The Quants Part 8

"How you doing?" Kabiller asked. He was smiling so hard his face hurt. There was a long pause. Kabiller could hear Asness breathing on the other end of the line. "You ready to do this now?"

"Yeah," Asness said.

And that was it. In December 1997, just a few days after the bank handed out its bonuses, Cliff Asness, Robert Krail, David Kabiller, and John Liew turned in their resignations to Goldman's management. Asness listened to the soundtrack from the Broadway play Les Miserables Les Miserables to psych himself up for the task. He didn't want to change his mind again. to psych himself up for the task. He didn't want to change his mind again.

Less than a year later, on August 3, 1998, AQR was up and running with $1 billion in start-up capital-one of the largest hedge fund launches on record at that point, and three times as much as they'd originally projected they could raise. Indeed, Asness and company turned down more than $1 billion in extra extra cash because they weren't sure their strategies could handle so much capital. Investors were desperate to get in. The charismatic French fund of funds manager Arpad "Arki" Busson, future beau of the supermodel Elle Macpherson and the actress Uma Thurman, offered the use of his Swiss chalet in exchange for capacity. AQR turned him down flat. cash because they weren't sure their strategies could handle so much capital. Investors were desperate to get in. The charismatic French fund of funds manager Arpad "Arki" Busson, future beau of the supermodel Elle Macpherson and the actress Uma Thurman, offered the use of his Swiss chalet in exchange for capacity. AQR turned him down flat.

Indeed, AQR had the ideal hedge fund pedigree: University of Chicago quant geniuses, a plethora of pension fund and endowment clients through Kabiller, sterling Goldman Sachs credentials, mind-boggling returns ...

"It was a total labor of love," recalled Kabiller. "We knew our s.h.i.t, we were prepared. We had the right blend of skills, we were the real deal."

In its first month, AQR Capital, once described as a dream-team blend of Long-Term Capital Management and Julian Robertson's Tiger Management, scored a small gain. From there, it fell off a cliff. It was a disaster. The reason for AQR's downturn was in many ways more unlikely than the chain of events that destroyed LTCM. Luck, it seemed, had abandoned Cliff Asness.

[image]WEINSTEIN[image]

A pair of black limos raced out of Las Vegas into the desert night. It was the fall of 2003, and Boaz Weinstein's credit traders were celebrating at an off-site bonding session. The plan was to discuss the changing landscape of the credit markets, but this was Vegas. Weinstein's traders were itching to cut loose.

"It was a lot of betting, a lot of drinking, a lot of blackjack," said a former Deutsche Bank trader who worked under Weinstein.

After hitting the blackjack tables, where Weinstein won over and over again using the card-counting techniques he'd learned from Beat the Dealer Beat the Dealer, and playing hand after hand of high-stakes poker and roulette, they piled into rented stretch limos, popped open bottles of chilled champagne, and told the drivers to step on it. Their destination: that cla.s.sic quant pastime, paintball.

At the paintball facility outside the city, the teams squared off. "Prop" traders, the gunslingers who did nothing but trade all day to earn money for the bank (and themselves), faced the "flow" traders, who had the less glamorous job of acting as go-betweens for clients of Deutsche Bank, matching up buy and sell orders that "flowed" through the firm. Flow traders were allowed to make side bets, making their lives somewhat worth living, but they were never able to put the real money on the line, the colossal billion-dollar b.a.l.l.s-to-the-walls positions that could make a year or break it.

Weinstein led the prop paintballers. One of his top lieutenants, Chip Stevens, led the flow squad. Clad in T-shirts that read "Credit Derivatives Offsite Las Vegas 2003," the Deutsche Bank credit quants donned their goggles and fanned out across the paintball obstacle course.

Naturally, the gunslingers were victorious. But it was all in good fun. Everyone piled back into their limos, guzzled more champagne, and convened at Weinstein's huge luxury suite at the Wynn Las Vegas, where the festivities-including a magician and mentalist recommended by Bear Stearns chairman Ace Greenberg-really began. If there was one thing Weinstein's credit traders knew, it was that they understood how the game was played-and they played it better than anybody else. Blackjack was a joke. The real casino, the biggest in the world, was the booming global credit derivatives market. And they were playing it like a fiddle. The money was huge, the women were beautiful, and everyone was brilliant and inside the secret. Deutsche Bank had just been named Derivatives House of the Year by Risk Risk magazine, topping the previous champ, J. P. Morgan, which started referring to Deutsche as "enemy number one." magazine, topping the previous champ, J. P. Morgan, which started referring to Deutsche as "enemy number one."

To Weinstein, ascending to the top wasn't a surprise. They had developed an aggressive, no-holds-barred approach that the rest of the Street couldn't match. And that was the real point of the Vegas trips, some of those attending thought. At Deutsche Bank, risk wasn't f.u.c.king managed managed. Risk was b.i.t.c.h-slapped, risk was tamed and told what to do.

