The Quants Part 12

"Has the feel of a big gorilla getting out of a lot of positions, fast," Benson added.

"Anything we can do about it?"

"Keep an eye on it. I doubt this will last much longer. The rate this guy is unwinding his trades, it can't go on for long. If it does ..."

"What?"

"We'll have to start unwinding, too."

At PDT that same Monday, Peter Muller was AWOL, visiting a friend just outside Boston. Mike Reed and Amy Wong manned the helm, PDT veterans from the old days when the group was nothing more than a thought experiment, its traders a small band of young math whizzes tinkering with computers like brainy teenagers in a cluttered garage. that same Monday, Peter Muller was AWOL, visiting a friend just outside Boston. Mike Reed and Amy Wong manned the helm, PDT veterans from the old days when the group was nothing more than a thought experiment, its traders a small band of young math whizzes tinkering with computers like brainy teenagers in a cluttered garage.

PDT was now a global powerhouse, with offices in London and Tokyo and about $6 billion in a.s.sets (the amount could change daily depending on how much money Morgan funneled its way). It was a well-oiled machine that did little but print money, day after day. That week, however, PDT wouldn't print money-it would destroy it like an industrial shredder.

The unusual behavior of stocks that PDT tracked had begun to slip sometime in mid-July and had gotten worse in the first days of August. The previous Friday, five of the biggest gainers on the Nasdaq were stocks that PDT had sold short, expecting them to decline, and five of the biggest losers were stocks PDT had bought, expecting them to rise. It was Bizarro World for quants. Up was down, down was up. The models were operating in reverse. The Truth wasn't the Truth anymore. It was the anti-Truth.

The losses were accelerating Monday and were especially bad in the roughly $5 billion quant fundamental book-the one PDT had increased in size after Muller returned in late 2006.

Wong and Reed knew that if the losses got much worse, they would need to start liquidating positions in the fundamental book to bring down PDT's leverage. Already the week before, the group had started to ease back on Midas's engine as the market's haphazard volatility picked up steam.

Midas was one thing. It was a high-frequency book that bought and sold securities at a rapid pace all the time. The fundamental book was different. The securities it held, often small-cap stocks that didn't trade very often, could be hard to get rid of, especially if a number of other traders who owned them were trying to dump them at the same time. The positions would need to be combed through and unwound piece by piece, block by block of unwanted stock. It would be hard, it would be time-consuming, and it would be very costly.

The market moves PDT and other quant funds started to see early that week defied logic. The fine-tuned models, the bell curves and random walks, the calibrated correlations-all the math and science that had propelled the quants to the pinnacle of Wall Street-couldn't capture what was happening. It was utter chaos driven by pure human fear, the kind that can't be captured in a computer model or complex algorithm. The wild, fat-tailed moves discovered by Benoit Mandelbrot in the 1950s seemed to be happening on an hourly basis. Nothing like it had ever been seen before. This wasn't supposed to happen! This wasn't supposed to happen!

The quants did their best to contain the damage, but they were like firefighters trying to douse a raging inferno with gasoline-the more they tried to fight the flames by selling, the worse the selling became. The downward-driving force of the deleveraging market seemed unstoppable.

Wong and Reed kept Muller posted on the situation through emails and phone calls. It would be Muller's decision whether to sell into the falling market to deleverage the fund, and by how much. Volatility in the market was surging, confusing PDT's risk models. Now Muller needed to decide whether to deleverage the fundamental book, which was taking the brunt of the damage. If the losses in that book continued much longer, PDT had little choice but to start selling. It would mean cutting off branches in the hope of saving the tree.

Quant funds everywhere were scrambling to figure out what was going on. Ken Griffin, on vacation in France, kept in touch with the traders at Citadel's Chicago headquarters. Renaissance was also taking big hits, as were D. E. Shaw, Barclays Global Investors in San Francisco, J. P. Morgan's quant powerhouse Highbridge Capital Management, and nearly every other quant.i.tative fund in the world, including far-flung operations in London, Paris, and Tokyo.

Tuesday, the downturn accelerated. AQR booked rooms at the nearby Delamar on Greenwich Harbor, a luxury hotel, so they could be available around the clock for stressed-out sleep-deprived quants. Griffin hopped in his private plane and flew back to Chicago for crisis management, and to tie up loose ends on the Sowood deal.

