The Quants Part 11

"The carry trade has pervaded every single instrument imaginable, credit spreads, bond spreads: everything is poisoned," HSBC currency a.n.a.lyst David Bloom told the paper.

Few, however, seemed to worry about what would happen if the trade suddenly fell apart. Every now and then, a hiccup foreshadowed the incredible turmoil to come. In February 2007, traders started getting nervous about whether stocks in China and other emerging markets had run up too far, too fast. As Chinese stocks started to fall, traders who'd plowed into the market using carry-trade rocket fuel started to panic, buying back their borrowed yen and causing the yen to spike.

At roughly the same time, the Bank of j.a.pan voted to raise a benchmark interest rate, further causing the yen to rise. A dangerous self-reinforcing feedback loop began: As the yen kept rising, others in the trade were forced to buy back yen to stem the bleeding, since the longer they waited, the more money they could lose. That caused further appreciation in the yen. The Chinese market began to collapse, falling 10 percent in a single day and triggering a global stock market rout that saw the Dow Jones Industrial Average drop more than 500 points.

It was only a blip, though, and the global stock-market freight train took off again in the spring. But it was a warning that few heeded. As long as the trade kept churning out seemingly riskless profits, the music kept playing.

Then, in 2007, the music stopped. The carry trade blew up. The securitization machine collapsed as homeowners started defaulting on their loans in record numbers.

As a risk manager, Brown watched it all go down at Morgan Stanley, one of the biggest players in the CDO casino, which he'd joined in 2004 after leaving Citigroup.

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Brown joined "Mother Morgan," as it was known, under the reign of Phil Purcell, who'd taken over several years earlier in a vicious power struggle with another Morgan kingpin, John Mack. Purcell had joined Morgan as part of a $10 billion merger in 1997 between the elite storied bank and Dean Witter Discover & Co., a brokerage that largely catered to middle-income customers. White-shoe Morganites were aghast. But Purcell, named CEO in the deal, proved a savvy rival to Mack, who'd been at Morgan since 1972, starting off as a bond trader. In 2001, Mack left the bank, realizing he couldn't unseat Purcell; he first worked at Credit Suisse First Boston before joining a hedge fund. "Mother Morgan," as it was known, under the reign of Phil Purcell, who'd taken over several years earlier in a vicious power struggle with another Morgan kingpin, John Mack. Purcell had joined Morgan as part of a $10 billion merger in 1997 between the elite storied bank and Dean Witter Discover & Co., a brokerage that largely catered to middle-income customers. White-shoe Morganites were aghast. But Purcell, named CEO in the deal, proved a savvy rival to Mack, who'd been at Morgan since 1972, starting off as a bond trader. In 2001, Mack left the bank, realizing he couldn't unseat Purcell; he first worked at Credit Suisse First Boston before joining a hedge fund.

After Mack left, however, earnings at Morgan hadn't kept pace with those of its rivals, especially Goldman Sachs. Between Mack's departure and early 2005, the market value of the company had fallen nearly 40 percent, to $57 billion. While the value of compet.i.tors had also taken a hit, Morgan's drop was among the steepest on Wall Street. Underlings fumed at Purcell. They said he was too cautious. That he wasn't a real risk taker. That he didn't have the b.a.l.l.s to make real money-like John Mack.

Brown thrived, however. He'd been hired to help the bank's credit system get up to speed with an arcane set of regulations known as the Basel Accord, an international standard designating how much capital banks needed to hold to guard against losses. Morgan's chief financial officer, Steve Crawford, a Purcell protege, had hired Brown. He wanted him to accomplish the task-which had taken commercial banks such as Citigroup several years-in eighteen months or less.

"If you can do that, you can have any job at the bank you want," Crawford promised.

Brown was impressed by Morgan's higher-ups, who seemed to appreciate the oft-ignored quants and had encouraged a number of programs to gear up the firm's risk management capabilities. But in a palace coup, Purcell and his favorites, including Brown's benefactor, Crawford, were forced out in June 2005 by a band of high-powered shareholders. His replacement: John Mack.