The traders lapped it up.

It was all happening. Weinstein's dream of becoming an elite Wall Street trader, nurtured ever since he watched Louis Rukeyser on TV as a precocious chess prodigy on the Upper East Side, was coming true.

And it had been so very easy.

Just as AQR was starting to trade in 1998, Weinstein had set up shop at Deutsche Bank's fledgling credit derivatives desk. A mere twenty-four years old, he seemed nervous and a bit frightened by the frantic action of a trading floor. But he absorbed knowledge like a sponge and was soon able to spit out information about all kinds of stocks and bonds at will from his steel-trap photographic memory. was starting to trade in 1998, Weinstein had set up shop at Deutsche Bank's fledgling credit derivatives desk. A mere twenty-four years old, he seemed nervous and a bit frightened by the frantic action of a trading floor. But he absorbed knowledge like a sponge and was soon able to spit out information about all kinds of stocks and bonds at will from his steel-trap photographic memory.

Weinstein's expertise at his previous job had been in trading floating rate notes, bonds that trade with variable interest rates. It wasn't much of a leap from there to credit default swaps, which act much like bonds with interest rates that swing up and down.

As Ron Tanemura had explained to Weinstein, traders can use the swap to essentially bet on whether a company is going to default or not. Thus, an entirely new dimension had been introduced into the vast world of credit: the ability to short a loan or a bond. Buying protection on a bond through a credit default swap was, in essence, a short position. In a flash, the sleepy bond market became the hottest casino in the world-and Weinstein was right at home.

Because the derivative was so new, few other banks were trading it in heavy volume. To help gin up volume, Weinstein started to make trips to other trading outfits across Wall Street, such as the giant money manager BlackRock, talking up the remarkable traits of the credit default swap.

In 1998, he was essentially shorting the credit market, buying insurance on all kinds of bonds through swaps. Because he was buying insurance-which would pay off if investors started worrying about the creditworthiness of the bond issuers-he was in a perfect position to capitalize on the turmoil that shot through the market after Russia defaulted on its debt and LTCM collapsed. He made a nice profit for Deutsche Bank, catapulting his career.

In 1999, Deutsche Bank promoted him to vice president. In 2001, he was named a managing director at the age of twenty-seven, one of the youngest to reach the t.i.tle in the history of the German bank.

Weinstein and his fellow derivatives dealers got help from regulators, who were rapidly deregulating. In November 1999, the Gla.s.s-Steagall Act of 1933, which had cleaved the investment banking and commercial banking industry in two-separating the risk-taking side of banks from the deposit side-was repealed. Giant banks such as Citigroup had argued that the act put them at a disadvantage compared to overseas banks that didn't have such restrictions. For Wall Street's growing legions of proprietary traders, it meant access to more cash; also, those juicy deposits could be used as fodder for prop desk exploits. Then, in December 2000, the government pa.s.sed legislation exempting derivatives from more intense federal scrutiny. The way had been cleared for the great derivatives boom of the 2000s.

A big test of the credit default swap market came in 2000, when the California utilities crisis struck and prices soared due to rampant shortages. Suddenly there was the real possibility that a number of large power companies could default. The implosion of Enron in late 2001 was another test of the market, which demonstrated that the credit derivatives market could withstand the default of a major corporation. The telecom meltdown and the collapse of WorldCom was another trial by fire.

The new credit derivatives market had shown that it could function properly, even under stress. Trades were settled relatively quickly. Skeptics were proven wrong. The credit default swap market would soon be one of the hottest, fastest-growing markets in the world. Few traders would be as well versed at it as Weinstein, who began putting together one of the most successful and powerful credit derivatives trading outfits on Wall Street.

By 2002, the economy was in a ditch. With formerly blue chip companies such as Enron and WorldCom unraveling, the worry was that anything could happen. Investors started feeling anxious about the largest media company in the world at the time, AOL Time Warner. Debt holders, especially, were panicking, while the stock was down less than 20 percent.

One day Weinstein was strolling past AOL's headquarters near Rockefeller Center. Thinking several steps into the future, much like a chess player plotting his strategy multiple moves in advance, he realized that while the stock had fallen about 20 percent, the collapse in its bond prices was far too severe, as if the company were on the verge of bankruptcy. Such a catastrophe was unlikely for a company with so many long-standing, relatively profitable businesses, including the television networks CNN and HBO. Deciding that the company had a good chance of surviving the turmoil, he purchased AOL bonds while shorting the stock to hedge the position. The bet turned into a huge home run as the bond market, and AOL (now simply Time Warner), recovered.

