The Quants: How a New Breed of Math Whizzes Conquered Wall Street and Nearly Destroyed It (45 page)

Weinstein was rarely seen on Saba’s trading floors as his losses ballooned. The trader was holed up in his office for long periods of time, often late into the night, conferring with top lieutenants about how to stop the bleeding. No one had answers. There was little they could do.

Paranoia took hold. It seemed as if the group could be shut down at any moment. Several of the group’s top traders, including the equity trader Alan Benson, were laid off. In late November, a trader was conducting a tour of Saba’s second-floor operation. “If you come back two weeks from now, this space will be empty,” he said.

He was a little early, but not by much.

A month
after Greenspan’s testimony, in mid-November, Waxman’s committee grilled another group of suspects in the credit crisis: hedge fund managers.

And not just any hedge fund managers. Waxman had summoned the top five earners of 2007 for a televised grilling about the risks the shadowy industry posed to the economy. The lineup, men whose take-home pay averaged $1 billion in 2007, included famed tycoon George Soros. Also on the hot seat was Philip Falcone, whose hedge fund, Harbinger Capital, boasted a 125 percent return in 2007 from a big bet
against subprime. His gains paled beside those of fellow witness John Paulson, whose Paulson & Co. posted returns as high as nearly 600 percent from a massive wager against subprime, earning him a one-year bonanza of more than $3 billion, possibly the biggest annual return for an investor ever.

The other two managers arrayed before Waxman’s House Committee on Oversight and Government Reform were Jim Simons and Ken Griffin. The quants had come to Capitol Hill.

Griffin, for one, had prepared for his appearance with Citadel’s typical discipline. Having flown to Washington from Chicago on his private jet just that morning, he was coached by a battery of lawyers, as well as Washington power broker Robert Barnett. In 1992, Barnett had helped Bill Clinton prepare for the presidential debates, acting as the stand-in for George H. W. Bush. He’d acted as a literary agent for Barack Obama, former British prime minister Tony Blair,
Washington Post
reporter Bob Woodward, and George W. Bush’s defense secretary Donald Rumsfeld.

The move was classic Ken Griffin. Money was no object. When he inevitably veered off script during his testimony, lecturing the congressmen on the value of unregulated free markets, that was also classic Ken Griffin.

But for the most part, the hedge fund kingpins made nice, agreeing that the financial system needed an overhaul but shying away from calling for direct oversight of their industry. Soros expressed outright scorn for the hedge fund industry, made up of copycats and trend followers destined for extinction. “The bubble has now burst and hedge funds will be decimated,” Soros said in his gruff Hungarian accent, a gleeful prophet of doom. “I would guess that the amount of money they manage will shrink by between 50 and 75 percent.”

Coming into 2008, hedge funds were in control of $2 trillion. Soros was estimating that the industry would lose between $1 trillion and $1.5 trillion—through either outright losses or capital flight to safer harbors.

Simons, looking every bit the frumpy professor with his balding pate, chalk-white beard, and rumpled gray jacket, said Renaissance
didn’t dabble in the “alphabet soup” of CDOs or CDSs that triggered the calamity. His testimony provided little insight into the problems behind the meltdown, though it did offer a rare glimpse into Renaissance’s trading methods.

“Renaissance is a somewhat atypical investment management firm,” he said. “Our approach is driven by my background as a mathematician. We manage funds whose trading is determined by mathematical formulas. … We operate only in highly liquid publicly traded securities, meaning we don’t trade in credit default swaps or collateralized debt obligations. Our trading models tend to be contrarian, buying stocks recently out of favor and selling those recently in favor.”

For his part, Griffin sounded a note of defiance, fixing his unblinking blue eyes on the befuddled array of legislators. Hedge funds weren’t behind the meltdown, he said. Heavily regulated banks were.

“We haven’t seen hedge funds as the focal point of the carnage in this financial tsunami,” said Griffin, clad in a dark blue jacket, black tie, and light blue shirt.

