The Quants

Scott Patterson, “The Quants” (How a New Breed of Math Whizzes Conquered Wall Street and Nearly Destroyed It, Crown Business, 2010, 326 Pages

In 2002 we moved on from the dot.com collapse and, unbeknownst to us, headed for the next collapse. Most believe this current collapse is essentially due to subprime loans. This book clearly shows that another component is the “Quants;” they are the wizards behind the curtain. With the Quants at the controls, banks and hedge funds became overleveraged using faulty risk models. They were using the same bell curve efficient market hypothesis assumptions that led to the 1998 LTCM collapse along with the illusion of portfolio insurance that had failed so miserably in 1987. This time, however, there was a popular delusion that the global economy was in a period of low volatility, which Ben Bernanke, in 2004, called the Great Moderation. The financial community believed that due to the quants, the entire system was now more efficient and certainly more liquid. It was the mathematical devices engineered by the quants that allowed the subprime loans to be sliced and diced until all our pension funds were put at risk.

My Notes:
Pg. 11: Bernanke’s 2004 speech credited the financial wizardry of the quants as providing “increased depth and sophistication of financial markets.” In other words, quants such as Griffin, Asness, Muller, Weinstein, Simons, and the rest of the math wizards who had taken over Wall Street, had helped tame the market’s volatility. Every time the market lurched too far out of equilibrium, their supercomputers raced to the rescue, gobbling up the mispriced securities and restoring stability.

Pg. 36: Ed Thorp, around 1975, created convertible bond arbitrage: he used mathematic formulas to determine where overpriced warrants were. He could the short the overpriced warrants and buy an equivalent chunk of stock to hedge his bet. If the stock started to rise unexpectedly, his downside would be covered by the stock. The formula also gave him a method to calculate how much stock he needed to hold in order to hedge his position. In the best of all worlds, the warrant price would decline and the stock would rise, closing out the inefficiency and providing a gain on each side of the trade. This trading strategy helped launch thousands of hedge funds.

Pg. 62: In 1991 Ed Thorp was asked to look over an investment portfolio proposed to a client by Bernie Madoff. This fund of Madoff’s put up returns of 20 percent or more every year. Once Thorp got the trading records, it took him all of one day to determine this fund was a fraud. He told the client that had made the investment to pull its money out of the fund.

Pg. 84: In the financial planning community, so-called Monte Carlo simulations, which can forecast everyday investors’ portfolio growth over time, use the idea that the market moves according to a random walk. Thus, an annual gain or loss of 5 percent a year is far more likely, since it falls near the center of the bell curve. A gain or loss of 50 percent, such as the stock market crash seen in the credit crisis of 2008 (or the 23 percent single-day plunge seen on Oct. 19th, 1987) was so unlikely as to be a virtual impossibility—in the models, at least. These calculations based on a normal distribution of risk are still the basis for most retirement planning.

Pg. 145: In 1999 the Glass-Steagall Act of 1935, which had separated the investment banking and commercial banking industry was repealed. No longer was their a separation between the risk-taking side of banks from the deposit side. Banks had argued that the act put them at a disadvantage to overseas banks that did not have such a restriction. Then in December of 2000 the government passed legislation exempting derivatives from more intense federal scrutiny. The way had been cleared for the great derivatives boom of the 2000s.

Pg. 148: Capital Structure Arbitrage: involves a search for gaps in pricing between various securities of a single company. For instance, if it was determined that bonds of a company were undervalued relative to its stock, you would take a bullish position on the bonds and simultaneously bet against the stock, waiting for the disparity to shrink or vanish. If your long position on the debt fell through, you would be compensated on the other side of the trade when the stock collapsed.

Pg. 197: As the CDO boom took off, so did home prices across the U.S. From January 2000 through July 2006, the peak of the housing bubble, the average price of a home in the U.S. rose 106 percent. In late 2006, the home price index started to move in the opposite direction, falling more than 30 percent three years later.

Pg. 201: In April 2004 the SEC met a contingent of representatives from Wall Street’s big investment banks to talk about risk. The banks had asked for an exemption for their brokerage units from a regulation that limited the amount of debt they could hold on their balance sheets. The SEC complied and loosened the requirements. Additionally, the SEC decided to rely on the banks’ own quantitative models to determine how risky their investments were, in effect outsourcing oversight of the nation’s largest financial firms to the banks’ quants.

Pg. 308: There are some encouraging signs. Increasingly, firms are now adapting models that incorporate the wild, fat-tailed swings described by Mandelbrot decades earlier. J.P. Morgan, the creator of the bell curve-based VAR risk model, is pushing a new asset-allocation model incorporating fat-tailed distributions. Morningstar, is offering retirement-plan participants portfolio forecasts based on fat-tailed bell curve assumptions. A team of quants has developed a cutting-edge risk-management strategy that accounts for potential black swans.