Gambling became a way of life for Weinstein's crew. One of his first hires was Bing w.a.n.g, who went on to finish in thirty-fourth place in the World Series of Poker in 2005. Weinstein learned that several traders at Deutsche were members of MIT's secretive blackjack team. He was soon joining them a few times a year to hit the blackjack tables in Las Vegas, deploying the skills he'd learned reading Thorp's Beat the Dealer Beat the Dealer in college. People who know Weinstein say his name is on more than one Vegas casino's list of players banned for card counting. in college. People who know Weinstein say his name is on more than one Vegas casino's list of players banned for card counting.

In their downtime, Weinstein's traders would randomly bet on just about anything in sight: a hundred on the flip of a coin, whether it would rain in the next hour, whether the Dow would close up or down. A weekly poker game with a $100 buy-in started up off Deutsche Bank's trading floor. Every Friday after the closing bell struck, Weinstein's traders would gather in a conference room and face off against one another for hours.

Deutsche's top managers either didn't know about the poker game or simply winked at it. It hardly mattered. Since Deutsche was a German company, most of its upper management was based in London or Frankfurt, Germany's financial hub. Weinstein became the seniormost member of the fixed-income side of the bank in New York. His traders had the run of the bank's headquarters on 60 Wall Street and by many accounts were running amok. With a young, freewheeling boss who liked to gamble, and billions in funds at the tips of their fingers, Deutsche's New York trading operation became one of the most aggressive trading outfits on the Street, the shimmering essence of cowboy capitalism.

Weinstein was also honing his poker skills. In 2004, he attended the second annual Wall Street Poker Night at the St. Regis Hotel. He'd heard about a private poker game run by several of Wall Street's top quant traders and hedge fund managers, including Peter Muller, Cliff Asness, and a rising star named Neil Chriss. A veteran of Goldman Sachs a.s.set Management, Chriss at the time was working at SAC Capital Advisors, a giant hedge fund in Stamford, Connecticut.

At the St. Regis, Weinstein approached Chriss. He mentioned that he'd heard about the game, and that he'd love to sit in on a few hands. Chriss hesitated. There was no official "membership" in the quant poker game, but there was little doubt that the game was highly exclusive. It was a high-stakes game, with pots in the tens of thousands. One of the key qualifications for players was that losing couldn't matter financially. Egos might be bruised. Self-esteem might slip a notch. But the hit to the wallet needed to be trivial. That required an epic bank account, eight digits minimum. Players had to be able to walk away ten, twenty grand short, and not care. Did Weinstein have the financial chops? Chriss decided to invite him, test him out-and the boy-faced Deutsche Bank credit-default-swap whiz turned out to be an instant hit. Not only was he an ace cardsharp, he was also one of the savviest investors Chriss, Muller, and Asness had ever met. Soon Weinstein was a permanent member of the quant poker group, part of the inner circle.

All the practice paid off. In 2005, Weinstein's boss, Anshu Jain, flew to meet with Berkshire Hathaway chairman Warren Buffett in Omaha, Nebraska, to discuss a number of the bank's high-profile trades, including Weinstein's. The two moguls were chatting about one of their favorite pastimes, bridge, and the conversation eventually switched to poker. Jain mentioned that Weinstein was Deutsche Bank's poker ace. Intrigued, Buffett invited Weinstein to an upcoming poker tournament in Las Vegas run by NetJets, the private-jet company owned by Berkshire.

Weinstein made his boss proud, winning the tournament's grand prize: a spanking new Maserati. Still, gambling was just a pastime, a mental curiosity or warm-up for the real deal. Weinstein's main focus, his obsession, remained trading-winning, crushing his opponents, and making money, huge money. He loved it. Soon he started expanding his operation into all kinds of markets, including stocks, currencies, and commodities-much as Ken Griffin was creating a diversified multistrategy fund at Citadel (Weinstein seemed to be modeling his group after Citadel). His signature trade was a strategy called "capital structure arbitrage," based on gaps in pricing between various securities of a single company. For instance, if he thought its bonds were undervalued relative to its stock, he might take bullish positions on the bonds and simultaneously bet against the stock, waiting for the disparity to shrink or vanish. If his long position on the debt fell through, he'd be compensated on the other side of the trade when the stock collapsed.

Weinstein was looking for inefficiencies in firms' capital structures, their blend of debt and stock, and used credit default swaps in creative ways to arb the inefficiencies. It was the old relative-value arbitrage trade, much like that crafted by Ed Thorp in the 1960s, wrapped in fancy new derivative clothes. But it worked like clockwork. Weinstein's group was racking up millions.

Then it all nearly fell apart in 2005 when the market didn't behave exactly as Weinstein's models had predicted.

It was May 2005. Weinstein stared in disbelief at one of several computer screens in his third-floor office. A trade was moving against him, badly. May 2005. Weinstein stared in disbelief at one of several computer screens in his third-floor office. A trade was moving against him, badly.