Mack, a native of North Carolina and son of Lebanese immigrants, promised to bring back the old aggressive culture of Morgan. He found the performance of his beloved Morgan under Purcell unacceptable. Over all his years at the bank, he'd overseen the first stat arb operation under Nunzio Tartaglia in the 1980s, and had also helped manage Peter Muller's group. He had a taste for risk. Morgan, he believed, had lost it. Upon his return, Mack marched onto the Morgan trading floor like a triumphant general on the streets of ancient Rome. The financial news channel CNBC broadcast the event live. The bank's traders peeled their eyes away from their ubiquitous Bloomberg terminals to loudly cheer the second coming of "Mack the Knife," a nickname earned by his willingness to slash payrolls and cut costs.

Morgan had been left behind by fast movers such as Goldman Sachs and Lehman Brothers, Mack said, and its profits were suffering. The new paradigm for investment banks on Wall Street was risk taking. The ideal model was Henry Paulson's Goldman Sachs, with its hugely successful Global Alpha Fund and outsized profits in private equity.

Paulson himself had outlined the new paradigm in the bank's 2005 annual report. "Another key trend is the increasing demand from clients for investment banks to combine capital and advice," he wrote. "In other words, investment banks are expected to commit more of their own capital when executing transactions. ... Investment banks are increasingly using their own balance sheets to extend credit to clients, to a.s.sume market risk on their behalf and sometimes co-invest alongside them."

Goldman's strategy reflected the shifts that had been going on at investment banks for more than a decade. Banks were in a life-and-death struggle to keep talented traders from jumping ship and starting hedge funds-as Cliff Asness had done in 1998. They were going head-to-head with the Greenwich gunslingers and losing. No bank saw this more clearly than Goldman. Others, such as Boaz Weinstein's Deutsche Bank and Peter Muller's Morgan Stanley, were close behind. The only way to compete would be to offer their best and brightest ma.s.sive paychecks, and open the gates wide on risk taking and leverage. In short order, Wall Street's banks morphed into ma.s.sive, risk-hungry hedge funds, Goldman leading the way and Morgan close behind.

Regulators lent a helping hand. On a spring afternoon in late April 2004, five members of the Securities and Exchange Commission gathered in a bas.e.m.e.nt hearing room to meet a contingent of representatives from Wall Street's big investment banks to talk about risk. The banks had asked for an exemption for their brokerage units from a regulation that limited the amount of debt they could hold on their balance sheets. The rule required banks to hold a large reserve of cash as a cushion against big losses on those holdings. By loosening up these so-called capital reserve requirements, the banks could become more aggressive and deploy the extra cash in other, more lucrative areas-such as mortgage-backed securities and derivatives.

The SEC complied. It also decided to rely on the banks' own quant.i.tative models to determine how risky their investments were. In essence, in a move that would come to haunt not just the agency but the entire economy, the SEC outsourced oversight of the nation's largest financial firms to the banks' quants.

"I'm happy to support it," said Roel Campos, an SEC commissioner. "And I keep my fingers crossed for the future."

Initially, Morgan wasn't eager to join the party. A mantra at Morgan before John Mack returned was that the bank "wouldn't be another Goldman," according to a person who worked at the bank. Morgan would exercise caution during boom times to be prepared for the inevitable bust when the music stopped.

Mack's return changed that. His solution was that the firm should take bigger, bolder gambles, and more of them, just like Goldman.

Looking on, Brown grew concerned as Morgan's risk appet.i.te surged. The new regime seemed to act as if risk management were simply a matter of filling out the forms, dotting the i i's and crossing the t's t's, but not a central part of the firm's ethos, which was to ring the cash register.

Brown also raised his eyebrows at one of Mack's themes. In meeting after meeting in conference rooms near the bank's executive offices, Mack said he wanted to double Morgan's revenues in five years and keep costs flat. Nice idea Nice idea, Brown thought. But how exactly are we going to do that? But how exactly are we going to do that?

The answer, he feared, was simply to take more risk.

Among the ideas Mack's staff cooked up for reaching his goal: increase investments in the financial derivatives business, plow headlong into the booming field of residential mortgages, and take more risk with the firm's own capital on its proprietary trading desks such as Peter Muller's PDT.