Authorities had little idea about the ma.s.sive losses taking place across Wall Street. That Tuesday afternoon, the Federal Reserve said it had decided to leave short-term interest rates alone at 5.25 percent. "Financial markets have been volatile in recent weeks, credit conditions have become tighter for some households and businesses, and the housing correction is ongoing," the Fed said in its policy statement. "Nevertheless, the economy seems likely to continue to expand at a moderate pace over coming quarters, supported by solid growth in employment and incomes and a robust global economy."

The crisis was mounting, and Washington's central bankers were completely out of touch. The losses on Monday and Tuesday were among the worst ever seen by quant hedge funds, with billions of dollars evaporating into thin air. Wednesday they got far worse.

At the headquarters of Goldman Sachs a.s.set Management in downtown New York, everyone was on red alert. One of the largest hedge fund managers in the world, with $30 billion in a.s.sets, GSAM was getting hit on all sides. It was seeing big losses in value, growth, small-cap stocks, mid-caps, currencies, commodities, headquarters of Goldman Sachs a.s.set Management in downtown New York, everyone was on red alert. One of the largest hedge fund managers in the world, with $30 billion in a.s.sets, GSAM was getting hit on all sides. It was seeing big losses in value, growth, small-cap stocks, mid-caps, currencies, commodities, everything everything. Global Alpha, the Global Equity Opportunity fund-every strategy was getting crushed. And like every other quant fund, its captains, Carhart and Iwanowski, had no idea why.

GSAM's risk models, highly sophisticated measures of volatility, had been spiking for all of July. It was a strange sight, because volatility had been declining for years. And the way GSAM's risk models worked, the decline in volatility meant that it had needed to take more risk, use more leverage, to make the same amount of money. Other quant funds had followed a similar course. Now volatility wasn't behaving anymore. Volatility was actually ... volatile volatile.

Another disturbing trend that Goldman's quants noticed was a rapid unwinding of the worldwide carry trade. Funds such as Global Alpha, AQR, Citadel, and others had been borrowing low-yielding yen on the cheap and investing it in higher-yielding a.s.sets, generating huge profits. The trade had been highly successful for years, helping fuel all kinds of speculative bets, but it depended on one trend remaining in place: cheap yen.

In early August 2007, the yen started to surge. Funds that had borrowed the yen, expecting to repay the loan at a later date, were scrambling to repay as the yen leapt in value against other currencies. That triggered a self-reinforcing feedback loop: As the yen kept rising, more funds were needed to repay the loans, pushing the yen up even more.

At GSAM, the sudden unwind meant a potential catastrophe. Many of its positions-bonds, currencies, even stocks-were based on the yen carry trade.

The collapse of the carry trade and the spike in volatility were potentially disastrous. The first major dislocation in the market, one not seen in years, had happened the previous Friday, August 3. The dislocation turned into an earthquake on Monday. By Tuesday, the situation was critical, and GSAM had to start selling hard.

Walking downtown on Broadway to Morgan Stanley's office through thick, sweaty crowds, Peter Muller was growing impatient. It was Wednesday, August 8, and traffic in midtown Manhattan was jammed up like he'd never seen before. People swarmed the sidewalks, not just the usual tourists but businessmen in suits, nearly everyone jabbering frantically on their cell phones. on Broadway to Morgan Stanley's office through thick, sweaty crowds, Peter Muller was growing impatient. It was Wednesday, August 8, and traffic in midtown Manhattan was jammed up like he'd never seen before. People swarmed the sidewalks, not just the usual tourists but businessmen in suits, nearly everyone jabbering frantically on their cell phones.

He'd just left his s.p.a.cious apartment in the Time-Warner Center at Columbus Circle, located at the southwest corner of Central Park and fourteen blocks north of Morgan's headquarters. There was no time to waste. He checked his watch for the twentieth time. The market would be opening soon. And he was worried-worried the meltdown would continue. He checked his BlackBerry for news. j.a.pan had gotten killed again. Christ. Muller didn't know why the meltdown had started. Worse, he didn't know when it would stop. It had to stop. If it didn't ...