Weinstein had recently entered one of his signature capital structure arbitrage trades on General Motors. GM's shares had tumbled in late 2004 and early 2005 as investors worried about a possible bankruptcy and the auto giant hemorrhaged cash. GM's debt was also getting crushed-too much, Weinstein thought. GM's debt had been pummeled so much that it seemed as though investors thought the automaker would go bankrupt. Weinstein knew that even if the company declared bankruptcy, debt holders would still receive at least 40 on the dollar, likely a lot more. The shares, however, would be worthless.

So he decided to sell protection on GM's debt through a credit default swap, collecting a steady fee to insure the bonds. If GM did declare bankruptcy, Deutsche Bank would be on the hook. To hedge against such a possibility, Weinstein shorted GM's stock, which was trading for about $25 to $30 a share.

But now, in a flash, the trade was looking like a disaster. The reason: a billionaire investor named Kirk Kerkorian had made a surprise tender offer for twenty-eight million GM shares through his investment company, Tracinda Corp., causing the stock to surge-and crushing short sellers such as Weinstein.

If that weren't enough, several days later, the rating agencies Standard & Poor's and Moody's downgraded GM's debt to junk, forcing a number of investors to sell it.

That meant both sides of Weinstein's trade were going against him, hard. The debt was plunging and the stock was soaring. It was incredible, and it wasn't how the market was supposed to work. There was little he could do about it except wait. The market is irrational The market is irrational, he thought, and Kerkorian is nuts. Eventually things will move back into line. The Truth will be restored and Kerkorian is nuts. Eventually things will move back into line. The Truth will be restored. In the meantime, Weinstein needed to figure out what to do.

Weinstein and his traders huddled at the New York apartment of one of his top lieutenants. On the table: what to do about the GM trade. Some in the room argued that it was too risky and that they should take the loss and get out. If the position kept moving against them, the losses could become unsustainable. The bank's risk managers would only allow things to go so far.

Others took the other side. Bing w.a.n.g, the poker expert, said that the trade was more attractive than ever. "Load the boat," w.a.n.g said, trader lingo for doubling down.

Weinstein decided to play it safe at first, but over the following months the group kept adding to the GM trade, expecting things to eventually move back into line.

And they did. By the end of 2005, Weinstein's GM trade had paid off. It did even better in 2006. GM's stock fell back to earth, and the debt recovered much of the ground it lost in the wake of the rating agency's downgrade.

It was a lesson Weinstein wouldn't soon forget. While his arbitrage trades were incredibly clever, they could spin out of control due to chance outside events. But if he could hold on long enough, they'd pay off. They had to. The market couldn't avoid the Truth.

Or so he thought.

LIVING THE DREAM

By the early 2000s, the hedge fund industry was poised for a phenomenal run that would radically change the investment landscape around the world. Pension funds and endowments were diving in, and investment banks were expanding their proprietary trading operations such as Global Alpha at Goldman Sachs, PDT at Morgan Stanley, and Boaz Weinstein's credit-trading shop at Deutsche Bank. Hundreds of billions poured into the gunslinging trading operations that benefited from an age of easy money, globally interconnected markets on the Money Grid, and the complex quant.i.tative strategies that had first been deployed by innovators such as Ed Thorp more than three decades before. early 2000s, the hedge fund industry was poised for a phenomenal run that would radically change the investment landscape around the world. Pension funds and endowments were diving in, and investment banks were expanding their proprietary trading operations such as Global Alpha at Goldman Sachs, PDT at Morgan Stanley, and Boaz Weinstein's credit-trading shop at Deutsche Bank. Hundreds of billions poured into the gunslinging trading operations that benefited from an age of easy money, globally interconnected markets on the Money Grid, and the complex quant.i.tative strategies that had first been deployed by innovators such as Ed Thorp more than three decades before.

Thorp, however, saw the explosion of hedge funds as a dark omen. So much money was flooding into the field that it was becoming impossible to put up solid returns without taking on too much risk. Copycats were operating everywhere in a field he'd once dominated. In October 2002, he closed shop, shutting down his stat arb fund, Ridgeline Partners.

Other traders weren't so inclined-especially Ken Griffin, whose Citadel Investment Group, the fund Thorp had helped start more than a decade before, was quickly becoming one of the most powerful and feared hedge funds in the world.

[image]GRIFFIN[image]

As Ken Griffin settled down into married life, Citadel kept growing like a very complex, digitized weed. The Chicago hedge fund had become one of the most technologically advanced trading machines on the street, hooked like a heroin addict into the Money Grid, with offices in Chicago, San Francisco, New York, London, Tokyo, and Hong Kong and more than a thousand employees. It had its own generator on the roof of 131 South Dearborn Street, the skysc.r.a.per it occupied, to ensure its computer systems could function in a blackout. The primary computer room was equipped with a system that could drain the room of oxygen in seconds in case of fire. Some thirty miles from the office, in a secret location in the town of Downers Grove, a redundant computer system hummed quietly. Every personal computer in the office-each one top of the line-had been partially walled off so that it could be accessible to a systemwide program that crunched the numbers of the fund's ma.s.sive mortgage positions, creating a virtual "cloud" computer that churned in cybers.p.a.ce twenty-four hours a day.

