The Quants: How a New Breed of Math Whizzes Conquered Wall Street and Nearly Destroyed It (34 page)

Despite his concerns, Brown didn’t raise serious alarms at Morgan. He realized that the bank was going to take losses, large ones, once the credit cycle turned. But it wouldn’t be fatal. Plus there was that sterling stock price.

Indeed, virtually no one on Wall Street had any notion of the massive implosion heading its way. The industry, fueled by greater and greater feats of financial engineering, seemed to be hitting on all cylinders. Huge profits were certainly rolling in at Morgan Stanley. Hubler’s bet on subprime, initiated in December 2006, contributed significantly to Morgan’s 70 percent increase in net income to a record $2.7 billion in its fiscal first quarter of 2007.

But problems in the complex bet sprouted in the spring of 2007 as homeowners started defaulting in huge numbers in states that had seen
massive run-ups in prices, including California, Nevada, and Florida. The higher-rated subprime CDO tranches also started to quiver.

Cracks had first started to appear in February 2007, when HSBC Holdings, the third-largest bank in the world, boosted estimates of expected losses from subprime mortgages by 20 percent to $10.6 billion. Just four years earlier, HSBC had piled into the U.S. subprime market when it snapped up Household International Inc., which became HSBC Finance Corp. Household’s chief executive at the time, William Aldinger, had boasted after the deal closed that the company employed 150 quants who were whizzes at modeling credit risk. Other firms, ranging from Seattle banking giant Washington Mutual to mortgage lenders such as New Century and IndyMac Bancorp, were also warning of large losses from subprime mortgage holdings.

Brown started to think of jumping ship, and that’s when he began talking to AQR.

It seemed like propitious timing. This new Morgan, this subprime-fueled leverage-happy hot rod, wasn’t a place he wanted to be a part of anymore. In late 2006, he’d taken a call from Michael Mendelson, a top researcher at AQR. Brown had recently published a book called
The Poker Face of Wall Street
, a mix of biographical reflections and philosophical ruminations about gambling and finance. The quants at AQR loved the book and thought Brown would be a good fit.

More important, AQR was considering an IPO and needed someone familiar with the nitty-gritty compliance details that went with becoming a public company. Disillusioned with Morgan and disappointed with a less-than-stellar bonus that spoke to the company’s lack of appreciation for his talents, Brown was intrigued. He had several interviews with AQR and met Asness, who seemed to speak his language and clearly understood quantitative risk management (though in their first meeting they primarily compared notes on a shared passion: old movies). By June 2007, Brown was making the daily commute on the Metro-North Railroad from New York to AQR’s Greenwich headquarters.

By then, serious trouble was erupting in subprime. The same month Brown joined AQR, news emerged that a pair of Bear Stearns
hedge funds that had dabbled heavily in subprime CDOs—the mind-numbingly named Bear Stearns High Grade Structured Credit Strategies Master Fund and Bear Stearns High Grade Structured Credit Strategies Enhanced Leverage Master Fund—were suffering unexpected losses. Managed by a Bear Stearns hedge fund manager named Ralph Cioffi, the funds had invested heavily in subprime CDOs.

Broadly, Bear Stearns was optimistic that while the housing market was shaky, it wasn’t poised for serious pain. A report issued on February 12, 2007, by Bear researcher Gyan Sinha argued that weakness in certain derivatives tied to subprime mortgages represented a buying opportunity. “While the subprime sector will experience some pain as it removes some of the froth created by excesses,” he wrote, “an over-reaction to headline risk will create opportunities for nimble investors.”

Such thinking was a recipe for a blowup. Cioffi’s Enhanced fund first started to lose money the same month Sinha wrote his report. The more sedate High Grade fund, which had posted positive returns for more than three years in a row, slipped 4 percent in March. The leveraged fund was on the cusp of imploding. In April, an internal Bear Stearns report on the CDO market revealed that huge losses could be on the way. Even those sterling AAA bonds could be in trouble. One of the Bear fund’s managers, Matthew Tannin, wrote in an internal email that if the report was correct, “the entire subprime market is toast. … If AAA bonds are systematically downgraded then there is no way for us to make money—ever.”

