The Quants Part 15

Alan Greenspan sat in the hot glare of ranks of TV cameras on Capitol Hill, sweating. On October 23, 2008, the former chairman of the Federal Reserve faced rows of angry congressmen demanding answers about the cause of a credit crisis ravaging the U.S. economy. For more than a year, Greenspan had argued time and again that he wasn't to blame for the meltdown. Several weeks earlier, President George W. Bush had signed a $700 billion government bailout plan for a financial industry devastated by the housing market's collapse. sat in the hot glare of ranks of TV cameras on Capitol Hill, sweating. On October 23, 2008, the former chairman of the Federal Reserve faced rows of angry congressmen demanding answers about the cause of a credit crisis ravaging the U.S. economy. For more than a year, Greenspan had argued time and again that he wasn't to blame for the meltdown. Several weeks earlier, President George W. Bush had signed a $700 billion government bailout plan for a financial industry devastated by the housing market's collapse.

In July, Bush had delivered a blunt diagnosis for the troubles in the financial system. "Wall Street got drunk," Bush said at a Republican fund-raiser in Houston. "It got drunk, and now it's got a hangover. The question is, how long will it sober up and not try to do all these fancy financial instruments?"

The credit meltdown of late 2008 had shocked the world with its intensity. The fear spread far beyond Wall Street, triggering sharp downturns in global trade and battering the world's economic engine. On Capitol Hill, the government's finger-pointing machinery cranked up to full throttle. Among the first called to account: Greenspan.

Greenspan, many in Congress believed, had been the prime enabler for Wall Street's wild ride, too slow to remove the punch bowl of low interest rates earlier in the decade. "We are in the midst of a once-in-a-century credit tsunami," Greenspan said to Congress in his characteristic sandpaper-dry voice. To his left sat the stone-faced Christopher c.o.x, head of the Securities and Exchange Commission, in for his own grilling later in the day.

Representative Henry Waxman, a Democrat from California overseeing the hearings, shifted in his seat and adjusted his gla.s.ses. A patina of sweat glistened on his egglike dome. Greenspan droned on about the causes of the crisis, the securitization of home mortgages by heedless banks on Wall Street, the poor risk management. It was nothing new. Waxman had heard it all before from countless economists and bankers who had testified before his committee that year. Then Greenspan said something truly strange to viewers unfamiliar with the quants and their minions.

"In recent decades, a vast risk management and pricing system has evolved combining the best insights of mathematicians and finance experts supported by major advances in computer and communications technology," he said. "A n.o.bel Prize was awarded for the discovery of the pricing model that underpins much of the advance in derivatives markets," he added, referring to the Black-Scholes option model. Greenspan kept his eyes glued to the speech laid out on the long wooden table before him.

"The modern risk management paradigm held sway for decades," he said. "The whole intellectual edifice, however, collapsed in the summer of last year."

Waxman wanted to know more about this intellectual edifice. "Do you feel that your ideology pushed you to make decisions that you wish you had not made?" he asked, indignant.

"To exist you need an ideology," Greenspan replied in his signature monotone. "The question is whether it is accurate or not. And what I'm saying to you is, yes, I have found a flaw. I don't know how significant or permanent it is. But I have been very distressed by that fact."

"You found a flaw in the reality?" Waxman asked, seeming genuinely bewildered.

"A flaw in the model that I perceived is the critical functioning structure that defines how the world works, so to speak."

The model Greenspan referred to was the belief that financial markets and economies are self-correcting-a notion as old as Adam Smith's mysterious "invisible hand" in which prices guide resources toward the most efficient outcome through the laws of supply and demand. Economic agents (traders, lenders, homeowners, consumers, etc.) acting in their own self-interest create the best of all possible worlds, as it were-guiding them inexorably to the Truth, the efficient market machine the quants put their faith in. Government intervention, as a rule, only hinders this process. Thus Greenspan had for years advocated an aggressive policy of deregulation before these very same congressmen in speech after speech. Investment banks, hedge funds, the derivatives industry-the core elements of the sprawling shadow banking system-left to their own devices, he believed, would create a more efficient and cost-effective financial system.

