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Did rocket scientists destroy world markets?

Latest update : 2008-06-13

With banks still counting the losses from the subprime crisis, some are blaming the “quants” – the number-crunching nerds of Wall Street. Once exalted for their brainpower, they are now under fire. Is it fair?

The subprime mortgage crisis of summer 2007 is still taking its toll, with some experts estimating worldwide losses will reach 500 billion USD. The whisper on some people’s lips has been “blame the quant.”

 

Quants (quantitative analysts), are the maths PhDs and rocket scientists who developed complicated financial instruments like Collateralised Debt Obligations (CDO)s and Mortgage-Backed Securities (MBS), which contributed to the subprime crisis.

 

Famed investor and philanthropist George Soros told USA Today in a recent interview that anyone who understood the uncertain nature of financial markets “would not have designed these CDOs, for instance.”

 

As early as 2003, US investment guru Warren Buffet referred to quant instruments as "financial weapons of mass destruction."

 

But quants say it’s unfair to place the blame on them, saying they only developed the tools for the banks, and it was the traders and salespeople who sold the products to the clients. Amit Metta, a risk management expert and a sometime maths PhD candidate, helped create these types of instruments for various major investment houses in New York before massive losses caused his department to shut down, leaving him jobless. He told FRANCE 24, “[i]t was fashionable to blame the quant, but with something this big, blame had to be spread evenly. I’m not sure how much (the sellers and traders) told the buyers.”

 

 

Quants: The golden age

  

Wall Street has always relied on number-crunchers. But in the early 90s, as computer technology advancements permitted massive amounts of data to be mined and analysed within microseconds, Wall Street started hiring slews of rocket scientists and mathematicians for a new category of job: the Quantitative Analyst, known as the quant. Their practises are shrouded in such Masonic secrecy that their products are often described as “black boxes.”  The goal: to make high returns whether the market goes up or down, which has always been the investor’s Holy Grail.

 

FRANCE 24 interviewed “Yan,” a senior financial analyst at a major New York investment institution, who sold quant instruments in his trader days. He is not permitted to speak to the press using his real name, because “anything that might be construed as marketing to the public violates federal securities law.” He explains, “Quant funds use algorithms to buy and sell stocks in a market-neutral fashion:  In theory, if the S&P (stock market index) goes up, these funds won’t move at all.”

 

Quant funds represented the triumph of brains over the traditional trader’s machismo. Maths students whose only previous prospect was academia became millionaires. They bought Ferraris and dated models. The nerd triumphed.

 

Some shops were entirely devoted to quant funds, but everyone wanted in; the big investment banks like Goldman Sachs started their own quant funds, as did boutique hedge funds. The latter relied upon a principle of “hedging” against losses by taking on multiple positions at once which became seductively easy with quant funds.

 

Aside from sporadic disasters, quant funds did extremely well, with some firms like the Renaissance Fund (started by a maths PhD and former codebreaker for the US Department of Defense) showing unprecedented annual returns, as high as 30-40%.

 

 

The Quant Crash

 

Then the unthinkable happened: an event that Metta describes as a “perfect storm” – a statistically improbable convergence of events that the rocket scientists had not anticipated.

 

In August 2007, the quant funds tanked at once. Tens of billions of dollars were lost. Wall Street analysts believe one of the large funds – it’s unclear which – started selling off a massive volume of quant funds at once to cover losses related to the subprime crisis.  Other firms responded with a panicked dumping of their own quant funds. In fact, their algorithms told them to, as an automated response to reduce risk. In other words, the supposed “market neutrality” of the funds was no match for an old-fashioned run on the bank.

 

Yan notes, “Quants were supposed to be the smartest people in finance. They seemed bulletproof. The quant meltdown hit them right between the eyes.” Some quants were purged outright; some were sacked along with their departments. “Quants lost their Ferraris,” says Yan.

 

These financial models were created under the assumption that they were unique and completely secret. The problem, says Yan, was that the models were neither unique nor secret.  “They were all mining the same data sets. They were all stealing each other’s employees and the information they brought with them. They may have cracked the code, but a lot of people cracked the same code.”

 

 

The Quant role in subprimes

 

The quant crash was separate from the subprime crisis that started around the same time.

 

Quant funds rely on large investments from wealthy investors. Thus, according to Yan, “[t]his quant crash only affected the firms and high rollers, not casual investors.” The plummeting quant funds did not directly affect, for example, stocks indexed by mutual funds.

 

Yet the subprime crisis did have a far-ranging effect. When substandard homeowners started defaulting on their mortgage payments, they discovered that their debts were linked with complicated financial instruments, often without knowing it.

 

When banks lend out mortgages, they don’t always hold on to the debt. Those days are gone; since the advent of quantitative finance in the 90s, bankers started selling debt to financial firms specialising in converting debt into CDOs and MBSes. Because of the constant repacking of debt, investors and fund managers – even those in no way related to mortgages discovered that their portfolios had, without their knowledge, been tied up with these mortgage-linked instruments. Only when homeowners defaulted on loans was it discovered that these instruments were not immune to risk. The house of cards collapsed.

 

The March 29 issue of Le Monde featured an article entitled “Crise financière: la faute aux mathématiques?” (Financial crisis: blame the mathematicians?). Professor Nicole El Karoui, who teaches financial mathematics at l’Ecole Polytechnique –one of France’s elite Grandes Ecoles and who is universally regarded as one of the world’s foremost quant trainers, thinks not. A financial model is just a model, she told Le Monde, and cannot be applied to all situations: “Our models are designed to work in ordinary situations.  A system designed to cover 50 million doesn’t work for 500 million,” she says. “Perhaps the mathematicians should have specified better that their models were approximate.”

 

Metta agrees the quant role in the subprime crisis has been exaggerated. He admits, though, that "[s]ome of the quants were lazy and relied on maths to push through every problem; they go so far along that they forget to take a look at the assumptions they made.” On the other hand, he says, it was the bankers themselves who got carried away with the idea of reducing risk. “The repackaging business was doing so well that people just kept pushing the envelope.  If there was no repackaging, I seriously doubt we’d have underwriting problems.” 

 

To make the blame game even more complicated, stock rating agencies are under fire for giving artificially high ratings to CDOs, causing investors to buy perhaps more than they ought. In April, a US Senate committee raised the question as to whether the bloated ratings were related to malpractice, or the faultiness of the instrument – a matter that is not likely to be resolved quickly.

 

 

 

 

 

 

 

Date created : 2008-06-13

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