Whether he believed it or not, the statement smacked of denial, overlooking the fact that Citadel’s dramatically weakened condition in late 2008 had added to the market’s turmoil. Regulators had been deeply concerned about Citadel and whether its demise would trigger even more blowups.

Griffin also opposed greater transparency. “To ask us to disclose our positions to the open market would parallel asking Coca-Cola to disclose their secret formula to the world.”

Despite Griffin’s warnings, Congress seemed to be heading toward greater oversight of hedge funds, which it saw as part of a shadow banking system that had caused the financial collapse. “When hedge funds become too big to fail, that poses a problem for the financial system,” MIT’s Andrew Lo, he of the Doomsday Clock, told the
Wall Street Journal
.

Citadel didn’t
fail, though it came dangerously close. Griffin, who’d once nurtured grand ambitions of a financial empire that could match the mightiest powerhouses of Wall Street, had been humbled. In the
first half of the year, he’d been coming into the office late, often around 10:00 a.m. instead of the predawn hours he used to keep, so he could spend time with his one-year-old son. He couldn’t help thinking that he was paying for letting his guard down.

But Griffin knew that the high-flying hedge fund fantasy of the past two decades would never again be the same. The mountain-moving leverage and ballsy billion-dollar bets on risky hands were all consigned to another age.

Griffin put a brave face on. As he said on the conference call that Friday afternoon in October: “We need to face the fact that we need to evolve. We will embrace the changes that are part of that evolution, and we will prosper in the new era of finance.”

His investors weren’t so sure. Many were asking for their money back. In December, after redemption requests totaling about $1.2 billion, Citadel barred investors from pulling money from its flagship funds. Assets at Citadel had already shrunk to $10.5 billion from $20 billion. To comply with further requests, Griffin would have to unload more positions to raise the funds, a bitter pill to swallow in a depressed market.

Investors had little choice but to comply. But the move had infuriated many, who saw it as a strong-arm tactic by a firm that had already lost them countless millions that year.

Griffin was also suffering a big hit to his mammoth pocketbook. Few outsiders knew exactly how much of Citadel Griffin owned, but some estimated that he held roughly 50 percent of the firm’s assets heading into the crisis, putting his personal net worth at about $10 billion, far higher than most believed. The 55 percent tumble by his hedge funds, therefore, hurt no one more than Griffin. Adding to the pain, he’d used $500 million of his own cash to prop up the funds and pay management fees typically borne by investors. Of course, he was also the biggest investor in the firm’s high-frequency quant powerhouse, Tactical Trading, which had pulled in $1 billion.

Citadel, meanwhile, was severely hobbled. The gross assets of its hedge funds had tumbled sharply in the meltdown, falling from $140 billion in the spring of 2008 to just $52 billion by the end of the year.
The firm had unloaded nearly $90 billion of assets in its frantic effort to deleverage its balance sheet, a wave of selling that had added further pressure to a panicked post-Lehman market.

Griffin had plenty of company, of course, in the great hedge-fund shakeout of 2008—including Cliff Asness.

Cliff Asness
was furious. The rumors, lies, and the cheap shots had to stop.

It was early December 2008. The small town of Greenwich, Connecticut, was in turmoil. The luxury yachts and streamlined powerboats lay moored in the frigid docks of the Delamar on Greenwich Harbor, a luxury hotel designed in the style of a Mediterranean villa. Caravans of limousines, Bentleys, Porsches, and Beamers sat locked in their spacious custom garages. Gated mansions hunched in the Connecticut cold behind their rows of exotic shrubbery, bereft of their traditional lacings of Christmas glitz. Few of the high-powered occupants of those mansions felt much like celebrating. It was a glum holiday season in Greenwich, hedge fund capital of the world.

Making matters worse, a multibillion-dollar money management firm run by a reclusive financier named Bernard Madoff had proved to be a massive Ponzi scheme, one that Ed Thorp had already unearthed in the early 1990s. The losses rippled throughout the industry like shock waves. A cloud of suspicion fell upon an industry already infamous for its paranoia and obsessive secrecy.