But as the banking collapse of 2008 showed, unregulated banks and hedge funds with young quick-draw traders with billions at their disposal and huge incentives to swing for the fences don't always operate in the most efficient manner possible. They might even make so many bad trades that they threaten to destabilize the system itself. Greenspan wasn't sure how to fix the system, aside from forcing banks to hold a percentage of loans they make on their own balance sheets, giving them the incentive to actually care about whether the loans might default or not. (Of course, the banks could always hedge those loans with credit default swaps.) Greenspan's confession was stunning. It marked a dramatic shift for the eighty-two-year-old banker who for so long had been hailed variously as the most powerful man on the planet and the wise central banker with a Midas touch. In a May 2005 speech he'd hailed the system he now doubted. "The growing array of derivatives and the related application of more sophisticated methods for measuring and managing risks had been key factors underlying the remarkable resilience of the banking system, which had recently shrugged off severe shocks to the economy and the financial system."

Now Greenspan was turning his back on the very system he had championed for decades. In congressional testimony in 2000, Vermont representative Bernie Sanders had asked Greenspan, "Aren't you concerned with such a growing concentration of wealth that if one of these huge inst.i.tutions fails it will have a horrendous impact on the national and global economy?"

Greenspan didn't bat an eye. "No, I'm not," he'd replied. "I believe that the general growth in large inst.i.tutions has occurred in the context of an underlying structure of markets in which many of the larger risks are dramatically-I should say fully-hedged."

Times had changed. Greenspan seemed befuddled by the meltdown, out of touch with the elephantine growth of a vast risk-taking apparatus on Wall Street that had taken place under his nose-and by many accounts had been encouraged by his policies.

After his testimony ended, Greenspan stood and walked, hunched over, out of the hot glare of the television lights. He seemed shaken, and it was painfully clear that Greenspan, once hailed as the savior of the financial system after orchestrating the bailout of Long-Term Capital Management in 1998, was a fragile and elderly man whose better days were long behind him.

Watching the telecast of the congressional hearings from his hedge fund in Greenwich, Cliff Asness couldn't believe what he was hearing. If anyone personified the system Greenspan called into question, it was Asness. A product of the University of Chicago's school of finance, which preached the dogma of free market libertarianism like a new religion, Asness believed with every fiber in his body and brain in the economic model Greenspan now seemed to reject. telecast of the congressional hearings from his hedge fund in Greenwich, Cliff Asness couldn't believe what he was hearing. If anyone personified the system Greenspan called into question, it was Asness. A product of the University of Chicago's school of finance, which preached the dogma of free market libertarianism like a new religion, Asness believed with every fiber in his body and brain in the economic model Greenspan now seemed to reject. There is no flaw There is no flaw.

"Traitor," he muttered to his TV set. Greenspan was turning his back on a theory about the efficiency of free markets simply to salvage his reputation, Asness thought. "Too late, old man."

The way Asness saw it, Greenspan had been right about free markets; his mistake was leaving interest rates too low for too long, helping inflate the housing bubble that fed the whole mess in the first place. That's what Greenspan should have apologized for, not his support of free markets.

Everything Asness believed in seemed under siege. Greenspan was turning his back on a movement that, Asness thought, had generated unprecedented wealth and prosperity for America and much of the rest of the world. Capitalism worked. Free markets worked. Sure, there were excesses, but the economy was in the process of purging those excesses out of the system. That's how it worked That's how it worked. To see Greenspan lose faith and betray the creed at its moment of weakness seemed the most extreme form of cretinism.

Far worse for Asness, AQR itself was under siege. It had lost billions in the market meltdown. Rumors had started to crop up that AQR was close to shutting down.

AQR wasn't the only fund suffering such rumors in October 2008. Another major hedge fund was perched on the very edge of a death spiral: Citadel.