Griffin was quietly building a high-frequency trading machine that would one day become one of Citadel's crown jewels and a rival to PDT and Renaissance's Medallion fund. In 2003, he'd hired a Russian math genius named Misha Malyshev to work on a secretive stat arb project. At first, the going was tough, and profits were hard to come by. But on July 25, 2004, the operation, which came to be named Tactical Trading, kicked into gear, posting gains that went up all day. After that, it almost never stopped going up, spitting out consistent returns with very little volatility. Malyshev focused on speed, leveraging Citadel's peerless computer power to beat compet.i.tors to the punch in the race to capture fleeting arbitrage opportunities in the stock market.

The same year that Tactical started turning a profit, Griffin hired Matthew Andresen, a whiz kid who'd launched an electronic trading platform called Island ECN, to turbocharge Citadel's technology and trading systems. Under Andresen, the hedge fund's options marketmaking business, known as Citadel Derivatives Group Investors, would soon become a cash cow, the largest listed options dealer in the world.

Griffin was steadily turning Citadel into far more than a hedge fund-it was becoming a sprawling financial juggernaut controlling the flow of billions in securities. Griffin's ambitions were expanding right along with Citadel's a.s.sets, which had neared $15 billion.

Like any power broker, Griffin was making his share of enemies. Citadel was scooping up more and more talented traders and researchers from other hedge funds. That infuriated one notoriously testy and outspoken compet.i.tor, Daniel Loeb, manager of Third Point Partners, a New York hedge fund. In 2005, Citadel hired Andrew Rechtschaffen, a star researcher for Greenlight Capital, the fast-rising fund managed by David Einhorn, one of the regulars, along with Griffin, at the Wall Street Poker Night. Loeb, a friend of Einhorn's, shot off an email to Griffin packed with a seething rage that indicated more was going on than just the filching of a star researcher.

"I find the disconnect between your self-proclaimed 'good to great, Jim Collinsesque' organization and the reality of the gulag you created quite laughable," Loeb wrote, referring to the popular management guru. "You are surrounded by sycophants, but even you must know that the people who work for you despise and resent you. I a.s.sume you know this because I have read the employment agreements that you make people sign."

Griffin was unfazed. Great men were bound to make enemies. Why sweat it?

But there was the cutting edge of truth to Loeb's attack. Turnover at Citadel was high. Griffin was grinding up employees and spitting them out like a meat factory. The pressure to succeed was intense, the abuse over failure dramatic. Departures from the fund were often bitter, dripping with bad blood.

Worse, returns for the fund weren't what they used to be. In 2002, Citadel's flagship Kensington Fund gained 13 percent, and annual gains slipped below 10 percent the next three years. Part of the reason, Griffin suspected, was an explosion of money flowing into hedge fund strategies-the same strategies Citadel used. Indeed, it was that very factor that had influenced Ed Thorp's decision to close up shop. Imitation may be the sincerest form of flattery, but it doesn't do much for the bottom line in hedge fund land.

That's not to say that work at Citadel turned into a life sentence in a gulag, as Loeb would have it (though some ex-employees might dispute that). The fund tossed lavish parties. A movie buff, Griffin frequently rented out theaters at Chicago's AMC River 24 for premieres of films such as The Dark Knight The Dark Knight and and Star Wars Episode III: Revenge of the Sith Star Wars Episode III: Revenge of the Sith. The money was head-spinning. Employees may have left Citadel bitter; they also left rich.

Concern was also mounting about an issue far more serious than interindustry squabbles: whether Citadel posed a risk to the financial system. Researchers at a firm called Dresdner Kleinwort wrote a report posing questions about the elephantine growth of Citadel and arguing that its heavy-handed use of leverage could destabilize the system. "At face value, and without being able to look into the black box, the balance sheet of today's Citadel hedge fund looks quite similar to LTCM," the report stated ominously.

Citadel's leverage, however, which was at roughly 8 to 1 around 2006-though some estimate it rose as high as 16 to 1-didn't approach that of LTCM, which hovered around 30 to 1 and topped 100 to 1 during its 1998 meltdown. But Citadel was quickly becoming far bigger than the infamous hedge fund from Greenwich in terms of a.s.sets under management, turning into a multiheaded leviathan of money almost entirely unregulated by the government-exactly as Griffin liked it.