Muller elbowed through the buzzing throng in front of the old Ed Sullivan Theater in frustration. Even nature seemed to be conspiring against him. Earlier that morning, a tornado had struck the city, hitting land shortly before the morning commute in New York City began in earnest. Whipped up by winds as high as 135 miles per hour, the freak twister first hit Staten Island, then leapfrogged across the Narrows of New York Bay to Brooklyn, knocking down trees, ripping up rooftops, and damaging cars and buildings in Sunset Park and Bay Ridge. It was the first tornado to strike Brooklyn in more than fifty years, and only the sixth to strike New York City since 1950.

Major roadways flooded and subway tunnels were drenched, shutting down services across the city and freezing traffic. The chaos that ensued as stranded commuters took to the streets brought to more than a few minds the horrors of six years earlier, when terrorists struck the World Trade Center's Twin Towers on September 11.

As quickly as the storm had rushed in, it cleared away, swirling into the Atlantic. A boiling August sun emerged, baking the city in a steamy, humid soup. Wall Street's army of traders struggled to make it to the office before the start of trading at 9:30 A.M A.M. Many were on edge, and that had nothing to do with the weather. The storm that was building in the world's financial markets was bursting forth in ways no one could have ever imagined. The first bands of the tempest had already hit, and Muller was in the center of it.

It had been a long, wild ride for Muller. PDT was an industrial electronic humming machine that spit out endless streams of money. But things had changed. It was so much more corporate now, regimented, controlled. Nothing like the group's glory days, a decade earlier, when the money seemed to fall from the sky like manna, surprising everyone.

There was that afternoon in-what was it, 1996, 1997?-when a band of PDTers were lounging on a beach in Grenada, the spice island. It was one of many trips to exotic ports around the world that the adventurous group of math wizards would take in those heyday years. As the tropical sunlight faded, and the warm breeze rolled off the blue waters of the Caribbean Sea, Muller decided to check in on the team back in New York. He pulled out his cell phone and hit the speed dial for PDT's trading desk, calling one of the few traders who'd stayed behind to man PDT's computers.

"What's the P&L?" he'd asked, using trader shorthand for profit and loss. Muller was in the habit of hearing a lot about the "P" side of the ledger. "L," not so much.

"Let's see," said a calm voice on the other end of the line. "Seventeen." As in $17 million.

"Beautiful," Muller said, and he meant it. Everything was beautiful. He smiled and flicked a lock of sandy-blond hair from his eyes, toasting another day's bonanza to the group of quants gathered around him in the golden Grenada sunset. Not bad for another day on the beach.

Muller pushed urgently toward Morgan Stanley's headquarters through the chaotic tangle of Times Square. He clenched his jaw and looked up. The storm was gone, the sun shining. The investment bank's impressive profile loomed against the slate-blue sky.

There it was: 1585 Broadway, world headquarters of Morgan Stanley. The skysc.r.a.per towered over Duffy Square in the heart of midtown Manhattan. Completed at the start of the go-go nineties, 1585 Broadway contained nearly 900,000 square feet of office s.p.a.ce on forty-two floors. Several stories above a row of shops, three rows of streaming data fly across the east-facing side of the high tower. Stock prices, currencies, breaking news from around the world. The hulking skysc.r.a.per looked somewhat like a heavyset floor trader itching to bully the neon-glutted towers of Times Square cowering at its concrete feet.

At the sight of the building, Muller still felt the old thrill. He knew, more than most who worked there, the trading power housed inside the intimidating structure. Through miles of endlessly ramifying fiber-optic cables and an array of satellite dishes mushroomed about the building, the gla.s.s-windowed tower was plugged into financial markets around the globe, mainlined into the Money Grid.

Traders deep in the bowels of 1585 Broadway bought and sold options on j.a.panese corporate bonds, derivatives linked to European real estate and West Texas crude, billions in currencies from Canada to Zimbabwe to Peru, as well as the odd slice of subprime mortgage and mortgage derivatives. And, of course, stocks. Billions of dollars' worth of stocks.