Ken Griffin marched into a brightly lit conference room on the thirty-seventh floor of the Citadel Center on South Dearborn Street, sat down before a polished wooden table, and donned a headset. Beside him sat Gerald Beeson, Citadel's green-eyed, orange-haired chief operating officer, the son of a cop who'd grown up on Chicago's rough-and-tumble South Side. Beeson was one of Griffin's most trusted lieutenants, a veteran of the firm since 1993. It was Friday afternoon, October 24, one day after Greenspan's testimony on Capitol Hill. More than a thousand listeners were on the line waiting for Griffin and Beeson to explain what had become of Citadel. marched into a brightly lit conference room on the thirty-seventh floor of the Citadel Center on South Dearborn Street, sat down before a polished wooden table, and donned a headset. Beside him sat Gerald Beeson, Citadel's green-eyed, orange-haired chief operating officer, the son of a cop who'd grown up on Chicago's rough-and-tumble South Side. Beeson was one of Griffin's most trusted lieutenants, a veteran of the firm since 1993. It was Friday afternoon, October 24, one day after Greenspan's testimony on Capitol Hill. More than a thousand listeners were on the line waiting for Griffin and Beeson to explain what had become of Citadel.

Rumors of Citadel's collapse were spreading rapidly, even hitting TV screens on the financial news network CNBC. Citadel, traders said, was circling the drain. The market turmoil after the collapse of Lehman Brothers had led to ma.s.sive losses in its giant convertible bond portfolio. If Citadel went under, many feared, the ripple effects would be catastrophic, causing other funds with similar positions to tumble like so many dominoes.

According to former senior executives at Citadel, Griffin had started to force out employees as Citadel's fortunes grew more precarious. Joe Russell, head of Citadel's credit trading group and the key man in the E*Trade deal, had been agitating for more power. Griffin wouldn't give it to him, and his ruthless side emerged. The word around Citadel was that Griffin and Russell engaged in a furious shouting match that left little doubt they'd never work together again. "Throw him under the bus," Griffin was heard to say, forcing Russell out in early September.

But Griffin was still confident that Citadel could withstand the pressure. One major unknown kept him up at night: Goldman Sachs. Goldman's stock had been plunging, and some feared it, too, would follow in the wake of Bear Stearns and Lehman Brothers. Goldman was a key counterparty to Citadel in numerous trades and also extended credit to the fund. Throughout the crisis, Griffin and Goldman CEO Lloyd Blankfein held numerous discussions about the state of the markets. As the system spiraled out of control, the impossible suddenly seemed all too possible. If Goldman went down, Griffin believed, Citadel would certainly follow.

The thought of Goldman Sachs collapsing seemed incredible. Impossible. But Bear had gone down. So had Lehman. Morgan Stanley was on the ropes. AIG, Fannie Mae, Washington Mutual. Even Ken Griffin's fortress of money was crumbling. He'd do everything in his power to keep that from happening. Even the unthinkable: hold a conference call open to the press.

Earlier that day, James Forese, Citigroup's head of capital markets, had called Griffin with a warning. "Ken, you guys are getting killed in the rumor mill," Forese said. "Most of these things are just blatantly false. If you get out there and say you're fine, it will mean a lot to the market right now."

And so, setting aside his penchant for secrecy, Griffin cleared his throat and prepared to explain what had happened to Citadel.

Trouble was, everything wasn't fine.

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In nearly two decades, Griffin had lost money in only a single year, 1994. Now his fund was on the verge of collapse. The suddenness of its downturn was head-spinning and spoke to the severity of the market's postLehman Brothers turbulence. two decades, Griffin had lost money in only a single year, 1994. Now his fund was on the verge of collapse. The suddenness of its downturn was head-spinning and spoke to the severity of the market's postLehman Brothers turbulence.

Citadel had been flushed into the public eye by the dramatic upheaval. The implosion of Lehman and the panic sparked by the near-collapse of AIG were like ma.s.sive earthquakes rattling through the global financial system. At first the shock waves seemed manageable. Markets were dislocated in the few days following Lehman's bankruptcy filing on September 15, but not so dramatically that Citadel would feel threatened. Griffin later described it as a huge wave that pa.s.ses unfelt beneath a ship as it heads treacherously toward sh.o.r.e.

