliff Asness. Griffin wasn’t calling as a friend. He wanted to know if AQR needed help.

Asness knew what that meant. He was hearing from Griffin the grave dancer, the vulture investor of Amaranth and Sowood fame. It brought home how much trouble he was in. While the call was friendly, there was an air of tension between the two managers. “I looked up and saw the Valkyries coming and heard the Grim Reaper’s scythe knocking on my door,” Asness later joked about the call. But at the time, he wasn’t laughing.

Friday morning
at AQR, August 10. Asness glanced pensively at a candy-colored array of Marvel superhero figurines lined up along his east-facing window: Spider-Man, Captain America, the Hulk, Iron Man. Comic book heroes of his boyhood days on Long Island.

The fund manager wished he had some kind of superhuman power over the markets to make it all stop.
Make the bleeding stop
. AQR’s Absolute Return Fund was down 13 percent for the month, its biggest drop in such a short stretch of time ever.
It doesn’t make sense … it’s perverse
. He walked to his desk and looked at the P&L on his computer screen, a red flash of negative numbers. The losses were astronomical. Billions gone.

Through the eastern window of his office, Asness could see the blue shimmer of the city’s teeming marina beyond Steamboat Road. A decade earlier, a short drive down Steamboat had led directly to the headquarters of Long-Term Capital Management.

If the losses continued, AQR would be seen as just another LTCM, a quant disaster that wreaked havoc on the financial system, Wall Street’s eggheads run amok all over again as their witchy black boxes turned into loose-cannon HAL 9000s destroying everything in sight.

He didn’t want to let that happen. And he thought:
Maybe there’s a way
.

Asness had been huddling with his top lieutenants in his office, including Mendelson, John Liew, and David Kabiller. They were getting ready to make a momentous decision. It wasn’t easy. The fate of the hedge fund hung in the balance.

Throughout the week, AQR, like every quant fund, had been trying to figure out what was going on, searching for the elusive patient zero. By the end of Thursday, they had determined that almost every large quant hedge fund had taken down its leverage significantly. Every quant fund but one: GSAM.

AQR had been frantically trying to get information about what was going on inside Goldman. But Goldman wouldn’t talk. Through careful analysis of the situation, AQR had determined that GSAM’s Global Equity Opportunities fund hadn’t completely deleveraged. That meant one of two things: either Goldman was going to inject a large amount of money into the fund to keep it afloat or it was about to implode in a vicious sell-off, causing the market to spiral even further out of control.

If the latter were the case, certain disaster would have been in store for AQR and every other quant fund, as well as the broader
market. Goldman’s GEO fund was massive, with roughly $10 billion in assets. If it had started selling on top of all the other losses quant funds had endured, a meltdown of epic proportions would have ensued, rocking investors everywhere.

Like PDT, the team at AQR had planned to shrink its book even further that day. But Asness made a gut decision, one of the most important of his trading career:
It’s time to buy
.

If not now, when?
he thought. Goldman, he decided, wouldn’t let the system collapse if it had the wherewithal. Instead, the bank would do the smart thing, the rational thing: inject capital into the GEO fund. That would allow it to hold on to its positions. It wouldn’t have to deleverage.

That meant it was time to get back in, throw more chips on the table. AQR put out the word to its traders and told them to be intentionally loud about the move. They wanted everyone to know that AQR, one of the big lumbering gorillas of quantdom, was back in action.
Maybe that will make the bleeding stop
, Asness thought.

It was like a poker game, the highest-stakes hand he’d ever played. This time, it wasn’t just that wiseass Peter Muller who could call his bluff; it was the market itself that could ruin him. Asness was all in, and he knew it.

Back in
New York, Muller sat poker-faced and pensive as strategies to cope with the chaos raced through his mind. As he waited for the market to open Friday morning, he knew PDT was on the edge. The group had lost an inconceivable $600 million. If the losses intensified much more, Morgan could decide to shut it down. The group’s brilliant fourteen-year run, and possibly Muller’s career, restarted only months earlier, could be over.

It didn’t look good. European markets were still a basket case. So was Asia. The tension mounted as the 9:30 a.m. start of regular trading in the United States neared. Muller, Simons, Asness, Weinstein, Griffin, and nearly every other quant manager in the world were glued to their screens as the minutes ticked by, sweating, nervous, sick with dread.

Then something of a miracle happened. When U.S. trading
began, quant strategies started to rally, hard. Muller gave the order: don’t sell. Other quants followed suit. There was an initial lull, and then their positions took off in a rocket-mad surge. By the end of the day, the gains were so strong that many quant managers said it was one of their best days ever. Whether the rebound was a result of AQR’s decision to leap back into the market is impossible to know for certain. But there’s little doubt that it helped turn the tide.

Inside Goldman, rescue efforts had in fact been in full swing since Wednesday—a $3 billion infusion of cash that helped to stop the bleeding. The bailout, about $2 billion of which was Goldman’s own money, was targeted at the GSAM’s Global Equity Opportunities fund, which had also suffered a huge blow and had lost a stunning 30 percent, or $1.6 billion, for the month through August 9. Global Alpha and its North American Equity Opportunities fund were left to fend for themselves. By the end of August, Global Alpha’s assets had plunged to $6 billion, down from $10 billion the previous year, an enormous 40 percent decline for one of Wall Street’s elite trading groups.

“There is more money invested in quantitative strategies than we and many others appreciated,” wrote Global Alpha’s managers in a report to battered investors later that month. A staggering amount of that money was sitting at Goldman Sachs Asset Management. Including the GEO fund and Global Alpha, GSAM had about $250 billion in funds under management, of which about $150 billion was in hedge funds.