Muller stepped briskly into Morgan's s.p.a.cious air-conditioned lobby, escaping the mayhem outside, swiped his ID badge at the electric turnstile, and jumped onto an elevator that would take him to PDT's high-tech trading hub.

The elevator stopped on the sixth floor, and Muller flew into the lobby, sweeping his security pa.s.s before the locked doors of PDT's office. He rushed past the Alphaville Alphaville poster that had hung in PDT's office for more than a decade and stepped into his private office. He flicked on his rank of computers and Bloomberg terminals with access to data on nearly every tradable security in the world. After a quick check of the market action, he checked PDT's P&L. poster that had hung in PDT's office for more than a decade and stepped into his private office. He flicked on his rank of computers and Bloomberg terminals with access to data on nearly every tradable security in the world. After a quick check of the market action, he checked PDT's P&L.

It was bad.

This was the most brutal market Muller had ever seen. Quant funds everywhere were getting crushed like bugs beneath a bulldozer. Muller had been swapping ideas about what was happening with other managers, ringing up Asness and grilling him about what was going on at AQR, trying to find out if anyone knew what was happening at Goldman Sachs. Everyone had theories. No one knew the answer. They all worried that it would be fatal if the unwind lasted much longer.

Rumors of a disaster were rife. The U.S. housing market was melting down, causing huge losses at banks such as Bear Stearns and UBS and hedge funds around the world. Stock markets were in turmoil. Panic was spreading. The subprime catastrophe was mutating through the Money Grid like some strange electronic virus. The entire system started to seize up as the delicate, finely wrought creations of the quants spun out of control.

As the losses piled up, the root of the meltdown remained a mystery. Oddly enough, as much as the furor seized the world of finance, it went largely overlooked in the larger world beyond. Indeed, investors on Main Street had little idea that a historic blowup was occurring on Wall Street. Aaron Brown at AQR had to laugh watching commentators on CNBC discuss in bewilderment the strange moves stocks were making, with absolutely no idea about what was behind the volatility. Truth was, Brown realized, the quants themselves were still trying to figure it out.

Brown had been spending all his time trying to get up to speed on AQR's systems to help manage the fund's risk. He'd decided to stay in the office that Tuesday night and sleep on a small couch he kept near his desk. He wasn't the only one. Near midnight, he stepped out of his office, eyes bloodshot from peering at numbers on a computer screen for the past twenty hours. The office was buzzing with activity, dozens of haggard quants chugging coffee, iPods plugged into their ears as they punched frantically on keyboards, unwinding the fund's positions in markets around the globe. It was a strange sight. The office was nearly as busy as it was during the day, but it was pitch black outside.

And still, the outside world had no idea that a meltdown of such size was taking place. One of the first to spread word to the ma.s.ses was an obscure quant.i.tative researcher who worked at Lehman Brothers.

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Matthew Rothman was still groggy from his red-eye flight into San Francisco the night before as he walked into the office of a potential client on Tuesday morning, August 7. The chief quant.i.tative strategist for Lehman Brothers was on a West Coast road trip, pitching the models he'd spent the last year sweating over during late nights at the office and tedious weekends. This was payoff time. was still groggy from his red-eye flight into San Francisco the night before as he walked into the office of a potential client on Tuesday morning, August 7. The chief quant.i.tative strategist for Lehman Brothers was on a West Coast road trip, pitching the models he'd spent the last year sweating over during late nights at the office and tedious weekends. This was payoff time.

As Rothman, a heavyset, middle-aged man with a moon face and curly brown hair, sat in the client's waiting room with his laptop and luggage-he hadn't had time to swing by the Four Seasons, where he was staying-he wondered about the odd activity in the market he'd seen the previous day. His quant.i.tative models had been hit hard, and he didn't know why.

He bolted up from his chair, startled. The trader he was waiting to see rushed toward him, his face frantic. "Oh my G.o.d, Matthew," he said, pulling him toward his office. "Have you seen what's going on?"

He showed Rothman his portfolio. It was down sharply. Something terrible was happening, something never seen before. Rothman didn't have any answers.

The pitch was out the window. No one wanted to hear about his whiz-bang models. Rothman visited several more quant funds that day. It was a bloodbath.

