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Citadel under siege, page 2

Last Updated: December 9, 2008: 3:54 PM ET

Not long after Bear Stearns collapsed in March, Griffin and his traders swooped in and bought truckloads of what they considered undervalued investments, mostly in the financial sector. They were hoping to catch a falling knife. They ended up catching the blade, not the handle.

Citadel's positions in financial companies seemed fine until mid-September. Up until then, Griffin would occasionally come into the office a little late, maybe even at 10 A.M., so that he could play with his 1-year-old in the morning. This new, semi-chilled-out Ken was a huge departure from the pre-fatherhood version, for whom the day rarely started no later than 7 A.M.

Sure, his two main funds, Kensington and Wellington, were experiencing general market losses, but they were still doing better than their benchmarks. In fact, the downdraft didn't start until Monday, Sept. 15, when Lehman Brothers filed for bankruptcy. Griffin's response was to get on the phone with Fed board members.

"We were very focused on the collateral damage from Lehman to the overall system. What I was worried about was the money market funds breaking the buck," he says. The Fed board members assured Griffin that the markets would remain orderly as Lehman unwound its positions.

But he says in retrospect that he experienced a false sense of security. He describes the feeling on that particular Monday as akin to watching a giant wave go underneath a boat you're sailing on, and nothing happens. As devastating as Lehman's failure was, it appeared to Griffin at the time to be a manageable event.

The big problems at Citadel didn't start until at least a week later. That's when Griffin realized that the wave was "an undersea earthquake," he says. "In the case of Lehman, it wasn't a few hours later but a few days later when the wave hit the shore. But it wasn't a little wave anymore. It was a giant tsunami."

The tsunami that threatened to capsize Citadel was the massive global credit freeze. Like other hedge funds, the firm found it nearly impossible to borrow money to finance its positions - particularly in convertible-bond arbitrage, a market Citadel had stormed into during the summer when convertible-bond prices were dirt cheap.

Convertible-bond arbitrage is a strategy in which investors generally buy the convertible bonds of a company while simultaneously shorting the company's common stock. It's essentially a bet that the bond will perform better than the stock.

An added headache for Citadel created by Lehman's throwing in the keys was that as Lehman's positions were sold into the market, the selloff brought down prices on all stripes of securities. It didn't matter whether Citadel was long equities or short equities; the assets the firm had to fund with banks suddenly were repriced to the point where Citadel struggled to fund them.

That was a shock wave that Citadel never anticipated. In other words, as many of Citadel's positions sank, the banks called, needing more collateral to back up the beaten-down assets.

Citadel's convertible-bond holdings - which accounted for around a quarter of the hedge fund's total losses - were hit hard when traders all over the world were forced to sell bonds to raise cash. It was even difficult to unwind positions.

"Anything credit-related like convertible bonds was tainted," said Tom Sowanick, chief investment officer at Clearbrook Financial in Princeton, N.J., which manages $22 billion.

The widespread selling also mangled Citadel's high-yield and investment-grade bonds and leveraged-buyout loans. All of these holdings were hedged with credit default swaps, which are supposed to protect buyers in the event of a default.

But the gap between credit default swaps and the prices of the bonds they insured widened as lenders stopped doling out money, and it became clear that more companies would default. The result was a topsy-turvy situation in which the credit default swaps were becoming pricier than the bonds they were supposed to protect.

The panic that swept through the capital markets after Lehman declared bankruptcy was one form of human frailty that Citadel's sophisticated mathematical models could never have anticipated. The second and perhaps more devastating one occurred on Wednesday, Sept. 17, when news broke that the Securities and Exchange Commission was considering a temporary ban on short-selling 900 stocks - 799 of them financial stocks.

The proposed ban was good news for the banks and brokers. It meant that Morgan Stanley (MS, Fortune 500), Citigroup (C, Fortune 500), and others didn't need to worry that hedge funds could drive them to the brink.

Yet the news was horrifying for hedge funds like Citadel. Scores of Citadel's positions - particularly in convertible arbitrage, which requires shorting - would simply blow up if the ban went into effect.

According to sources, Griffin phoned Christopher Cox, the SEC's chairman. Griffin pleaded with Cox, telling him the ban could mean certain death to many hedge funds - including Citadel. Cox, according to these sources, was unmoved and merely responded with the party line about how the country was going through a national financial crisis and the SEC needed to do what it had to.

There was nothing Griffin could do or say to sway him, and on Friday, Sept. 19, the ban was made official. (The SEC declined to comment for this story.)

Citadel was now hemorrhaging money. Over the weekend and throughout the following week, Griffin talked with his portfolio managers and told them to dump the dogs and keep the racehorses, meaning preserve the positions that they believed had long-term upside as they engaged in a selloff.

By the end of September, Citadel's funds were down 20%. In early October, Griffin sent a letter to investors stating that September had been the "single worst month, by far, in the firm's history. Our performance reflected extraordinary market conditions that I did not fully anticipate, combined with regulatory changes driven more by populism than policy."

Aside from having to deal with the panic and the "populism" of Christopher Cox, Citadel would also get a lesson in the importance of another emotion - namely confidence. Hedge funds and banks need to have confidence in each other for markets to operate efficiently. By the time Griffin turned 40 on Oct. 15, that trust in Citadel's viability was starting to fray.

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