Taking Stock

Quants accept no blame for financial crisis

The Globe and Mail

(SHANNON STAPLETON)

It reads like a sci-fi thriller: A bunch of eccentric math geniuses figure out how to master the universe - or at least its markets - using their knowledge of quantum physics, advanced geometry and sophisticated computer programs.

They succeed so spectacularly in exploiting the tiniest of market inefficiencies that they rake in untold billions in profits, dominate global trading in everything from commodities and currencies to mortgages and stock options and render traditional financial risk analysis obsolete. Such is their talent to print money that big investment banks give them free rein; pension and endowment funds eagerly hand over their money; and others seek to emulate them. No one asks them how they do what they do.

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Meanwhile, their opaque derivative products, like the notorious synthetic CDOs (collateralized debt obligations), spread like a toxic fungus throughout the financial world. And their disciples rise to positions of power in financial institutions as far afield as Iceland.

But then the story takes a dark turn. They fall victim to a human virus that leaves them vulnerable to the same mixture of greed and fear that has always ruled the markets. Their computer models, based on a now derided academic theory known as the efficient market hypothesis (which holds that prices of stocks and other assets reflect all available information) can't cope with extremes of human behaviour. And their vaunted strategies stop working almost overnight.

Billions go up in smoke. A dazed Wall Street is driven to the edge of the abyss. Lehman falls into it and the global financial system freezes over.

That, in a nutshell, is the story that unfolds in The Quant s, a new book by Wall Street Journal reporter Scott Patterson about the stunning rise and precipitous fall of a handful of poker-loving whiz kids with enough hubris to fill one of their oversized mansions.

There is little doubt the quantitative crowd played a key role in inflating the global asset bubble and subsequent meltdown. Going back to their earliest days, the quant pioneers also featured prominently in the 1987 market crash and later on in the 1998 collapse of a hedge fund called Long-Term Capital Management, which rocked world markets.

Yet the culprits accept no blame.

"From what I can tell, there is no sense of personal responsibility from any of these people," Mr. Patterson says. "They feel that this situation was created either by the government or by other risk-takers," and that they are as much victims as other market players.

"It's very hard for them [the quants]to grapple with the reality of this situation, because for so long, many of these people were the most successful hedge-fund managers and investors. They considered themselves to be the smart guys in the room. They had figured out how certain parts of the market worked and had quantified it and were on top of risk."

Or so they thought.

Sifting through the rubble of the hedge fund universe today, we find that the traditional gut-feeling types like David Tepper and George Soros are riding high again, while most of the algorithmic gymnasts who once derided the old-guard operators are still trying to figure out how it all went so wrong.

Mr. Tepper led all hedge types in 2009 with a tidy gain of $4-billion (U.S.), which is perhaps not surprising, considering that he specializes in distressed companies. The secret to his success, as relayed to The New York Times: heavy-duty analysis combined with common sense.

A couple of major quants also recovered to score big gains last year, underlining Mr. Patterson's assessment that this lot is definitely here to stay, for better or worse.

The chastened quants are still wrestling with the sad truth that they are mere mortals prone to follow the herd and other bad habits of ordinary investors. But while some have drifted back to the hallowed halls of academe or retired to a life of leisure on their smaller but still substantial nest eggs, most remain in the high-stakes game they created.

And sooner or later, they will be back to many of their old tricks.

"Things have absolutely changed for these guys. Their ability to access leverage has diminished fairly dramatically, but that's going to be a temporary situation. Eventually, the leverage will come back," Mr. Patterson says.

"They're hard at work. They've got to do something. They're not going to go back to electrical engineering or whatever. They're entrenched in Wall Street. They're not going anywhere."