Among the first to feel the crushing impact of the wave once it hit sh.o.r.e were credit-trading powerhouses Citadel and Boaz Weinstein's Saba, which dabbled heavily in corporate bonds and credit default swaps. Citadel's flagship fund, Kensington, lost a staggering 20 percent in September. By late October, it was down 35 percent for the year. Saba was also gravely wounded, losing hundreds of millions in positions in companies such as General Motors and Washington Mutual, the Seattle thrift and subprime-mortgage giant seized by federal regulators and sold to J. P. Morgan shotgun-wedding-style for $1.9 billion in late September. Weinstein had been making bets that financial firms deemed systemically important would survive the crisis, but the relentless violence of the credit meltdown crushed his optimistic forecasts.

Now Citadel and Saba were in the crosshairs. The rumors of Citadel's collapse were adding to the market's already volcanic volatility, triggering big downturns and wild swings. One of the most damaging rumors, popping up on message boards and financial blogs, was that Federal Reserve officials had swooped into Citadel's Chicago headquarters and were combing through its positions to determine whether it needed a bailout-bad memories of LTCM's 1998 bailout a decade ago still lingered among many Wall Street veterans.

Citadel denied it was in trouble, but the Fed rumors were partially true. Officials from the central bank were privately worried about the prospects of a collapse by Citadel. The fund sat on nearly $15 billion worth of corporate bonds in its convertible-bond arbitrage book, which was the most highly leveraged portion of the fund, according to people familiar with the fund. While the amount of leverage was a closely guarded secret, one bank's a.s.sessment put it north of 30 to 1 in 2007, though the leverage had been reduced to 18 to 1 by the summer of 2008.

The convertible-bond arbitrage book, whose roots went all the way back to Ed Thorp's breakthrough insights in the 1960s, was Citadel's hot zone. If the fund failed and started dumping bonds on the market, the system would sustain yet another brutal shock. It was already on the very cusp of doom. To gauge the risk, regulators from the Fed's New York branch started questioning the fund's major counterparties such as Deutsche Bank and Goldman Sachs about their exposure to Citadel, worried that Citadel's collapse could threaten yet another bank.

Inside Citadel's Chicago office, the mood was grim but professional. Traders went to work as they did every day, showing up early, staying late-often much later than usual. Inside, many were quietly terrified by the huge losses they saw on their screens.

Griffin knew he had to stop the bleeding. Egged on by Wall Street bankers such as Forese, he made a snap decision that late October Friday to hold a conference call with Citadel bondholders to quell the rumors. It was set to begin at about 3:30 P.M P.M. Eastern time. In keeping with the nerve-wracking tenor of the moment, nothing was working the way it was supposed to. The lines were such hot commodities that many listeners couldn't get through. A technical glitch created by the demand led to a twenty-five-minute delay, an embarra.s.sing gaffe for a fund that prided itself on its military-style precision.

By the time the call started, Beeson seemed fl.u.s.tered by the huge turnout, stumbling on his opening lines. "Today we'd like to thank you for taking ..." He started again, his voice flat: "Today we'd like to thank you for taking the time to join us on this conference call on short notice."

Griffin chimed in, curtly thanking his team for its hard work, then turned the call back over to Beeson, who sounded almost in awe of the destructive powers of the market meltdown.

"To call this a dislocation doesn't go anywhere near the enormity of what we've seen," he said. "What have we seen here? We have seen the near-collapse of the world's banking system."

Beeson described the impact the powerful deleveraging was having on Citadel's positions. Just as investors plowed into cash or Treasury bonds during Black Monday in 1987 and the collapse of Long-Term Capital in 1998, a torrent of money had flowed into highly liquid a.s.sets following Lehman's collapse. At the same time, investors dumped less-safe a.s.sets such as corporate bonds like a panicked mob fleeing a burning building.

Normally Citadel wouldn't have even been singed too severely by such a move. Like any good quant fund, it had hedged its bets with credit default swaps. The swaps were supposed to gain in value if the price of the bonds declined. If a GM bond fell 10 percent, the credit default swap insuring the bond would gain 10 percent. Simple. As Boaz Weinstein liked to say, it wasn't rocket surgery.

