March 10, 2009

"Options theory is kind of deep in some way. It was very elegant; it had the quality of physics."

Quants.
Seduced by a vision of mathematical elegance underlying some of the messiest of human activities, they apply skills they once hoped to use to untangle string theory or the nervous system to making money....

Asked to compare her work to physics, one quant, who requested anonymity because her company had not given her permission to talk to reporters, termed the market “a wild beast” that cannot be controlled, and then added: “It’s not like building a bridge. If you’re right more than half the time you’re winning the game.” There are a thousand physicists on Wall Street, she estimated, and many, she said, talk nostalgically about science. “They sold their souls to the devil,” she said, adding, “I haven’t met many quants who said they were in finance because they were in love with finance.”...

Given the state of the world, you might ask whether quants have any idea at all what they are doing....

Lee Smolin, a physicist at the Perimeter Institute for Theoretical Physics in Waterloo, Ontario, who was one of the authors, said, “What is amazing to me as I learn about this is how flimsy was the theoretical basis of the claims that derivatives and other complex financial instruments reduced risk, when their use in fact brought on instabilities.”...

Quants say that they should not be blamed for the actions of traders. They say they have been in the forefront of pointing out the models’ shortcomings.

Quants! Scapegoats or devils?

Quants: scapegoats or devils?
Scapegoats
Devils
  
pollcode.com free polls

52 comments:

Original Mike said...

It's an illusion. Sure it's mathematical, but the available data is paltry.

fcai said...

In Barnaby Street they say Quants are just fab!

downtownlad said...

Scapegoats. Derivatives are a zero sum game. For every winner, there is a loser. The economy AS A WHOLE has never lost one penny from options trading.

The problem with the economy today is that you have had an enormous bursting of an asset bubble. The prices of real assets, such as real estate, have plummeted by trillions of dollars.

Peter V. Bella said...

Derivatives are a zero sum game. For every winner, there is a loser.

All free trade markets and trade operate in that manner. Those who espouse the laughable idea of fair markets and fair trade- everyone wins- are tools. Big, useless tools.

Paul Zrimsek said...

I hate Quants. (/koala)

MadisonMan said...

The problem is that the people using the models didn't develop them and don't quite grasp all the underlying assumptions.

Two lines in the Article jumped out at me:

The first time he tried to show it off, the screen froze, but his boss was fascinated anyway by the graphical user interface, a novelty on Wall Street at the time.

Managers on Wall Street love a novelty especially if it promises a big return double especially if they have it before their competitors. So they leap in not understanding it all.

figured out how to price and hedge these options in a way that seemed to guarantee profits.

That sounds too good to be true! IME, anything that sounds too good to be true is something to be avoided.

Tibore said...

"Options theory is kind of deep in some way. It was very elegant; it had the quality of physics."

Elegance is indeed a useful quality to use in judging the validity of hypothetical concepts; the whole concept of Occam's Razor is based on it. However, it is not the final one, and it unfortunately can mislead. The ultimate judge of a concept's validity has always been and will always be how well a concept reflects validity; if it doesn't, then possesion of elegance doesn't matter a bit. Elegance cannot overcome inaccuracy.

Philosophically, it all comes down to wheter a concept, hypothesis, proposal, or whatever construct is in question reflects truth. As Einstein said, "If you are out to describe the truth, leave elegance to the tailor."

Big Mike said...
This comment has been removed by the author.
Big Mike said...

@Althouse, how come you didn't have a "both" option on your poll?

@downtownlad, as usual you liberals assume that economics is a zero sum game. @Peter, that goes for you, too. The notion was utterly demolished by John Nash in his elegant twelve page (typed, double-spaced) doctoral dissertation.

The real problem is that physicists often do not understand deeper mathematics. Some notion of what chaos theory is all about would have been useful for the quants to contemplate.

Eventually some really bright people will crunch the numbers from the current fiasco and come up with new, and better, mathematical models, and the markets will move on.

Golden West said...

Is Barnaby Street anywhere near Carnaby Street? ;-)

downtownlad said...

Big Mike - You are a moron. Options are a zero sum game.

I never said that "economics" is a zero sum game. Real assets, like stocks and real estate, can of course go up AND down in value.

But the underlying derivative products based on those assets are ALWAYS a zero sum game.

Here's another moron who thinks otherwise, but he's too dumb to realize that a Mortgage backed security is NOT a derivative. It's an asset backed SECURITY.

Only forwards, futures, options, and swaps are derivatives.

http://www.moneyweek.com/investments/stock-markets/derivatives-the-mother-of-all-bubbles.aspx

fcai said...

Golden West - thank you.

I should not type on 5 hours of sleep. I need more layers of fact checkers. I think I will volunteer to work at the NYT.

Maybe I was thinking of Barnaby Jones, who was certainly less fab than Mary Quant.

Henry said...

“It’s not like building a bridge. If you’re right more than half the time you’re winning the game.”

Uh, no. If you're right more than half the time you win for a while -- until your luck runs out. Then you lose.

