An exposé of the math guys who broke the economy
The quants: how a new breed of math whizzes conquered Wall Street and nearly destroyed it, by Scott Patterson, Crown Business, 2010. $27.00, 337 pp.
Wall Street titans like Lehman Brothers CEO Dick Fuld, AIG CEO Hank Greenberg, and scam artist Bernie Madoff have emerged as the central villains of the financial crisis. But in The Quants, Wall Street Journal reporter Scott Patterson introduces us to a breed of mysterious figures who played a crucial role in the crisis but have largely avoided media scrutiny. They are the quants, analysts who use arcane mathematical techniques to reap enormous financial rewards.
More Riemann than Rothschild, the quants bring advanced mathematical knowledge from academia to Wall Street in order to execute complex and lucrative trades. Patterson focuses on the men behind the formulas, giving us a fascinating glimpse into their motivations and eccentricities, without casting judgment. Ultimately, though, his story suggests that the quant subculture and methodology helped bring about the financial crisis. And despite the huge losses they sustained, the quants will remain stars on Wall Street for the foreseeable future, relatively safe from populist anger.
Beating the Dealer
Patterson appropriately begins his book with a poker game, in which young quant prodigies vie for the respect of their bosses. Card games are a favorite pastime of the quants; the mix of competition and calculation is intoxicating for them. Edward O. Thorp, a noted mathematician and legendary investor, did pioneering research into blackjack strategy before realizing that his ideas could be applied to trading convertible bonds. The entire cast of The Quants began their careers after reading Thorp’s classic 1962 book, Beat the Dealer.
Patterson’s quants are, at heart, math whizzes out to solve a challenging problem whose solution, only incidentally, can make them billions of dollars. What lures them to Wall Street is the desire to win more than the desire to earn money—hence the fascination with poker and blackjack. In cards and in investing, the quants look to win for winning’s sake; taking home the pot is just a bonus.
The quants got their start as star students in math and science, and then migrated to New York to test their algorithms in an industry then run largely by men making gut decisions. (Not all even waited to graduate. Ken Griffin, Harvard Class of 1989, put a satellite dish on the roof of Cabot House and traded convertible bonds on his grandmother’s bank account.) Patterson describes the tension on Wall Street between the quants and the old-guard traders, whom the quants affectionately deride as “Big Swinging Dicks,” and traces it back to tension between the nerds and the preppy jocks at Harvard.
The Biggest Casino of Them All
While The Quants is a story about geeks, Patterson helpfully assumes that his audience will not necessarily grasp the difference between Brownian motion and Gaussian copula. Nor must one be a banker to appreciate the book. Although some knowledge of finance is certainly helpful, you need no PhD or MBA to understand Cliff Asness’s computer-smashing rampages at Goldman Sachs or Ken Griffin’s single-minded quest to build Citadel Investment Group into an empire. At its best, The Quants is more about the people than the formulas.
But even as Patterson focuses on the unique personalities of his subjects, he links them with a theme that he, quite frankly, pounds into the reader’s brain. In fact, he repeats one narrative so frequently that the book can be summarized thusly: the quants, looking for “the Truth” in “the biggest casino of them all,” nearly brought down the whole system. Patterson ends a chapter with this page-turning tease: “If Boaz Weinstein could hold on long enough, [the trades] would pay off. They had to. The market couldn’t avoid the Truth. Or so he thought.” How could the market avoid the Truth? We do not find out for another 150 pages. Lines like “Those close enough to the action could almost feel the fabric of the financial system tearing apart” add vague tension but clarify little. The repetition of such clichés is a symptom of Patterson’s attempt to make a complicated financial crisis seem like the inevitable result of his subjects’ high-stakes games.
Quants in the Crisis
Still, Patterson offers an interesting theory about how common quant strategies exacerbated the financial crisis. He starts with the common intellectual heritage and tight-knit community of the quants. Nearly all see themselves as the arbitraging “piranhas” from Eugene Fama’s Efficient Market Hypothesis. Fama famously posited that an asset’s price in efficient markets (including the American stock market) would reflect all of the available information about the asset. Thus, the only way to beat the market would be to have information that no one else has, or to act fastest on newly released information. Like piranhas devouring fresh meat, traders arbitrage “incorrect” prices until they reach equilibrium. The quants designed models to discover the closest approximation of what the “true” value of an asset should be, and used the best computers to act fast on newly released information.
Ultimately, these lucrative methods turned toxic when the sub-prime crisis arrived. The quant funds had grown large enough that “hall-of-mirrors-like, it became difficult to tell the difference between the model and the market itself.” The quants believed that their models represented, rather than approximated, true asset values, and they made trades that were big enough to move the markets toward those values. But when sub-prime losses led one large fund to scramble for cash to cover its loans, it unwound the entire quant system, causing the market to move in the opposite direction from where it was expected to go. Since nearly all of the quants had similar investments, as each quant fund cut its losses, it made the next fund’s losses worse. The rapid computer-executed trades only added to the volatility.
The New Deans
Still, in spite of the huge losses that Patterson recounts, the quants are probably here to stay. This is in part due to the tight-knit quant culture that the book so ably portrays. They are endlessly devising new moneymaking strategies, and are once again earning enormous profits for the banks and hedge funds that employ them. It was the same story after the crises of 1987 and 1998. It seems that, for all of their recent failings, the quants have permanently upset the old “Big Swinging Dick” order. The professors are the new barons of Wall Street, and they appear poised to accrue even more power. They are like “civil engineers … after a bridge collapse,” Patterson writes: they’re to blame, but they’re also needed for the rebuilding. The Quants is a great starting point for understanding how the members of this new financial elite brought down, and might again build up, our nation’s economy.
Jeffrey Kalmus ‘12 is the Webmaster.