But in the financial tsunami of late 2008, the swaps were dysfunctional. The deleveraging had grown so powerful that most banks and hedge funds weren't willing to buy insurance from anyone; that meant the swaps that were supposed to protect investors weren't working as promised. Many were afraid the seller of the insurance might not be around much longer to pay up if the underlying bond defaulted. Banks essentially stopped lending, or clamped down on lending terms tighter than a cinch knot, making it extremely hard for many investors, including hedge funds such as Citadel, to fund their trades-which were almost entirely conducted with leverage. No leverage, no trading, no profits.

It was the same problem that always occurred during financial crises: when the s.h.i.t hit the fan, the fine-tuned quant models didn't work as panicked investors rushed for the exits. Liquidity evaporated, and billions were lost. Like frightened children in a haunted house, investors had grown so skittish that they were running from their own shadows. The entire global credit market suffered a ma.s.sive panic attack, threatening to bring down trading powerhouses such as Saba and Citadel in its wake.

Another blow came from the federal government's ban on short selling in the weeks following the Lehman-AIG debacle. Shares of financial firms across the board-even stalwarts such as Goldman Sachs and Morgan Stanley-were collapsing. To keep the situation from spiraling out of control, the Securities and Exchange Commission in September inst.i.tuted a temporary ban on shorting about eight hundred financial stocks. Citadel, it turned out, had short positions in some of those companies as part of its convertible bond arbitrage strategy. Just as Ed Thorp had done in the 1960s, Citadel would buy corporate bonds and hedge the position by shorting the stock. With the short-selling ban, those shares surged dramatically in a vicious short squeeze that inflicted huge losses on hedge funds. Shares of Morgan Stanley, a bank squarely in the short sellers' crosshairs, surged more than 100 percent in a matter of days from about $9 to $21 in early October when the ban was in place.

Before the ban took effect, Griffin got SEC chairman Christopher c.o.x on the phone.

"This could mean a catastrophe for us, and a lot of other funds like us," Griffin told c.o.x. "The ban could also inject greater uncertainty and risk into the market," he said.

The chairman was unmoved. "The financial system is in crisis, Ken," he said. "The people need to be protected from a collapse."

It was a quant nightmare. Markets were at the mercy of unruly forces such as panicked investors and government regulators. As the conference call proceeded, Beeson kept repeating a single word: unprecedented unprecedented. Citadel's losses, he said, were due to "the unprecedented deleveraging that took place around the world over the past several weeks."

To quants, unprecedented unprecedented is perhaps the dirtiest word in the English language. Their models are by necessity backward-looking, based on decades of data about how markets operate in all kinds of conditions. When something is unprecedented, it falls outside the parameters of the models. In other words, the models don't work anymore. It was as if a person flipping a coin a hundred times, expecting roughly half to turn up heads and the rest tails, experienced a dozen straight flips where the coin landed on its edge. is perhaps the dirtiest word in the English language. Their models are by necessity backward-looking, based on decades of data about how markets operate in all kinds of conditions. When something is unprecedented, it falls outside the parameters of the models. In other words, the models don't work anymore. It was as if a person flipping a coin a hundred times, expecting roughly half to turn up heads and the rest tails, experienced a dozen straight flips where the coin landed on its edge.

Finally Griffin took charge of the call. "Again, good afternoon," he said, quickly reminding listeners that while he might be a forty-year-old whippersnapper, he'd been in the game for a long time, having seen the crash in 1987, the debt panic of 1998, the dot-com bust. But this market was different-unprecedented.

"I have never seen a market as full of panic as I've seen in the past seven or eight weeks," he said. "The world is going to change on a going-forward basis."

Then the stress broke through. Griffin's voice cracked. He seemed on the verge of tears. "I could not ask for a better team to weather the storm that we are going through," he said in a sentimental flourish. "They are winning on a going-forward basis," he said, sounding almost wistful even as he lapsed into the most generic corporatese.

After just twelve minutes, the call ended. The rumors about Citadel's collapse had been quieted, but not for long.