In March 2006, Griffin attended the Wall Street Poker Night, hooting down Peter Muller as the Morgan Stanley quant faced off against Cliff Asness. Several months later, in September 2006, he made one of his biggest coups yet.

A $10 billion hedge fund called Amaranth Advisors was on the verge of collapse after making a horrifically bad bet on natural gas prices. A lanky, thirty-two-year-old Canadian energy trader and Deutsche Bank alum named Brian Hunter had lost a whopping $5 billion in the course of a single week, triggering the biggest hedge fund blowup of all time, outpacing even the collapse of LTCM.

Amaranth, which had originally specialized in convertible bonds, had built up its energy-trading desk after the collapse of Enron in 2001. It brought Hunter on board soon after the trader left Deutsche Bank amid a dispute over his pay package. Hunter proved so successful at trading natural gas that the fund let him work from Calgary, where he zipped to and from work in a gray Ferrari. Hunter had a reputation as a gunslinger, doubling down on trades if they moved against him. He was preternaturally confident that he would make money on them in the long run, so why not?

But Hunter's trigger-happy trading habit got him in trouble when natural gas prices turned highly volatile late in the summer of 2006, after Hurricane Katrina plowed into the energy-rich Gulf Coast. Hunter was deploying complex spread trades that exploited the difference between the prices of contracts for delivery in the future. He was also buying options on gas prices that were far "out of the money" but would pay off in the event of big moves. In early September, Hunter's trades started turning south after reports showed that a natural-gas storage glut had been building up. Hunter believed prices would rebound, and boosted his positions. As he did so, prices continued to fall, and his losses piled up-soon reaching several billion. Eventually the pain proved too much and Amaranth started to implode from within.

Griffin smelled an opportunity. Citadel's energy experts, including a few of his own Enron alumni wizards, started poring over Amaranth's books. They were looking to see if there was a chance that Hunter's bets would, in fact, eventually pay off. While the short-term losses could prove painful, Citadel's vast reserves would let it ride out the storm. Griffin called Amaranth's chief operating officer, Charlie Winkler, and started to work out a deal. Within days, Citadel agreed to take half of Amaranth's energy book. JP Morgan took the other half.

Critics scoffed that Citadel had made a stupid move. They were wrong. The fund gained 30 percent that year.

The gutsy deal further cemented Citadel's reputation as one of the most powerful and aggressive hedge funds in the world. The speed and size of the deal and the decisiveness, not to mention its success, reminded experts of similar quick-fire exploits pulled off by none other than Warren Buffett, the "Oracle of Omaha." Buffett was always near the top of the list of deep-pocketed investors whom distressed sellers would speed-dial when things turned south. Now Ken Griffin, the boy-faced hedge fund t.i.tan of Chicago, had joined that list.

He continued to s.n.a.t.c.h up artwork at jaw-dropping prices. In October 2006, he purchased False Start False Start by Jasper Johns, a rainbow-colored pastiche of oils stenciled with the names of various colors-"red," "orange," "gray," "yellow," and so on. The seller: Hollywood mogul David Geffen. The price: $80 million, making it the most expensive painting by a living artist ever sold. It was also a fair indicator of the boom in art prices-fueled in large part by hedge fund billionaires-having been sold to publishing magnate S. I. Newhouse less than twenty years earlier for $17 million. (Newhouse sold it to Geffen in the 1990s for an undisclosed price.) Shortly before buying the painting, Griffin and his wife donated $19 million to the Art Inst.i.tute of Chicago to finance a 264,000-square-foot wing to house modern art. by Jasper Johns, a rainbow-colored pastiche of oils stenciled with the names of various colors-"red," "orange," "gray," "yellow," and so on. The seller: Hollywood mogul David Geffen. The price: $80 million, making it the most expensive painting by a living artist ever sold. It was also a fair indicator of the boom in art prices-fueled in large part by hedge fund billionaires-having been sold to publishing magnate S. I. Newhouse less than twenty years earlier for $17 million. (Newhouse sold it to Geffen in the 1990s for an undisclosed price.) Shortly before buying the painting, Griffin and his wife donated $19 million to the Art Inst.i.tute of Chicago to finance a 264,000-square-foot wing to house modern art.

The Griffins ate well, dining regularly at the ritzy j.a.panese mecca NoMi, which was located in the Park Hyatt Chicago building where they lived and boasted $50 plates of sushi. Griffin was also known for his junk food obsessions, wolfing down b.u.t.tered popcorn on the trading floor or ordering Big Macs from the local McDonald's on business trips.

He also indulged his pa.s.sion for cars. Citadel's garage was often filled with about half a dozen of Griffin's Ferraris, each constantly monitored on screens inside the hedge fund's office.