Nassim Nicholas Taleb, author of The Black Swan, points out that the flaw of mathemetical models in regard to the markets (or any dynamic human system), is that they only work when the mathematicians throw out impossible-to-quantify outliers.

But it is the impossible-to-quantify outliers that make the difference between predictable profits and losing everything.

Megan McArdle has a pithy summation: the market can stay irrational longer than you can stay solvent.

commenter said...

What no sixties Mary Quant post followup?

I'll pick this simple one just for the mathematical reference:

www.visualbliss.co.uk/themes/images/60s/MaryQuantBackdrop.jpg

wow, i had the choice between studying mathematics or tailoring (and design) when i was young because I was very good at both. As a female and straight, it's lonely in mathematics and tailoring(design).

Maybe that's the problem.

commenter said...

http://www.shinyshiny.tv/maryquant_kettle.jpg

I'll had that image because it just begs for a donut and a teacup!

Henry said...

commenter -- that is truly perfect Althousiana commentary. My hat is off to you.

downtownlad said...

And what a rally on Wall Street. What a huge show of confidence for Obama.

commenter said...

yes, and it jives so well with the theme of the article that i didn't even read. I just read the excerpt.

but look, even the urls are about AA on the internet:

visual bliss and shiny, shiny.

Hey! and my grammar and typing, except for the capital i, was even pretty good.

It's not hard, Henry. I find Althouse to be quite transparent and obvious in her personality if not her blogging objectives. I could comment quite a bit more and effectively, but Ann ignores me ever since she can't do a fake apology for the nausea link post when I started out. Besides, I really want to get away and leave her alone. Honestly. I so ache for spring at the moment and a home without internet 24/7.

I'll give it time.

Quayle said...
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Martin Gale said...

Madison Man says . . .

"The problem is that the people using the models didn't develop them and don't quite grasp all the underlying assumptions."

Oh really? In the case of the hedge fund, Long Term Capital Management, which failed in 1998, two of the partners, Myron Scholes and Robert Merton, won Nobel prizes for their work on derivative valuation models -- specifically, the Black/Scholes/Merton framework of mathematical finance. Hard to argue that they didn't appreciate the assumptions of their own work.

LTCM's collapse is important because the treasury's failure to grasp the potential for a global cascade of financial failures resulting from firms using models rather than markets to value their positions is the precursor to today's distress. Indeed, after LTCM's failure then Tsy Sec Rubin went on to preside over the birth of the unregulated CDS insurance market which is ground zero for the present collapse of the global financial system.

Quayle said...

The huge irony here is that it was Volker's own grandson that engineered the specific mortgage backed securities tranche structures that caused this whole mess.

The investment banks, using Volker's grandson's basic financial engineering, learned that if they structured the tranches of the security pool just so, that they could get AAA ratings from the ratings agencies.

(The conflict of interest of the ratings agengies plays a big part in this also. They were paid suppliers to the banks - they were not independent agencies.)

The ratings agencies looked only to the amount and degree of subordination below the supposed AAA piece and rated it on that basis only. They never ran the underlying numbers on the mortgage pool, or if they did, were overruled by their highly conflicted managers on the outcome.

That allowed the investment banks to fill the pool with any crap mortgages and still get a AAA.

Then blind financial asset managers (small funds, insurance pools) that only needed AAA, and didn't want to or know how to run analysis of the underlying mortgage pool, were caught in the trap.

Eventually the banks drank so much of their own kool aid that they were holding them as well, even though they knew the alchemy.

And when Volker's grandson said he was only doing what he was told, it has been widely reported that Volker said, "I don't accept the Nuremberg defense."

Quayle said...
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downtownlad said...

That allowed the investment banks to fill the pool with any crap mortgages and still get a AAA.

So? You do realize that there was a very good financial theory that assumed that was correct, don't you?

It had to do with correlation.

The model was wrong, of course, but most people didn't realize that until recently. Don't blame the rating agencies.

Here's a very good article on the subject.

http://www.wired.com/techbiz/it/magazine/17-03/wp_quant?currentPage=all

Martin Gale said...

Henry says . . .

"Nassim Nicholas Taleb, author of The Black Swan, points out that the flaw of mathemetical models in regard to the markets (or any dynamic human system), is that they only work when the mathematicians throw out impossible-to-quantify outliers.
"

Taleb doesn't argue that outliers are impossible to quantify, he just thinks that the present ordinary brownian motion model underlying mathematical finance should be replaced with fractional brownian motion. This would fatten the tails of the return distribution and introduce long term autocorrelation to the return series. Unfortunately, it also largely discards all asset classes except cash and deep in/out of the money options. BTW, Taleb has argued that our present unpleasantness is NOT a black swan event. Make of that what you will. (He makes of it a very good living.)

jdeeripper said...

Quants: scapegoats or devils?

Aspergy Assholes.

They are at or below the level of the typical Lawyer Asshole.

Quants and numerically obsessed, lawyers are verbally obsessed.