Morgan quickly found a way to combine all three of those goals in one area: subprime mortgages. In August 2006, Morgan rolled out a plan to purchase subprime mortgage lender Saxon Capital for $706 million. The bank's perpetual-motion subprime machine was cranking up.

Brown could see it all happening before his eyes. His job as a risk manager for the bank's credit division gave him unique visibility into the positions on Morgan's fixed-income balance sheet. For the most part, it seemed under control. But there was one area that troubled him: securitization and all those subprime mortgages.

Subprime mortgages had become the new darlings of Wall Street. The more high-risk borrowers who could be enticed to take high-interest mortgages, the more high-risk/high-reward CDOs-and synthetic CDOs-could be created by and for Wall Street investors. As long as the carousel kept spinning, everyone would get a bra.s.s ring.

Brown, however, was growing increasingly concerned about Morgan's securitization merry-go-round. Just as it had at Citigroup, one of his biggest worries centered on the ma.s.sive "warehouses" of subprime mortgages Morgan used to store the loans. Most banks, inspired by Salomon Brothers, had created off-balance-sheet vehicles that would temporarily house the loans as they were bundled, packaged, sliced, diced, and sold around the world. Such vehicles funded themselves using the commercial paper markets, short-term loans that constantly needed to be rolled over. Any hitch in the chain, Brown realized, could result in disaster. Still, he didn't think it represented a risk that could substantially damage the bank. Profits were through the roof. He also took consolation in Morgan Stanley's sky-high share price. If the bank suffered a huge hit, it could always raise cash on the open market with a share offering. He hadn't factored in the possibility that Morgan's share price would collapse in an industrywide meltdown.

By early 2007, Morgan Stanley was on one of the hottest streaks in its history. The bank was coming off its best quarter ever, and its best year ever, in profitability. One big success, Mack noted in the firm's April 2007 conference call, was the inst.i.tutional securities group run by Morgan's high-flying co-president, Zoe Cruz. The group managed "a tremendous amount of risk in a very smart and disciplined way," Mack said.

Its leverage ratio, however-the amount of borrowed money it uses to trade every day-was a whopping 32 to 1. In other words, Morgan was borrowing $32 for every $1 it actually owned. Other investment banks, such as Bear Stearns, Lehman Brothers, and Goldman Sachs, also had sky-high leverage ratios. Internal measures at some of these banks showed the leverage was even higher than the official numbers reported to the SEC.

One of Cruz's desks was a proprietary credit-trading group formed in April 2006. Howard Hubler, a managing director with years of experience trading complex securities at Morgan, was in charge of it. It was a hedge-fund-like trading outfit that would wager Morgan's own money in the credit markets, a bond-trading mirror image of PDT.

At first Hubler's group was a roaring success, netting the firm $1 billion by early 2007. Hubler was among Wall Street's new breed of correlation traders using David Li's Gaussian copula to measure the risks of defaults among various tranches of CDOs. His strategy involved shorting the lower rungs of subprime CDOs (or derivatives tied to them) while holding on to the higher-rated CDO tranches. By the quants' calculations, those high-quality CDO slices had little chance of losing value.

As subsequent events proved, correlation trading turned out to be a hornet's nest of risk. Hubler thought he was shorting subprime. But in a cruel twist, Hubler ended up long subprime. He got the correlations wrong.

Brown, meanwhile, had been growing more and more alarmed about the risks the firm was taking in the subprime mortgage market. The loans were fed into one end of Morgan's securitization machine by subprime lenders such as Countrywide and New Century Financial and pumped out the other end to investors around the world. Indeed, though few realized it at the time, Morgan was one of the biggest players during the peak years of subprime, 2005 and 2006, underwriting $74.3 billion in subprime mortgages, according to Inside Mortgage Finance Inside Mortgage Finance (Lehman was number one, with $106 billion in mortgages underwritten). (Lehman was number one, with $106 billion in mortgages underwritten).

