Tuesday, February 9, 2010

Quants’ Risk-Free Ideas Sink Market, Cause Ruin

Posted on Business Week by Susan Antilla:

To become a potentially market- destroying “it” group on Wall Street, you need some arrogance, enough brains to justify making huge financial bets, utter cluelessness about lessons learned from finance’s booms and busts, and a sincere belief that your unique contributions to Wall Street will mean, ahem, that that this time it really is different, so old truths can be ignored.

Such is the profile of Wall Street’s nerdy quants, the most recent contingent to reach stardom and then keel over on its pocket protectors when boom turned bust. I learned much about this geek gaggle by reading “The Quants,” a new book by Wall Street Journal reporter Scott Patterson.

Most of all, I learned that the brainy brigade -- they are mostly poker-junkie Ph.D.s with physics, cryptology and game- theory backgrounds -- was no different from any of the groups that, from time to time, take their turns as Wall Street luminaries. True, they can do long division in their heads, and the computer models they stuff with can’t-lose trading instructions may even garner a Nobel Prize.

But just like investment bankers, junk-bond kings and other finance superstars who came before them, the quants reached a pinnacle where they figured they alone had The Answer (and the profits) and that no one should question their methods.

History of Meltdowns

Take, for example, a market-meltdown scene Patterson describes, when a quant guru is trying to sell. A trader has to inform the guy that he can’t sell because “the market’s frozen.” It’s a real Say What? Moment, because the quants had promised that a financial collapse was really, really, really unlikely -- a 27-standard-deviation event, in quant-speak.

Problem is, this little anecdote dates from the stock market crash of 1987, when geek-designed portfolio insurance helped send the market on a roller-coaster ride. A flurry of they-blew-it books were published in the wake of that meltdown, and a Newsweek cover asked, “Is The Party Over? A Jolt for Wall Street’s Whiz Kids.” So the nerds proved to be not too swift at the learning-curve thing -- mandatory for true Wall Street heroes -- when you consider it happened all over again at Long Term Capital Management in 1998. And yet again at all the quant- run hedge funds in 2007.

They were, though, fantastic at understanding their role as newly anointed Wall Street celebrities. The manager of one quant fund got married at the Palace of Versailles, hired acrobats from Cirque du Soleil to perform and dropped $80 million on a Jasper Johns painting. Another trashed plans to live in a 12,500-square-foot mansion in Greenwich, Connecticut, in favor of a larger place.

Can’t-Lose Formula

They excelled at persuading their bosses, regulators and the media that some of them were market neutral, meaning that they couldn’t lose money because every bet was offset by a counter-bet that would go up if the other went down.

Genius-designed or not, somehow, starting Aug. 6, 2007, the models “were operating in reverse,” Patterson writes, depicting a scene at the hedge fund AQR Capital Management LLC with the in-house brainiacs watching in a daze as losses mounted. “You know what’s going on?” one would ask, only to hear the response, “No. You?” At another hedge fund, which had placed bets on small-cap stocks, the reality suddenly hit that selling illiquid stocks in a downturn would be time-consuming and expensive.

In the meantime, Patterson writes, the ultimate horror was that the financial regulators didn’t have a clue about what was happening -- perhaps the book’s least-surprising revelation.

Computer Models Surprised

As it turns out, the collapse in the subprime mortgage market set off margin calls on funds heavily invested in subprime, and that triggered the need to sell stocks, which are relatively liquid, to meet the call. Selling pressure that the computer models hadn’t anticipated? Who knew?

Proving that they deserved their esteemed positions nonetheless, quants got moving at rationalizing the mess and warding off regulation so they could get back to business.

Hedge funds shouldn’t be forced to publicly disclose all their positions, said Citadel Investment Group LLC’s Ken Griffin in testimony to the House Committee on Oversight and Government Reform in November 2008. That would be like “asking Coca-Cola to disclose their secret formula,” Griffin told the committee. A nice try, but I’m stuck on figuring out how Coke’s secret formula has the potential to bring down the global financial system.

Some Success

Best of all: Patterson says AQR Capital Management founder Cliff Asness wrote a letter to investors on Aug. 10, 2007, noting that his was a “long-term winning strategy” despite the recent bad performance. So what was the glitch that sent the markets into a tailspin? “The very success of the strategy over time has drawn in too many investors.” In other words: We were so darned good at this that everybody tried to copy us, and that messed things up.

OK, you say, so quants can finger-point and dodge responsibility like the best of them. Everybody knows, though, that to really be part of Wall Street’s elite, you’ve got to have contempt for the little people.

Patterson assures us that the quants make that cut. As the crisis was unfolding in the summer of 2007, a group at Deutsche Bank made a big win by betting against subprime mortgages. To celebrate, the author says, traders at the bank sported gray T- shirts that read, in bold black letters, “I Shorted Your House.”

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