And it made no sense. A true believer in market efficiency who'd studied under Eugene Fama at Chicago, Rothman expected the market to behave according to the strict quant.i.tative patterns he lived to track. But the market was acting in a way that defied any pattern Rothman-or any other quant-had ever seen. Everything was losing money. Every strategy was falling apart. It was unfathomable, if not outright insane.

That evening, Rothman dined out with his friend Asriel Levin at a sushi restaurant in downtown San Francisco. Levin had once run the flagship quant fund 32 Capital inside Barclays Global Investors in San Francisco, the largest money manager in the world. In late 2006, he'd started up his own hedge fund, Menta Capital. "Uzi," as people called Levin, was one of the smartest quants Rothman knew. He felt lucky to be able to pick Levin's brain during such a critical time. Over sushi and wine, the two started hashing out their ideas about what had triggered the meltdown. By the time they were through-they closed the restaurant-they had a working hypothesis that would prove prescient.

A single, very large money manager had taken a serious. .h.i.t from subprime a.s.sets, they theorized. That, in turn, would have triggered a margin call from its prime broker.

Margin call: two of the most frightening words in finance. Investors often borrow money from a prime broker to buy an a.s.set, say a boatload of subprime mortgages. They do this through margin accounts. When the value of the a.s.set declines, the prime broker calls up the investor and asks for additional cash in the margin account. If the investor doesn't have the cash, he needs to sell something to raise it, some liquid holding that he can get rid of quickly. two of the most frightening words in finance. Investors often borrow money from a prime broker to buy an a.s.set, say a boatload of subprime mortgages. They do this through margin accounts. When the value of the a.s.set declines, the prime broker calls up the investor and asks for additional cash in the margin account. If the investor doesn't have the cash, he needs to sell something to raise it, some liquid holding that he can get rid of quickly.

The most liquid a.s.sets tend to be stocks. Rothman and Levin figured the money manager in trouble was a multistrategy hedge fund, one that dabbled in every kind of investing strategy known to man, from futures to currencies to subprime mortgages.

The trigger, they realized, had to be the collapse in subprime. When Ralph Cioffi's Bear Stearns hedge funds started to melt down, the value of all subprime CDOs started to decline at once. Ratings agencies such as Moody's and Standard & Poor's were also downgrading large swaths of CDOs, pushing their value down even further and prompting more forced selling. Margin calls on funds with significant subprime holdings were rolling across Wall Street.

Funds that primarily owned mortgages were stranded, since the only way they could raise cash would be to dump the very a.s.sets that were plunging in value. Multistrat funds, however, had more options. At least one of these funds-there may have been several-had a large, highly liquid equity quant book, Rothman and Levin reasoned. The fund manager must have looked around for a.s.sets he could dump with the utmost speed to raise cash for the margin call, and quickly fingered the quant equity book.

The effects of that sell-off would have started to ripple through other funds with similar positions. The short positions were suddenly going up, and the longs were going down.

In other words, a large hedge fund, possibly several large hedge funds, was imploding under the weight of toxic subprime a.s.sets, taking down the others in the process, like a ma.s.sive avalanche started by a single loose boulder. All the leverage that had piled up for years as quant managers crowded into trades that increasingly yielded lower and lower returns-requiring more and more leverage-was coming home to roost.

It was impossible to know how much money was in these trades, but by any estimate the figure was ma.s.sive. Since 2003, a.s.sets in market-neutral hedge funds that made long and short bets, such as AQR's, had nearly tripled to about $225 billion by August 2007, according to the widely followed Lipper Ta.s.s Database of hedge funds. At the same time, profits in the strategies were dwindling as more and more funds divvied them up. Several quant funds were slouching toward gigantism, plowing cash into the sector. Renaissance's RIEF fund had added $12 billion in just the past year, bringing its a.s.sets under management to $26 billion. AQR had bulged to $40 billion. Other Wall Street operators were jumping on the quant bandwagon as well. Among the most popular trading strategies at the time were so-called 130/30 funds, which used the smoke and mirrors of leverage and quant wizardry to amp up their long positions to 130 percent of capital under management, while shorting stocks equal to another 30 percent of capital (RIEF was a 170/70 fund, indicating the use of even more leverage). By the summer of 2007, about $100 billion had been put in such strategies, many of which were based on quant.i.tative metrics such as Fama's value and growth factors.