Griffin was growing paranoid, convinced that rival hedge funds and take-no-prisoners investment bank traders were taking bites out of his fund, sharks smelling blood in the water and trying to swallow Citadel whole. Inside his fund, he fumed at white-knuckled bond traders who refused to keep adding positions in the market's madness. He clashed with his right-hand man, James Yeh, a reclusive quant who'd been at Citadel since the early 1990s. Yeh thought his boss was making the wrong move. After the Bear Stearns debacle, as the crisis was heating up, Citadel had taken on huge blocks of convertible bonds. Griffin had even been eyeing pieces of Lehman Brothers before the firm collapsed. Yeh and others at Citadel, however, were far more bearish than Griffin and thought the best move was to batten down the hatches and wait for the storm to pa.s.s.

That wasn't how Ken Griffin played the game. In past crises, when everyone else was ducking for cover, Griffin had always been able to make money by wading into the market and scooping up bargains-the LTCM debacle of 1998, the dot-com meltdown, the Enron implosion, Amaranth, Sowood, E*Trade. Citadel always had the firepower to make hay while others cowered in fear. As the system cratered in late 2008, Griffin's instincts were to double down.

Griffin's signature trade, however, worked against him this time. The market wasn't stabilizing. Values kept sinking, bringing Citadel down with them.

As the meltdown continued, Griffin began personally buying and selling securities. Griffin, who hadn't personally traded in size for years, seemed to be desperately trying to save his firm from catastrophe using his own market savvy. There was one problem, traders said: The positions were often losers as the market kept spiraling lower.

But Griffin, like Asness, was certain the situation would stabilize. When it did, Citadel, as always, would be on top.

Citadel's lenders, big Wall Street banks, weren't so confident. Citadel depended on the banks to bankroll its trades. In the spring of 2008, its hedge funds held about $140 billion in gross a.s.sets on $15 billion in capital, or the stuff it actually owned. That translated to a 9-to-1 leverage ratio. Most of the extra positions came in the form of lines of credit or other arrangements with banks.

Concerned about the impact a Citadel collapse would have on their balance sheets, several banks organized ad-hoc committees to strategize for the possibility. J. P. Morgan was playing hardball with Citadel's traders regarding the financing of certain positions, according to traders at the fund. Regulators, meanwhile, pressed the banks not to make drastic changes in their dealings with Citadel, worried that if one lender blinked, the others would also flee, triggering another financial shock as the entire system teetered on the edge.

Investors were clearly worried. "There's a rumor a day about how Citadel is going to go out of business," Mark Yusko, manager of Citadel investor Morgan Creek Capital Management in North Carolina, told his clients on a conference call.

Inside the firm, as the carnage dragged on, employees were running ragged. Visitors noted dark rings around traders' bloodshot eyes. The three-day beards, the loose, coffee-stained ties. As rumors about Citadel's situation spread, traders were barraged by calls from outside the firm asking whether Federal Reserve examiners were scouring the premises. At one point an exasperated trader stood and shouted into his phone, "Sorry, I don't see any Fed here." Another quipped: "I just looked under my desk and didn't see any Fed."

Beeson, meanwhile, was the front man for Citadel as the firm suffered more losses. He leapt into damage-control mode, shuttling nonstop between Chicago and New York to meet with edgy counterparties, trying to rea.s.sure them that Citadel had enough capital to make it through the storm. Traders were frantically unloading a.s.sets to raise cash and trim the firm's leverage. At one point, as flagship fund Kensington's net worth continued to plunge, Citadel arranged an $800 million loan from one of its own funds, the high-frequency machine Tactical Trading run by Misha Malyshev that had been spun out of the flagship fund in late 2007, according to people familiar with the fund. Investors who learned of the odd arrangement took it as a sign of desperation and realized it meant the firm was truly on the precipice-if it was lending itself its own money, that could mean it was having a hard time getting a decent loan elsewhere.

Several days after the bond-holder's call, Griffin distributed an email to Citadel's employees around the world. Citadel would survive and thrive, he said, ever the optimist. The fund's situation reminded him of Christopher Columbus's journey across the Atlantic in 1492, he explained. When land was nowhere in sight and the situation seemed desperate, Griffin said, Columbus wrote two words in his journal: Sail on.