Spooked investors started to ask for their money back. Goldman Sachs, which acted as a trading partner for the Bear funds, said its own marks on the securities the funds held were much worse than Cioffi’s marks. From there, it was only a matter of time. On June 15, Merrill Lynch, a creditor to the funds, seized about $800 million of their assets. The following week, Merrill started to sell off the assets in a series of auctions, triggering shock waves throughout the CDO market. The fire sale forced holders of similar CDOs to mark down the prices of their own securities.

Back at Morgan Stanley, Howie Hubler was beginning to sweat. The collapse of low-rated CDO tranches was exactly what he’d bet on. But weakness in the high-rated tranches, the AAAs, wasn’t in his playbook.
Hubler was short $2 billion worth of low-quality CDOs. Disastrously, he held $14 billion of high-rated “supersenior” CDOs—the kind that in theory could
never
suffer losses.

In July, panic set in. Credit markets began to quake as investors in subprime CDOs all tried to bail out at once. The commercial paper market, which had been used to fund the off-balance-sheet vehicles that were the engine of Wall Street’s securitization machine, started to freeze up. With all the forced selling and few buyers, the losses proved far worse than anyone could have imagined.

The bad news came rapid-fire, one catastrophe after another. First, there were Ralph Cioffi’s collapsing hedge funds at Bear Stearns. On July 30, the funds were instructed to file for bankruptcy. Soon after, Cioffi and Tannin were fired. In June 2008, the two were indicted for conspiring to mislead investors about the health of their funds.

Illustrating the international nature of the crisis, an Australian hedge fund called Basis Capital Fund Management that had invested heavily in subprime securities collapsed. From there, the falling dominoes multiplied. Sowood, the hedge fund Ken Griffin had snapped up, fell by more than 50 percent in a matter of weeks. American Home Mortgage Investment, one of the nation’s largest mortgage lenders, saw its stock plunge nearly 90 percent after it warned it was having trouble accessing cash from the capital markets and might have to shut down. A week later, American Home filed for
Chapter 11
bankruptcy protection.

In early August, Countrywide Financial, the nation’s largest mortgage lender, warned of “unprecedented disruptions” in the credit market. The company said that while it had “adequate funding liquidity … the situation is rapidly evolving and the impact on the company is unknown.”

All the bad news made it clear that many CDOs were worth far less than most had thought. The losses proved jaw-droppingly large. Later that year, Morgan took a loss of $7.8 billion, much of it from Hubler’s desk.

The losses in high-rated tranches of CDOs—the superseniors—devastated the balance sheets of banks in the United States and overseas and were a primary cause of the credit meltdown that swept
the financial system starting that summer. The CDO machine, and the highly leveraged house of cards built upon it, cascaded into a black hole. Trading dried up, and pricing for CDOs became nearly impossible due to the complex, misused models such as the Gaussian copula.

As the mortgage market imploded, quant funds such as AQR, Renaissance, PDT, Saba, and Citadel believed they were immune to the trouble. Renaissance and PDT, for instance, didn’t dabble in subprime mortgages or credit default swaps. They mostly traded stocks, options, or futures contracts, which had little to do with subprime. Citadel, AQR, and Saba believed they were the smart guys in the room and had either hedged against losses or were on the right side of the trade and were poised to cash in.

Deutsche Bank, for example, was cashing in on Weinstein’s bearish bet, which eventually made about $250 million for the bank. A thirty-six-year-old colleague named Greg Lippmann had also placed a huge bet against subprime that would earn the bank nearly $1 billion. Lippmann’s colleagues could be seen wearing gray T-shirts around the trading floor that read “I Shorted Your House” in bold black letters.