The carnage also revealed a dangerous lack of transparency in the market. No one-not Rothman, not Muller, not Asness-knew which fund was behind the meltdown. Nervous managers traded rumors over the phone and through emails in a frantic hunt for patient zero, the sickly hedge fund that had triggered the contagion in the first place. Many were fingering Goldman Sachs's Global Alpha. Others said it was Caxton a.s.sociates, a large New York hedge fund that had been suffering losses in July. More important, Caxton had a large quant equity portfolio called ART run by a highly secretive manager, Aaron Sosnick.

Behind it all was leverage. Quant funds across Wall Street in the years leading up to 2007 had amped up their leverage, reaching for yield. Returns had dwindled in nearly all of their strategies as more and more money poured into the group. The fleeting inefficiencies that are the very air quants breathe-those golden opportunities that Fama's piranhas gobble up-had turned microscopically thin, as Fama and French's disciples spread the word about growth and value stocks and stat arb became a commoditized trade copied by guys with turbo-charged Macs in their garages.

The only way to squeeze more cash from the wafer-thin spreads was to leverage up-precisely what had happened in the 1990s to Long-Term Capital Management. By 1998, nearly every bond arbitrage desk and fixed-income hedge fund on Wall Street had copied LTCM's trades. The catastrophic results for quant funds a decade later were remarkably similar.

Indeed, the situation was the same across the entire financial system. Banks, hedge funds, consumers, and even countries had been leveraging up and doubling down for years. In August 2007, the global margin call began. Everyone was forced to sell until it became a devastating downward spiral.

Near midnight, Rothman, luggage still in tow, hopped in a cab and told the driver to take him to the Four Seasons. As he leaned back in the cab, exhausted, he pondered his next move. He was scheduled to fly to Los Angeles the next day to visit more investors. But what was the point? The models were toast. Forget it Forget it, he thought, deciding to cancel the L.A. trip. I need to hammer out a call I need to hammer out a call.

As the losses piled up at AQR, Asness continued to put in frantic calls to Goldman Sachs a.s.set Management. But GSAM was in radio silence. At the height of the convulsions, Robert Jones, who ran Goldman's quant.i.tative equities team, emailed Asness with a terse three-word note: "It's not me." losses piled up at AQR, Asness continued to put in frantic calls to Goldman Sachs a.s.set Management. But GSAM was in radio silence. At the height of the convulsions, Robert Jones, who ran Goldman's quant.i.tative equities team, emailed Asness with a terse three-word note: "It's not me."

Asness wasn't so sure. He knew GSAM about as well as anybody outside of Goldman, having launched Global Alpha more than a decade before. And he knew Global Alpha had cranked up the leverage. He looked with horror at how big his creation had become, a lumbering monster of leverage. Asness knew that if GSAM imploded, it would be a disaster.

AQR traders were running low on fuel, high on adrenaline. It was something like the energy of a firefight, full of both fear and grim exhilaration, as if history was in the making.

Asness decided to give a pep talk to his bedraggled quants. Rumors that AQR was on the verge of melting down were spreading. There was no central meeting area in the office, so employees huddled in a number of conference rooms and Asness addressed the troops over speakerphones from his office. Some of the traders thought the setup was strange. Why didn't Cliff address them directly, face-to-face? Instead, he was just a voice, like the Wizard of Oz behind his curtain. Beside him were partners such as John Liew and David Kabiller, as well as Aaron Brown.

He acknowledged that the fund was seeing unprecedented losses, but told his crew not to panic. "We're not in a crisis," he said. "We have enough money to keep the trades on. We can handle the situation."

He ended the call on an optimistic note, referring back to the dotcom bubble that had nearly crushed AQR. "The partners have been in this situation before. The system works. This is something that we'll get through, although I understand that it's difficult."

But there was one cruel fact Asness couldn't escape: AQR's IPO would have to be put on hold, he said. "And it may never come back."