It was a rallying cry for Citadel's beleaguered employees. Just the year before, Citadel had been one of the mightiest financial forces in the world, a $20 billion powerhouse on the verge of greater things. Now it was faced with disaster. While the situation might seem bleak, Griffin said, and calamity imminent, land would eventually be found.

Some reading the email thought back to their history lessons and recalled that Columbus had been lost.

Soon after, Griffin held his fortieth-birthday party at Joe's Seafood Prime Steak and Stone Crab in downtown Chicago, a dozen blocks from Citadel's headquarters. Employees presented Griffin with a lifeboat-sized replica of one of Columbus's ships. Griffin laughed and accepted the gift gracefully, but there was a sense of overhanging doom, a chill in the air, that killed any sense of festivity. Everyone could feel it: Citadel was sinking.

At Morgan Stanley, Peter Muller and PDT were in crisis mode. The investment bank's shares were collapsing. Many feared it was the next Lehman, destined for Wall Street's mounting sc.r.a.p heap. The market was making insane moves. The volatility was out of control, like nothing ever seen before. Muller decided to reduce a large portion of PDT's positions, putting a h.o.a.rd of its a.s.sets into cash before everyone else did. Stanley, Peter Muller and PDT were in crisis mode. The investment bank's shares were collapsing. Many feared it was the next Lehman, destined for Wall Street's mounting sc.r.a.p heap. The market was making insane moves. The volatility was out of control, like nothing ever seen before. Muller decided to reduce a large portion of PDT's positions, putting a h.o.a.rd of its a.s.sets into cash before everyone else did.

"The types of volatility we were seeing had no historical basis," said one of PDT's traders. "If your model is based on historical patterns and you're seeing something you've never seen before, you can't expect your model to perform."

It was a tumultuous time for Muller on other fronts. Ever the restless globetrotter, he'd decided to pull up stakes again. His girlfriend was pregnant, and he wanted to put down roots in a place he truly loved. He purchased a luxurious house with a three-car garage and a pool in Santa Barbara, California. Still manning the helm of PDT from afar, he was making trips to New York one or two weeks a month, where he would meet up with his poker pals.

Morgan Stanley, meanwhile, was under heavy fire. Hedge funds that traded through Morgan tried to pull out more than $100 billion in a.s.sets. Its clearing bank, the Bank of New York Mellon, asked for an extra $4 billion in capital. It was a move from the same playbook that had taken down Bear Stearns and Lehman Brothers.

In late September, Morgan and Goldman Sachs sc.r.a.pped their investment banking business model and converted into traditional bank holding companies. Effectively, Wall Street as it had long been known ceased to exist. The move meant the banks would be far more beholden to bank regulators and would be subject to more restrictive capital requirements. The glory days of ma.s.sive leverage, profits, and risk taking were a thing of the past-or so it seemed.

Days later, Morgan CEO John Mack orchestrated a $9 billion cash infusion from j.a.pan's Mitsubishi UFJ Financial Group. Goldman negotiated a $5 billion investment from Warren Buffett's Berkshire Hathaway.

Catastrophe seemed to have been averted. But the financial mayhem continued to churn through the system. PDT was riding it out on a much-diminished cushion of cash while Muller set up house in sunny Santa Barbara and played the odd gig in Greenwich Village. Seemingly little had changed for Muller, although behind the scenes he was drafting major changes for PDT that would come to light several months later. The same couldn't be said for Boaz Weinstein.

By outward appearances, Boaz Weinstein was sailing through the credit meltdown unfazed. Internally, he was deeply worried. Saba was taking ma.s.sive hits from the credit market. The Deutsche Bank trader watched in disbelief as his carefully designed trades came unglued. appearances, Boaz Weinstein was sailing through the credit meltdown unfazed. Internally, he was deeply worried. Saba was taking ma.s.sive hits from the credit market. The Deutsche Bank trader watched in disbelief as his carefully designed trades came unglued.

