Mathematicians and the Meltdown

I can’t wait for the release of The Quants, a new book by Wall Street Journal reporter Scott Patterson about the role of so-called “quant funds” in the financial near-meltdown in September 2008, to be published on February 2. The weekend edition of The Wall Street Journal printed excerpts from the book, a powerful indictment of the mathematicians and computer whizzes who “nearly destroyed Wall Street.”

According to Patterson, “quants” was a name given to “traders and financial engineers who used brain-twisting math and super-powered computers to pluck billions in fleeting dollars out of the market.” In a major departure from traditional trading – evaluating individual companies’ management, performance and competitive positions – the quants used mathematical formulae to wager on which stocks will rise or fall.

Because of breakthroughs in the application of mathematics to financial markets – some of them so novel so as to have won their discoverers Nobel Prize awards — quant funds had quickly come to dominate Wall Street, with most of them piling up profits day after day. (To the senior brass at the investment houses, who likely knew little if anything about how these funds operated except that they made a lot of money, a hands-off policy seemed just the thing.)

And just as in so many other fields, technology elevated the “nerds” to the position of “stars” – with commensurately stratospheric compensation.

Unfortunately, in September 2008 the quant funds could not anticipate the effect of the collapse of the housing market bubble. In fact, this development turned the mathematical formulae of the quant funds on their head: What should have declined, rising … and what should be going up, dropping.

Patterson’s book promises to go into the details of just how things spun out of control, as seen through the eyes of key Wall Street managers such as the piano-playing, songwriting Peter Muller, founder of Morgan Stanley’s Process Driven Trading (PDT) quant fund, and Cliff Asness, formerly of Goldman Sachs and leader of the Applied Quantitative Research (AGR) quant fund.

In addition to presenting all the facts and all the drama, I’m hoping that Patterson will offer a few observations on how we can avoid a debacle like this from happening again in the future.

Another key question is whether any of the proposed regulations being debated in Congress will address the practices of quant funds – or is it all too complicated for anyone to figure out?

If that’s so, it’s pretty scary.

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