At Saba, Alan Benson, the trader in charge of its quant fundamental book, was verging on collapse. He was putting in eighteen-hour days, trading like a rat trapped in a maze that seemed to never end. He and only a few other traders ran billions worth of a.s.sets, and it was impossible to keep track of it all. The fund had lost about $50 million or $60 million in two days alone, and Weinstein wasn't happy. He kept pressing Benson to sell and cut his losses as fast as possible.

The losses were brutal throughout quantdom. Tykhe Capital, a New York quant fund named after the Greek G.o.ddess of good luck, was in tatters, down more than 20 percent. In East Setauket, Renaissance's Medallion fund was getting pummeled, as was the Renaissance Inst.i.tutional Equity Fund, the ma.s.sive quant fundamental fund Jim Simons had once said could handle $100 billion in a.s.sets.

The losses in Medallion, however, were the most perplexing. Simons had never seen anything like it. Medallion's superfast trading strategy, which acts as a liquidity provider for the rest of the market, was buying up the a.s.sets from quant funds that were frantically trying to exit positions. Medallion's models predicted that the positions would move back into equilibrium. But the snapback didn't happen. The positions kept declining. There was no equilibrium. Medallion kept buying, until its portfolio was a near mirror image of the funds that were in a ma.s.sive deleveraging. It was a recipe for disaster.

The losses were piling up so quickly, it was impossible to keep track of them. The Money Grid was on the precipice of disaster and no one knew when it would stop.

At PDT, Muller kept ringing up managers, trying to gauge who was selling and who wasn't. But few were talking. In ways, Muller thought, it was like poker. No one knew who was holding what. Some might be bluffing, putting on a brave face while ma.s.sively dumping positions. Some might be holding out, hoping to ride through the storm. And the decision facing Muller was the same one he confronted all the time at the poker table, but on a much larger order of magnitude: whether to throw in more chips and hope for the best or to fold his hand and walk away.

Other managers were facing the same problem. "We were all freaking out," recalled AQR cofounder John Liew. "Quant managers tend to be kind of secretive; they don't reach out to each other. It was a little bit of a poker game. When you think about the universe of large quant managers, it's not that big. We all know each other. We were calling each other and saying, 'Are you selling?' 'Are you?'"

As conditions spun out of control, Muller was updating Morgan's top bra.s.s, including Zoe Cruz and John Mack. He wanted to know how much damage was acceptable. But his chiefs wouldn't give him a number. They didn't understand all of the nuts and bolts of how PDT worked. Muller had kept its positions and strategy so secret over the years that few people in the firm had any inkling about how PDT made money. Cruz and Mack knew it was profitable almost all the time. That was all that mattered.

That meant it was Muller's call. By Wednesday morning, August 8, he'd already decided. The previous day, he'd caught a flight out of Boston as it became clear that something serious had happened. At La Guardia Airport, he was picked up by his chauffeur, a retired police officer. Riding into the city in the backseat of his BMW 750Li, he placed a phone call to the office to gauge the damage.

The losses had been severe, twice as bad as on Monday. He knew something had to be done fast. There wasn't much time. It was already late in the day. A decision had to be made.

After stopping off at his Time-Warner apartment, he walked down to the office. It was about 7 P.M P.M. He'd come into Morgan's office to meet Amy Wong, the trader in charge of the quant fundamental portfolio getting clobbered. They huddled in a conference room just off PDT's small trading floor, along with several other top PDT staffers. Wong tallied up the damage. The quant fundamental book had suffered a loss of about $100 million.

"What should we do?" Wong asked.

Muller shrugged and gave the order: sell.

By Wednesday morning, PDT was executing Muller's command, dumping positions aggressively. And it kept getting killed. Every other quant fund was selling in a panicked rush for the exits.

That Wednesday, what had started as a series of bizarre, unexplainable glitches in quant models turned into a catastrophic meltdown the likes of which had never been seen before in the history of financial markets. Nearly every single quant.i.tative strategy, thought to be the most sophisticated investing ideas in the world, was shredded to pieces, leading to billions in losses. It was deleveraging gone supernova.

Oddly, the Bizarro World of quant trading largely masked the losses to the outside world at first. Since the stocks they'd shorted were rising rapidly, leading to the appearance of gains on the broader market, that balanced out the diving stocks the quants had expected to rise. Monday, the Dow industrials actually gained 287 points. It gained 36 more points Tuesday, and another 154 points Wednesday. Everyday investors had no insight into the carnage taking place beneath the surface, the billions in hedge fund money evaporating.

