Don’t Blame Quants for Crisis

776398_40868655“Beware of geeks bearing formulas”-Warren Buffet

In a classic twist of Virgil’s Aeneid, Warren Buffet says it all.  I have just finished reading the highly readable and engaging book by Wall Street Journal writer Scott Patterson entitled The Quants. I am reminded of a similar excellent work written by Richard Bookstaber entitled A Demon of Our Own Design: Markets, Hedge Funds, and the Perils of Financial Innovation.

These two books are hugely instructive and really should be read as a pair.  Bookstaber, who holds a doctorate in Economics from MIT, lived the dream on Wall Street in the first heady days when computers and quantitative methods were just cutting their teeth.  He was a participant in the events leading up to the 1987 market collapse.  His specialty was risk management and he chronicles its failure and how it managed to create the massive market vortex in late October 1987 through a process called ironically, portfolio insurance.

Patterson has a different perspective as a journalist, not being so embedded in the process but rather as an observer who has managed to string together a rather frightening tale through interviews and anecdotal evidence.  He has most of the major Wall Street players covered in the second heady days when computers and quantitative methods had completely taken over.  His book lets you in on the personalities of the major quant players-Cliff Asness, Ken Griffin, Boaz Weinstein and Peter Muller to trace the impact of huge sums of money being run by computer-operated, highly leveraged hedge funds and prop desks through complex formulas dreamed up by these mathematics wunderkinds.  Goldman Sachs, Morgan Stanley, Bear Stearns, Lehman Bros., AQR and Citadel are regularly featured in the compelling narrative.

Patterson picks up where Bookstaber leaves off at LTCM in 1998.  The real action begins with the massive Quant Unwind that began late in July 2007 and crescendoed in August. I recall having to comment on this event at a Roger’s Media Risk Management Conference in August 2007, and frankly I am stunned at how close to the money my explanation was. At the time massive confusion existed in the market and it has only been the passage of time that has let observers like Patterson chronicle the events.

There are many lessons evident in both of these books.  The latest market crisis cannot be blamed on Quants-they and their processes were one of the enablers of the collapse just as Alan Greenspan was (no matter how much he protests to the contrary!).  Both these books should be required reading by all who labour in our industry in order to make them understand the overarching roles of luck and hubris in the financial dealings of man…