Weinstein, poised to cash in on his bets, threw a party at his Southampton digs on July 28, a warm summer Saturday night. A row of tiki torches illuminated the unassuming front of Weinstein’s two-story cottage. Guests lounged under a white tent in the expansive backyard as they sipped white wine from self-illuminated cocktail glasses. Weinstein, dressed in a jet-black button-down shirt, trim brown hair slicked back to reveal his pale, broad forehead, was relaxed and confident as he mingled with his well-heeled guests.

Two days later, the credit crisis that had been building for years would explode with full force. With Muller back from his self-imposed exile, Asness poised to make untold millions with AQR’s IPO, Weinstein planning to break away from Deutsche to launch his own hedge fund powerhouse, and Griffin ready to vault into the highest pantheon of the investing universe, the stakes were as high as they’d ever been for the small band of quants.

At the
start of August 2007, the nation was treated to the typical midsummer news lull. The junior senator from Illinois, Barack Obama, gave a speech in Washington declaring that the United States should shift its military focus away from the Iraq war to fight Islamic extremism. More than a dozen people drowned near Minneapolis after the Mississippi River flooded. Starbucks said its quarterly profits rose 9 percent and that it planned to open another 2,600 stores in fiscal 2008. Barbie and Hot Wheels maker Mattel said it was recalling one million toys made in China, including Elmo Tub Sub and Dora the Explorer figures, because they contained lead.

But beneath the calm surface, a cataclysm was building like magma bubbling to the surface of a volcano. All the leverage, all the trillions in derivatives and hedge funds, the carry-trade cocktails and other quant esoterica, were about to explode. Those close enough to
the action could almost feel the fabric of the financial system tearing apart.

On the afternoon of August 3, a Friday, a torrential downpour hit New York City like a fist. As the rain fell, CNBC talk-show host and onetime hedge fund jockey Jim Cramer had a televised fit of hysteria in which he accused the Federal Reserve of being asleep at the switch. “These firms are going to go out of business! They’re nuts, they’re nuts! They know nothing!” he screamed into the stunned face of his colleague, Erin Burnett. Cramer raved about calls he’d been fielding from panicked CEOs. Firms were going to go bankrupt, he predicted. “We have Armageddon in the fixed-income markets!”

Viewers were stunned and unnerved, though most couldn’t begin to fathom what he was raving about. One of the CEOs Cramer had been talking to was Angelo Mozilo, CEO of the mortgage giant Countrywide Financial. The Dow Jones Industrial Average gave up 281 points, most of which came after Cramer’s outburst. Over a sultry August weekend, Wall Street’s legions of traders, bankers, and hedge fund titans tried to relax, hopping in their Bentleys and BMWs, their Maseratis and Mercedeses, and retreating to the soft sands of the Hamptons beaches or jetting away for quick escapes to anywhere but New York City or Greenwich. They knew trouble was coming. It struck Monday with the force of a sledgehammer.

Cliff Asness
walked to the glass partition of his corner office and frowned at the rows of cubicles that made up AQR’s Global Asset Allocation group.

GAA was replete with hotshot traders and researchers who scoured the globe in search of quantitative riches in everything from commodity futures to currency derivatives. On the other side of the building, separated by a wall that ran down the middle of the office, AQR’s Global Stock Selection team labored away. A job at GSS could be rough. It involved the grunt work of combing through reams of data about stock returns and the grueling task of hoping to find some pattern that the thousands of other Fama-bred quants hadn’t found yet.

That Monday afternoon, August 6, 2007, something was going
wrong at GSS. The stocks its models picked to buy and sell were moving in strange directions—directions that meant huge losses to AQR.

Asness snapped shut the blinds on the glass partition and returned to his desk. He reached out and clicked his mouse, bringing his computer screen to life. There it was in bright red digits. The P&L for AQR’s Absolute Return Fund. Sinking like a rock.

Throughout AQR, the hedge fund’s legions of quants also were mesmerized by the sinking numbers. It was like watching a train wreck in slow motion. Work had ground to a halt that morning as everyone tried to assess the situation. Many of the fund’s employees walked about the office in a confused daze, turning to one another in hope of answers.