Morgan was also lending aggressively elsewhere, backing ma.s.sive volumes of credit card debt and corporate loans. Brown realized it was an unsustainable process bound to come crashing down. "It all only made sense if the people we were lending to could pay us back," recalled Brown. "But it became clear that the only way they could pay us back was by borrowing more. There were all kinds of deals we were doing that only made sense if credit is good. We knew at some point that the musical chairs would stop, and we would own a lot of this stuff, and we wouldn't have the capital to pay for it."

Brown believed the quants who worked on the CDO models were often narrowly focused on the Byzantine details of the deals and rarely looked at the big picture-such as the looming bubble in the housing market. "They were showing zero risk," he recalled. It was the same mistake everyone made, from the rating agencies to the banks to the home builders to the buyers of those homes who expected to refinance their mortgages as soon as the payments shot up. On the surface there was little reason to think otherwise. Home prices had never declined on a national level since the Great Depression. Plus, everyone was happy. Some were getting filthy rich.

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 ma.s.sive 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 ma.s.sive 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 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 quant.i.tative risk management (though in their first meeting they primarily compared notes on a shared pa.s.sion: 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 a.s.sets. The following week, Merrill started to sell off the a.s.sets 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 never suffer losses. 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.

Ill.u.s.trating 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 Chapter 11 bankruptcy protection. 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 Sat.u.r.day night. A row of tiki torches illuminated the una.s.suming 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 c.o.c.ktail gla.s.ses. Weinstein, dressed in a jet-black b.u.t.ton-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.

THE AUGUST FACTOR

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. 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 c.o.c.ktails 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 t.i.tans 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 gla.s.s part.i.tion of his corner office and frowned at the rows of cubicles that made up AQR's Global a.s.set Allocation group. walked to the gla.s.s part.i.tion of his corner office and frowned at the rows of cubicles that made up AQR's Global a.s.set Allocation group.

GAA was replete with hotshot traders and researchers who scoured the globe in search of quant.i.tative 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 gla.s.s part.i.tion 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 a.s.sess the situation. Many of the fund's employees walked about the office in a confused daze, turning to one another in hope of answers.

"You know what's going on?"

The answer was always the same: "No. You?"

Rumors of corporate collapses were making the rounds. Banks and hedge funds were reeling from their exposure to toxic subprime mortgages. Countrywide Financial, some said, was imploding and looking in desperation for a white knight, such as Warren Buffett's Berkshire Hathaway or Bank of America. But no one wanted anything to do with the distressed mortgage lender.

Inside his office, Asness again stared grimly at his computer screen. Red numbers washed across it. He didn't know what to do. His greatest fear was that there was nothing he could do.

Outside, people noticed the closed blinds on the boss's office. It was unusual and a bit spooky. Asness always had an open-door policy, even if very few people used it. Employees figured Asness couldn't stand the idea of his employees peeking in through the window to see how the big guy was taking it.

The registration statements for AQR's initial public offering were ready and waiting to be shipped off to the SEC. Indeed, Asness was set to make the big announcement about his plans later that month, making headlines in all the important papers. But now, the IPO and all the money it would have spun off were getting more distant by the second, a distance measured by the tick-by-tick decline of Absolute Return, as well as a number of other funds at AQR that were getting pounded by the mysterious downturn.

Several blocks away from AQR's office, Michael Mendelson, head of global trading, was in line at the local Greenwich Subway sandwich shop. He glanced at his BlackBerry, which came equipped with a real-time digital readout of all of AQR's funds. His jaw dropped. Something bad was happening. Something horrible.

A longtime Goldman Sachs veteran, mastermind of the bank's elite high-frequency trading outfit, Mendelson was one of the brightest thinkers at AQR, and one of the first people Asness would call when he needed answers about a trade going awry. He knew instantly that something needed to be done fast to stem the bleeding.

He raced back to AQR's office and huddled with several of AQR's top traders and researchers, including Jacques Friedman, Ronen Israel, and Lars Neilson. After determining that a huge deleveraging was taking place, directly impacting AQR's funds, they marched to Asness's office.

"It's bad, Cliff," Mendelson said, stepping into the room. Friedman, Israel, and Neilson followed close behind. "This has the feel of a liquidation."

