Wednesday, February 9, 2011

Scott Patterson's "The Quants: How a New Breed of Math Whizzes Conquered Wall Street and Nearly Destroyed It"

This is a fun read. It is fast paced with a style of breathless excitement about the growth of quant strategies for hedge funds with all the hoopla of fast success and then the crash and burn of 2007-2008. You get a very personal look at a number of the "big name" quant characters.

The theme is built around gambling, with the author coming back to the private poker games these quants frequently played, compared to the really big gamble of Wall Street. You get characterizations of bigger than life ego-driven "smart guys" who first succeed beyond their wildest dreams then find themselves caught up in the death spiral of the stock markets. Lots of drama.

Will you learn anything about how to play the stock market in this book? No. This is an entertainment. It is based on real lives, but it is written to let you vicariously live the thrilling ride these characters took. It gives you no insight into the math behind the strategies and it doesn't get into details. It acquaints you with the terminology and the big name characters. It lets you thrill and spill along with their lives, but it isn't going to teach you anything. It is just a "fun read".

You get a picture of how the hedge fund world grew and topsy-turvy from the late 1980s until the crash in 2008. It gives you passing acquaintance with the philosopical foundations of this phenomenon: the economic theory of the "efficient-market hypothesis" (EMH) of Eugene Fama. It is a seductive thesis, but a moment's thought should convince you it can't be true. Markets jump up and down, they crash. The underlying society with its industrial infrastructure and workforce don't jump by 10% or 50%. This is purely a financial phenonmenon and it is marred by panic and greed that create the "fat tails" that the EMH ignores.

I liked the book. The writing style is brisk and clear. My only complaint is that it jumps around a bit too quickly for my taste without enough road markers to keep tabs on the underlying timeline. I would occasionally have to page back to find a year so that I could keep oriented about the historical place in the story.

Here's a taste of writing style where he makes the point that the crash broke the quants because of the "unexpected" correlation between different markets (i.e. everybody ran for the exits at once, something their math didn't anticipate but which anybody with knowledge of historic panics clearly knows is a risk):
The most terrifying asp0ect of the meltdown, however, was that it revealed hidden linkages in the Money Grid that no one had been aware of before. A collapse in the subprime mortgage market triggered margin calls in hedge funds, forcing them to unwind positions in stocks. The dominoes started falling, hitting other quant hedge funds and forcing them to unwind positions in everything from currencies to futures contracts to options in markets around the world. As the carry trade unraveled, assets that had benefited from all the cheap liquidity it has spun off began to lose their mooring.

A vicious feedbak loop ensued, causing billions to evaporate in a matter of days. The selling cycle had stopped before major damage had been inflicted -- but there was no telling what would happen the next time around, or what hidden damage lurked within the system's mostly invisible plumbing.
And this...
Greenspan, many in Congress believed, had been the prime enabler for Wall Street's wild ride, too slow to remove the punch bowl of low interest rates earlier in the decade. "We are in the midst of a once-in-a-century credit tsunami," Greenspand said to Contress in his characteristic sandpaper-dry voice. ...

"In recent decades, a vast risk management and pricing system has evolved combining the best insights of mathematicians and finance experts supported by major advances in computer and communications technology," he said. "A Nobel Prize was awarded for the discovery of the pricing model that underpins much of the advance in derivatives markets," he added, referring to the Black-Scholes option model. ...

"The modern risk management paradigm held sway for decades," he said. "The whole intellectual edifice, however, collapsed in the summer of last year."

Waxman wanted to know more about this intellectual edifice. "Do you feel that your ideology pushed you to make decisions that you wish you had not made?" he asked, indignant.

"To exist you need an ideology," Greenspan replied in his signature monotone. "The question is whether it is accurate or not. And what I'm saying to you is, yes, I have found a flaw. I don't know who significant or permanent it is. But I have been very distressed by that fact."

"You found a flazw in the reality?" Waxman asked, seeming genuinely bewildered.

"A flaw in the model that I perceived is the critical functional structure that defines how the world works, so to speak."

The model Greenspan referred to was the belief that financial markets and economies are self-correcting -- a notion as old as Adam Smith's mysterious "invisible hand" in which prices guide resources toward the most efficient outcome through the laws of supply and demand. Economic agents (traders, lenders, homeowners, consumers, etc.) acting in their own self-interest create the best of all possible worlds, as it were -- guiding them inexorably to the Truth, the efficient market machine the quants put their faith in. Government intervention, as a rule, only hinders this process. Thus Greenspan had for years advocated an aggressive policy of deregulation before these very same congressmen in speech after speech. Investment banks, hedge funs, the derivatives industry -- the core elements of the sprawling shadow banking system -- left to their own devices, he believed, would create a more efficient and cost-effective financial system.

But as the banking collapse of 2008 showed, unregulated banks and hedge funds with young quick-draw traders with billions at their disposal and huge incentives to swing for the fences don't always operate in the most efficient manner possible. They might even make so many bad trades that they threaten to destabilize the system itself. Greenspan wasn't sure how to fix the system, aside from forcing banks to hold a percentage of loans they make on their own balance sheets, giving them the incentive to actually care about whether the loans might default or not. (Of course the banks could always hedge those loans with credit default swaps.)

Greenspan's confesszion was stunning. ...


Watching the telecast of the congressional hearing from his hedge fund in Greenwich, Cliff Asness couldn't believe what he was hearing. If anyone personified the system Greenspan called into question, it was Asness. A product of the University of Chicago's school of finance, which preached the dogma of free market libertarianism like a new religion [bold emphasis added], Asness believed with every fiber in his body and brain in the economic model Breenspan now seemed to reject. There is no flaw.

"Traitor," he muttered to his TV set. Greenspan was turning his back on a theory about the efficiency of free markets simply to salvage his reputation, Asness thought. "Too late, old man."
I've emphasized the "libertarian religion" because that is the EMH and other creeds that so poisoned government, and regulation, and the banks. Libertarianism is a utopianism, a madness that believes in a perfection that doesn't exist. People are not infinitely rational calculators and the future cannot be calculated, not even with super-fast computers. The world is more complex than we know and models are always a simplification and therefore will surprise us when reality refuses to match our simple models.

The book is worth reading to help you understand the latest bubble and crash. This won't be the last crash. In fact, because the ideology of the EMH still holds and because Obama refused to act like FDR and restructure the market rules and clip the wings of the insiders, another bubble will soon form and another crash will occur. These will get wilder until a real leader arises who is willing to face down Wall Street, put them back in the box, and allow Main Street to take centre stage again. There has been 30 years under the Reagan "magic" of deregulation and right wing ideology that has let the economy become wilder, more unpredictable, and less fair for the ordinary person. This will end. It could have ended by simple politics, but the American people have been bought off by right wing social conservatism as the flim-flam front for a behind the scenes restructuring by Wall Street big money types to create a "financialized economy" which has gutted the industrial heartland, lowered wages, and destroyed the "American dream". Someday the electorate will wake up and throw off this hideous era. But it will be a monumental struggle, just like the current struggle of the Egyptian people is a monumental struggle. The forces of suppression are very rich, very powerful, and have no intention of leaving unless they are forced to.

Nota bene: One of my bugaboos is low quality of proof reading. On page 260 of this book they make the gaff of citing "Arizona senator Harry Reid". What? The guy represents Nevada. How can this kind of gross error creep into a book that is supposedly giving a factual account of events from two years ago. If the author doesn't who which state Harry Reid represents, how many more "facts" has he misconstrued?

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