Of course, there was plenty of evidence that something was seriously amiss. Heavily shorted stocks were zooming higher for no logical reason. Vonage Holdings, a telecom stock that had dropped 85 percent in the previous year, shot up 10 percent in a single day on zero news. Online retailer Overstock.com; Taser International, maker of stun guns; the home building giant Beazer Homes USA; and Krispy Kreme Doughnuts-all favorites among short sellers-rose sharply even as the rest of the market tanked. From a fundamentals perspective, it made no sense. In an economic downturn, risky stocks such as Taser and Krispy Kreme would surely suffer. Beazer was obviously on the ropes due to the housing downturn. But a vicious marketwide short squeeze was causing the stocks to surge.

The huge gains in those shorted stocks created an optical illusion: the market seemed to be rising, even as its pillars were crumbling beneath it. Asness's beloved value stocks were spiraling lower. Stocks with low price-to-book ratios such as Walt Disney and Alcoa were getting hammered.

"A ma.s.sive unwind is occurring," Tim Krochuk, managing director of Boston investment manager GRT Capital Partners, told the Wall Street Journal Wall Street Journal. p.i.s.sed-off plain-vanilla investors vented their rage on the quants as they saw their portfolios unravel. "You couldn't get a date in high school and now you're ruining my month," was one sneer Muller heard.

Amid the carnage, Mike Reed had an idea: stop selling for an hour to see if PDT itself was driving the action-a clear indication of how chaotic the market had become. No one knew who was causing what. But the desperate move didn't work. PDT continued to get crushed. There was a deceptive lull soon after lunchtime. But as the closing bell neared in the afternoon, the carnage resumed. Mom-and-pop investors watching the market make wild swings wondered what was going on. They had no way of knowing about the ma.s.sive computer power and decades of quant strategies that were behind the chaos making a hash of their 401(k)s and mutual funds.

Reed's intuition that PDT's decision to sell was hurting the market wasn't completely wrongheaded. A source of the extreme damage Wednesday and the following day was the absence of high-frequency stat arb traders that act as liquidity providers for the market. Among the largest such funds were Renaissance's Medallion fund and D. E. Shaw. PDT had already significantly deleveraged its stat arb fund, Midas, the week before. Other stat arb funds were now following suit. As investors tried to unload their positions, the high-frequency funds weren't there to buy them-they were selling, too. The result was a black hole of no liquidity whatsoever. Prices collapsed.

By the end of the day on Wednesday, PDT had lost nearly $300 million-just that day. PDT was going up in smoke. Other funds were seeing even bigger losses. Goldman's Global Alpha was down nearly 16 percent for the month, a loss of about $1.5 billion. AQR had lost about $500 million that Wednesday alone, its biggest one-day loss ever. It was the fastest money meltdown Asness had ever seen. He was well aware that if it continued for much longer, AQR would be roadkill.

And there was nothing he could do to stop it. Except keep liquidating, liquidating, liquidating.

Inside GSAM, the grim realization was taking hold that a catastrophic meltdown would occur if all the furious liquidations weren't somehow stopped. Goldman's elite traders were running on fumes, staying at the office fifteen or twenty hours-some not leaving at all.

Carhart and Iwanowski, like every other quant manager, were feverishly trying to delever their funds, trying to get their volatility-based risk models back into alignment. But there was a problem: every time GSAM sold off positions, volatility spiked again-meaning it had to keep selling. Higher volatility readings automatically directed the fund to dump more positions and raise cash.

The upshot was terrifying: GSAM was trapped in a self-reinforcing feedback loop. More selling caused more volatility, causing more selling, causing more volatility. It was a trap that had snared every other quant fund.

They were trying to make sure that their positions were liquid, that they could exit them whenever necessary without major losses. But every time they deleveraged positions, they were back to square one. The GSAM team realized, with shock, that they might be trapped in a death spiral. Talk about an LTCM-like meltdown, one that didn't just take down one giant fund but dozens, started to make the rounds.