Weinstein had rolled into 2008 at the top of his game. He and a colleague in London, Colin Fan, were overseeing all global credit trading for Deutsche. Saba was in control of nearly $30 billion in a.s.sets, a monster-sized sum for the thirty-five-year-old trader. Weinstein's boss, Anshu Jain, had offered him the powerful position of head of all global credit trading. But Weinstein turned him down flat. He'd already drawn up plans to break away from Deutsche in 2009 and launch his own hedge fund (to be called Saba, naturally).

After the collapse of Bear Stearns in March 2008, Weinstein believed the worst of the credit crisis was in the rearview mirror. He wasn't alone. Griffin thought the economy was stabilizing. Morgan's John Mack told shareholders that the subprime crisis was in the eighth or ninth inning. Goldman Sachs CEO Lloyd Blankfein was somewhat less optimistic, saying, "We're probably in the third or fourth inning."

To capitalize on depressed prices, Weinstein scooped up the distressed bonds of companies such as Ford, General Motors, General Electric, and Tribune Co., publisher of the Chicago Tribune Chicago Tribune. And, of course, he hedged those bets with credit default swaps. At first the bets paid off as corporate bonds rallied, giving Saba a tidy profit. Weinstein continued to plow cash into bonds through the summer, and Saba cruised into September 2008 in the black for the year.

Then everything fell apart. The government took over the mortgage giants Fannie Mae and Freddie Mac. Lehman declared bankruptcy. AIG teetered on a cliff, threatening to pull the entire global financial system over with it.

Just like Citadel, Saba was getting mauled. As the losses mounted, the flow of information among Saba's traders ground to a halt. Normally junior traders on the group's desks would compile profit-and-loss reports summarizing the day's trading activities. With no warning or explanation, the reports stopped circulating. Rumors of huge losses were bandied about around the water cooler. Some feared the group was about to be shut down. The weekly $100 poker games held off Saba's trading floor came to a halt.

Weinstein's hands were tied. He watched in horror as investors avoided risky corporate bonds like three-day-old fish, causing prices to crater. Like Citadel, its positions were hedged with credit default swaps. But investors, worried about whether the counterparties to the traders would be around to fulfill their obligations, wanted nothing to do with the swaps. Typically, the price of the swaps, which are traded every day on over-the-counter markets between banks, hedge funds, and the like, fluctuate according to market conditions. If the value of the swaps Saba held increased in value, it could mark those positions higher on its books, even if it didn't actually trade the swaps itself.

But as the financial markets imploded and leverage evaporated, the swaps market became dysfunctional. The trades that would indicate the new value for the swaps simply weren't happening. Increasingly, Weinstein's favorite investing vehicle, which he'd helped spread across Wall Street since the late 1990s, was seen as the fuse to the powder keg that blew up the financial system.

Weinstein remained outwardly calm, quietly brooding in his office overlooking Wall Street. But the losses were piling up rapidly and soon topped $1 billion. He pleaded with Deutsche's risk managers to let him purchase more swaps so he could better hedge his positions, but the word had come down from on high: buying wasn't allowed, only selling. Perversely, the bank's risk models, such as the notorious VAR used by all Wall Street banks, instructed traders to exit short positions, including credit default swaps.

Weinstein knew that was crazy, but the quants in charge of risk couldn't be argued with. "Step away from the model," he begged. "The only way for me to get out of this is to be short. If the market is falling and you're losing money, that means you are long the market-and you need to short it, as fast as possible."

He explained that the bank's ability to see around the subprime model in 2007 had earned it a fortune. Now the right move was the same-think outside the quant box.

It didn't work. Risk management was on autopilot. The losses piled up, soon reaching nearly two billion. Saba's stock trading desk was instructed to sell nearly every holding, effectively closing the unit down.

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 s.p.a.ce 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. 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 tyc.o.o.n 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 ma.s.sive 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 Washington Post reporter Bob Woodward, and George W. Bush's defense secretary Donald Rumsfeld. reporter Bob Woodward, and George W. Bush's defense secretary Donald Rumsfeld.

The move was cla.s.sic 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 cla.s.sic 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."