Ground zero of Greenwich’s hedge fund scene was Two Greenwich Plaza, a nondescript four-story building beside the town’s train station that once had housed a hodgepodge of shippers, manufacturers, and stuffy family law firms. That was before the hedge fund crowd moved in.

One of the biggest hedge funds of them all, of course, was AQR. Its captain, Cliff Asness, was on a rampage. He wasn’t quite rolling steel balls around in his hand like Captain Queeg on the
Caine
, but he wasn’t far off. The battered computer monitors Asness destroyed in anger were piling up. Some thought Asness was losing his mind. He seemed to be slipping into a kind of frenzy, the polar opposite of the rational principles he’d based his fund upon. Driving his fury
was the persistent chatter that AQR was blowing up, rumors such as AQR had lost 40 percent in a single day … AQR was on the verge of shutting its doors forever … AQR was melting down and tunneling to the center of the earth in a crazed China syndrome hedge fund catastrophe …

Many of the rumors cropped up on a popular Wall Street blog called Dealbreaker. The site was peppered with disparaging comments about AQR. Dealbreaker’s gossipy scribe, Bess Levin, had recently written a post about a round of layoffs at AQR that had included Asness’s longtime secretary, Adrienne Rieger.

“Uncle Cliff is rumored to have recently sacked his secretary of ten years, and as everyone knows, it’s the secretaries who hold the key to your web of lies and bullshit and deceit, and you don’t get rid of them unless you’re about to go down for the dirt nap,” she wrote.

Dozens of readers posted comments on Levin’s report. Asness, reading them from his office, could tell that many came from axed employees or, worse, disgruntled current employees sitting in their cubicles just outside his office. Some of the posts were just plain mean. “I guess the black box didn’t work,” read one. Another: “AQR is an absolute disaster.”

On the afternoon of December 4, Asness decided to respond. Unlike Griffin, who held a conference call, Asness was going to confront the rumormongers in their den: on the Internet. From his third-floor corner office, he sat before his computer, went to Dealbreaker’s site, and started to type.

“This is Cliff Asness,” he began. He sat back, wiped his mouth, then leaned forward into the keyboard:

Asness posted the rant on the site and quickly realized he’d made a terrible mistake—later he’d call it “stupid.” It was a rare public display of anger for a widely respected money manager. It became an immediate sensation within AQR and throughout the hedge fund community. Morale at the fund had been on the wane as its fortunes suffered. Now the founder of a firm known for rationality and mathematical rigor seemed to have let his emotions get the best of him.

Investors didn’t seem to mind the dustup. What they did mind were the billions of dollars AQR had lost. But Asness was convinced the following year would be better. The models would work again. Decades of research couldn’t be wrong. The Truth had taken a shot in the mouth, but it would eventually come back. When it did, AQR would be there to clean up.

The travails of AQR, once one of the hottest hedge funds on Wall Street, and the intense pressures placed on Asness captured the plight of an industry struggling to cope with the most tumultuous market in decades.

The market’s chaos had made a hash of the models deployed by the quants. AQR’s losses were especially severe in late 2008 after Lehman Brothers collapsed, sending markets around the globe into turmoil. Its Absolute Return Fund fell about 46 percent in 2008, compared with a 48 percent drop by the Standard & Poor’s 500-stock index. In other words, investors in plain-vanilla index funds had done just about as well (or poorly) as investors who’d placed their money in the hands of one of the most sophisticated asset managers in the business.

It was the toughest year on record for hedge funds, which lost 19 percent in 2008, according to Hedge Fund Research, a Chicago research group, only the second year since 1990 that the industry lost money as a whole. (In 2002, hedge funds slid 1.5 percent.)

The Absolute Return Fund had lost more than half of its assets from its peak, dropping to about $1.5 billion from about $4 billion in mid-2007. AQR in total had about $7 billion in so-called alternative
funds and about $13 billion in long-only funds, down sharply from the $40 billion it sat on heading into August 2007, when it was planning an IPO. In a little more than a year, AQR had lost nearly half its war chest.