"Who is it?" Asness said.

"We're not sure. Maybe Global Alpha."

"Oh G.o.d, no."

Since Asness had left Goldman in 1998, Global Alpha had been run by Mark Carhart and Ray Iwanowski, alums, like Asness, of the University of Chicago's finance program, and Fama proteges. Under their guidance, Global Alpha had expanded its reputation as one of the smartest investing outfits on Wall Street. It never had a losing year through 2005, when it posted an eye-popping return of 40 percent.

But Global Alpha had been slipping, losing money in 2006 and the first half of 2007. The worry: to reverse its fortunes, it was juicing up its leverage. And the more leverage, the more risk. Many feared that Global Alpha and its sister fund, Global Equity Opportunity-a stock-focused fund-were doubling down on bad trades with more and more borrowed money.

"They're one of the few funds big enough to leave such a big footprint." Mendelson hunched his shoulders in frustration.

"Have you talked to anyone over there?"

"No," Mendelson said. "I was going to ask you."

"I'll give it a shot."

There had been no small amount of bad blood between Asness and his old colleagues at Goldman, who were embittered after being left behind when Asness and the others bolted. Asness felt bad about it all, but he hadn't wanted to alienate the head honchos at Goldman by leading a ma.s.s exodus. Leaving behind Carhart and Iwanowski to manage Global Alpha, he'd hoped, was a peace offering to the company that had rolled the dice on him when he was fresh meat out of Chicago. But Carhart and Iwanowski weren't overjoyed about being the sacrificial lambs.

The tensions had cooled over the years. Global Alpha had developed into an elite trading outfit, with $12 billion in a.s.sets and a solid record-except for a severe misstep in 2006-that could go head-to-head with the best hedge funds in the business, including AQR.

Asness put in a few calls to Goldman, but no one was picking up the phone. That made him more worried than ever.

Boaz Weinstein was relaxed that Monday after the weekend bash at his house in the Southhamptons. But soon after lunch, he started to fret. Something was going wrong with Saba's quant equities desk, which he'd added to his operation to complement his bond-trading group. The news trickled in around two o'clock when Alan Benson, the trader who ran the desk, sent his second daily email with his desk's P&L. was relaxed that Monday after the weekend bash at his house in the Southhamptons. But soon after lunch, he started to fret. Something was going wrong with Saba's quant equities desk, which he'd added to his operation to complement his bond-trading group. The news trickled in around two o'clock when Alan Benson, the trader who ran the desk, sent his second daily email with his desk's P&L.

Benson's first email, sent at 10:00 A.M. A.M., showed early signs of losses. But Weinstein had shrugged it off. Benson's desk, which managed $2 billion worth of positions in stocks and exchange-traded funds, could be highly volatile. Losses in the morning could easily turn into gains by the afternoon.

The 2:00 P.M P.M. update showed the losses hadn't turned to gains. They'd gotten much worse. Benson was down tens of millions. Weinstein stood and walked one floor down to Saba's trading operation on the second floor. Benson looked tense and was sweating.

"What's up, Alan?" Weinstein said, outwardly calm as always. But there was tension in his voice caused by the startling sight of millions of dollars going up in smoke, just like the GM trade back in 2005.

"It's weird," Benson said. "Stocks that we're betting against are going up, a lot. Looks like short covering on a really big scale, across a lot of industries."

In a short sale, an investor borrows a stock and sells it, hoping to purchase it back at a lower price sometime in the future. Say IBM is trading at $100 a share and you expect it to decline to $90. You borrow a hundred shares from another investor through a prime broker and sell them to yet another investor for $10,000. If your crystal ball was correct and IBM does in fact fall to $90, you buy the stock back for $9,000, return the shares to the broker, and pocket the $1,000.

But what if, for instance, IBM starts to shoot higher? You're on the hook for those shares, and every dollar it goes up is a $100 loss. To minimize your losses, you buy the stock back. That can have the effect of pushing the stock even higher. If hundreds or thousands of short sellers are doing this at once, it turns into what's known as a short squeeze. That Monday, August 6, was beginning to look like possibly the biggest short squeeze in history.