Griffin's Napoleonic ambitions were becoming painfully evident to those around him. He was known to say that he wanted to turn Citadel into the next Goldman Sachs, a startling goal for a hedge fund. A catchphrase he seized upon: Citadel would be an "enduring financial inst.i.tution," one that could last beyond even its mercurial leader. Rumors percolated that Citadel was mulling an initial public offering, a deal that would reap billions in personal wealth for Griffin. As a mark of its sky's-the-limit aspirations, Citadel sold $2 billion worth of high-grade bonds in late 2006, becoming the first hedge fund to raise money on the bond market. It was widely seen as a move to lay the groundwork for an IPO.

A few other funds beat Griffin to the IPO punch bowl in early 2007. First, there was Fortress Investment Group, a New York private equity and hedge fund operator with $30 billion under management. Fortress, whose name echoed Citadel's, stunned Wall Street in February 2007 when it floated shares at $18.50 each. On the first day of trading, the stock shot up to $35 and finished the day at $31. The five Wall Street veterans who'd created Fortress reaped an instant gain of more than $10 billion from the deal.

Private equity firms are akin to hedge funds in that they are largely unregulated and cater to wealthy investors and large inst.i.tutions. They wield war chests of cash raised from deep-pocketed investors to take over stumbling companies, which they revamp, strip down, and sell back to the public for a tidy profit.

They also like to party. The Tuesday after the Fortress IPO, Stephen Schwarzman, cofounder and chief executive of private equity powerhouse Blackstone Group, threw himself a lavish sixtieth-birthday bash in midtown Manhattan. Blackstone had just completed its $39 billion buyout of Equity Office Properties, the largest leveraged buyout in history, and Schwarzman was in a festive mood. The celebrity-studded, paparazzi-thick blowout smacked of the grandiose robber baron excesses of the Gilded Age, and it marked the crest of a decades-long boom of vast riches on Wall Street-though few knew it at the time.

The location was the Seventh Regiment Armory on Park Avenue. New York police closed part of the fabled boulevard for the event. The five-foot-six Schwarzman didn't need to travel far for the festivities. The elite gathering was held near his thirty-five-room Park Avenue co-op, once owned by oil tyc.o.o.n John D. Rockefeller. He'd reportedly paid $37 million for the s.p.a.cious pad in May 2000. (Schwarzman had also purchased a home in the Hamptons on Long Island, previously owned by the Vanderbilts, for $34 million, and a thirteen-thousand-square-foot mansion in Florida called Four Winds, originally built for the financial advisor E. F. Hutton in 1937, which ran $21 million. He later decided the house was too small and had it wrecked and reconstructed from scratch.) The guest list at Schwarzman's fete included Colin Powell and New York mayor Michael Bloomberg, along with Barbara Walters and Donald Trump. Upon entering the orchid-festooned armory to a march played by a bra.s.s band, ushered by smiling children in military garb, visitors were treated to a full-length portrait of their host by the British painter Andrew Festing, president of the Royal Society of Portrait Painters. The dinner included lobster, filet mignon, and baked Alaska, topped off with potables such as a 2004 Louis Jadot Cha.s.sagne-Montrachet. Comedian Martin Short emceed. Rod Stewart performed. Patti LaBelle and the Abyssinian Baptist Church choir sang Schwarzman's praises, along with "Happy Birthday." On its cover, Fortune Fortune magazine declared Schwarzman "Wall Street's Man of the Moment." magazine declared Schwarzman "Wall Street's Man of the Moment."

High-society tongues were still wagging about the party a few months later, when Schwarzman gave himself another eye-popping gift. In June, Blackstone raised $4.6 billion in an IPO that valued the company's stock at $31 a share. Schwarzman, who was known to sh.e.l.l out $3,000 a weekend on meals, including $400 on stone crabs ($40 per claw), personally pocketed nearly $1 billion. At the time of the offering, his stake in the firm was valued at $7.8 billion.

None of this was lost on Griffin. He was biding his time, waiting for the right moment to strike with his own IPO and his dream of rising to challenge Goldman Sachs.

As spring turned to summer, the subprime crisis was heating up. Griffin had been planning for this moment for years, having girded Citadel for hard times with provisions such as those long lockups for investors to keep them from bolting for the exits during market panics. With billions at his fingertips, Griffin could sense a golden opportunity was presenting itself. Weak hands would be flushed out of the market, leaving the pickings for muscle-bound powerhouses such as Citadel. It had about thirteen hundred employees toiling away for Griffin in offices around the world. By comparison, AQR had about two hundred employees and Renaissance about ninety, almost all of them Ph.D.'s.

In July 2007, Griffin got his first chance to strike. Sowood Capital Management, a $3 billion hedge fund based in Boston run by Jeffrey Larson, a former star of Harvard University's endowment management, was on the ropes. Earlier in the year, Larson had started to grow worried about the state of the economy and realized that a great deal of risky debt would lose value. To capitalize on those losses, he shorted a variety of junior debt that would take the first hits as other investors grew concerned. To hedge those positions, Larson purchased a chunk of higher-grade debt. Turbocharging the bets, Larson borrowed ma.s.sive amounts of money, leveraging up the fund to maximize its returns. 2007, Griffin got his first chance to strike. Sowood Capital Management, a $3 billion hedge fund based in Boston run by Jeffrey Larson, a former star of Harvard University's endowment management, was on the ropes. Earlier in the year, Larson had started to grow worried about the state of the economy and realized that a great deal of risky debt would lose value. To capitalize on those losses, he shorted a variety of junior debt that would take the first hits as other investors grew concerned. To hedge those positions, Larson purchased a chunk of higher-grade debt. Turbocharging the bets, Larson borrowed ma.s.sive amounts of money, leveraging up the fund to maximize its returns.

The first losses. .h.i.t Sowood in June, when its investments lost 5 percent. Larson stuck to his guns and even put $5.7 million of his own cash into the fund. Expecting his positions to rebound, he told his traders to add even more leverage to the bets, pushing the fund's leverage ratio to twelve times its capital (it had borrowed $12 for each $1 it owned).

Larson, without realizing it, had stepped into a snake pit of risk at the worst possible time. The subprime mortgage market was collapsing, triggering shock waves throughout the financial system. In June, the ratings agency Moody's downgraded the ratings of $5 billion worth of subprime mortgage bonds. On July 10, Standard & Poor's, another major ratings group, warned it might downgrade $12 billion of mortgage bonds backed by subprime mortgages, prompting many holders of the bonds to dump them as quickly as possible. A number of the bonds S&P was reviewing had been issued by New Century Financial, a subprime mortgage giant based in Southern California that had filed for bankruptcy protection in April. The subprime house of cards was crumbling fast.

Other hedge funds making bets similar to Sowood's were also under fire and started unloading everything they owned into the market, including supposedly safe high-grade bonds owned by Sowood. The trouble was, few other investors wanted to buy. Credit markets gummed up. "S&P's actions are going to force a lot more people to come to Jesus," Christopher Whalen, an a.n.a.lyst at Inst.i.tutional Risk a.n.a.lytics, told Bloomberg News. "This could be one of the triggers we've been waiting for."

It was the first hint of the great unwinding that would nearly destroy the global financial system in the following year. The value of Sowood's investments cratered, and Larson started selling to raise cash as its lenders demanded more collateral, adding to the distress that was roiling the market. Larson appealed to the executives of Harvard's endowment for more cash to carry him through what he believed was just a temporary, irrational hiccup in the market. Wisely, they turned him down.

The speed of the collapse of Sowood was stunning. On Friday, July 27, the fund was down 10 percent. By the end of the weekend, it was down 40 percent. Larson picked up the phone and called the one investor he knew who could bail him out: Ken Griffin.

Griffin, vacationing in France with his wife, called a team of thirty Citadel traders at their homes and ordered them into the office to begin poring over Sowood's books, sniffing for value. They liked what they saw. On Monday, Citadel purchased most of Sowood's remaining positions for $1.4 billion, more than half of what the fund had been worth a few months prior. In an email sent to clients the week before, Griffin had opined that the markets were acting irrationally and that the robust U.S. and global economy would soon soar to new heights. That meant it was time for some deal making to capitalize on all those foolish investors who couldn't see the rebound coming. Sowood fit the bill.

Citadel swept in on the distressed fund and picked it clean, profiting as many of the positions rebounded as Larson had expected. Just as he had done with Amaranth, Griffin had amazed Wall Street once again with his ability to make quick judgments and deploy billions in the blink of an eye. By the start of August 2007, Citadel seemed poised for even greater triumphs. It had $15.8 billion in a.s.sets, a huge leap from the $4.6 million Griffin had started with in 1990.

Little did he realize that a year later, Citadel itself would be teetering on the edge of collapse.

[image]MULLER[image]

Peter Muller, sweating hard, gazed down upon the expansive blue Pacific Ocean. Palm trees rippled in the warm breeze. He was standing high up on the winding Kalalau Trail, a rugged eleven-mile trek on the west coast of the lush island of Kauai in Hawaii.

Wall Street seemed so far way. In the late 1990s, Muller was running away from Wall Street. The Kalalau Trail, a place he'd visited repeatedly since working at BARRA years before, was about as far as he could get.

Muller was doing what he loved most: hiking. And not just hiking anywhere-he loved being on the Kalalau Trail, an ancient path that winds through five valleys and past high green waterfalls and overgrown terraces of taro along the steep Na Pali cliffs of the oldest Hawaiian island, ending at Kalalau Beach, a remote hangout for hippies and drifters, but not a typical haunt of megamillionaire Wall Street traders.