Both groups are filled with emotionally disturbed and cognitively twisted individuals.

jdeeripper said...

downtownlad said...And what a rally on Wall Street. What a huge show of confidence for Obama.

Yes, incredible isn't it.

The Dow Jones industrial average has fallen 21 percent during Obama's first seven weeks in office.

Count back to Election Day and the results are even bleaker: a loss of 32 percent.


Chant it dtl - Yes We Can! Yes We Can! Yes We Can!

Henry said...

BTW, Taleb has argued that our present unpleasantness is NOT a black swan event. Make of that what you will. (He makes of it a very good living.)

Has he written about it? I'd love to read what he has to say.

Quayle said...

The model was wrong, of course, but most people didn't realize that until recently. Don't blame the rating agencies.

Here's a very good article on the subject.


No, the ratings agencies ignored the actual risk of each individual pool, and simply put a AAA on the senior tranche if it "looked" sufficiently subordinated.

In other words, if the old average default rate of a 1980s mortgage pool was 15%, and these new tranches were subordinated so that would require a 35% default to eat through the subordinated pieces and hit the senior tranche, that was given a AAA regardless of what was actually in the pool.

Once the investment banks realized that all they had to do was show the senior tranche cushioned by enough subordinated pieces (i.e. a 40% default rate would hit only the subordinated pieces), they started to construct pools that had a 70% chance of failure, knowing that all the ratings agency looked at was the 40% cushion in the subordination.

And you haven't addressed the clear conflict of interest of the ratings agencies in being paid huge sums to rate these tranches.

It is the same conflict of interest that brought down Enron and Worldcom - the auditor doesn't want to make the customer made and threaten their consulting business, by giving a bad audit.

Here the ratings agencies didn't want to threaten their continuing business with the investment banks by giving a senior tranche a low rating because of the true, actual credit risk of the underlying mortgage pool.

Martin Gale said...

Henry asks ...

"Has he written about it? I'd love to read what he has to say.
"

I believe Taleb made his "not a black swan" statement in an interview with Charlie Rose.

Quayle said...
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former law student said...

The quants were distracted by shiny objects, and neglected to look at the soundness of the underlying securities. Warren Buffett actually made money in derivatives, because he analyzed the securities underlying them, then built in the margin of safety his mentor, Benjamin Graham, had always advised.

Graham was a man far ahead of his time, operating the world's first hedge fund, according to Buffett.

Quayle said...

downtownlad, the link you post to give a very simplistic description.

The fact is that the ratings agencies are either guilty of fraud (i.e. they ran the numbers and ignored them) or they are guilty of gross negligence (i.e. they didn't run any numbers, or they ran very crude and obsoltete credit analysis models.)

Not everyone was fooled by the sub-prime laden mortgage securities. A lot of top fund managers that run their own pool analysis models saw right through the game and weren't caught holding crap.

former law student said...

Quayle is 100% correct, by the way.

Quayle said...

they started to construct pools that had a 70% chance of failure, knowing that all the ratings agency looked at was the 40% cushion in the subordination.


In other words, they figured out how to turned tin into gold.

William said...

Things I've learned by watching the Discovery Channel: In the subatomic world, Newtonian concepts of gravity and time have no validity. Ptolemy, Newton, Einstein all had elegant models of the universe that desribed not the universe but only that spectrum of the universe which they observed.....It seems to me that the Black Swan, i.e. the statistical anomaly that has never before been observed, is not the current market crash but the twenty year bull market that preceded it....We underestimate the power of random events in human affairs. But in order to have any kind of life it is necessary to play the probabilities and believe that tomorrow will be just like yesterday-- until it isn't....My model of the universe was that if you go to work every day, save a portion of your paycheck every week, and don't marry a meth addicted stripper, you will not die broke. Man proposes. God disposes.

downtownlad said...

Actually Quayle is wrong. He obviously didn't even read the article.

downtownlad said...

The ratings agencies knew what was in the pool. They give it a AAA rating, because they didn't think the mortgages were correlated so closely. They were using valid financial models (since disproved) to price the securities.

Henry said...

They were using valid financial models (since disproved)...

Well, that's an understatement!

Henry Buck said...

Does "widely used by people who don't understand them" mean "valid" in downtownlad's world?

downtownlad said...

Isn't the conservative meme supposed to be that lazy Black people caused this crisis . . .

commenter said...

i read the aspergy assholes wiki entry.

My favorite was the last paragraph.


I guess if you were an asperass researching aspergers you would have double indemnity or even exponential indemnity for researching it beyond the cause or usefulness.

Peter V. Bella said...

Isn't the conservative meme supposed to be that lazy Black people caused this crisis . . .

Nope. The meme is that greedy, stupid, and ignorant people tried to get deals- homes they could not afford or should never have been allowed to buy- that were too good to be true; they come from all races and backgrounds. Even people like you.

commenter said...

I just said this to my dad over the weekend:


I've worked with seven or eight, even more real estate agents. I have gone in with the limit that i want to spendh. Every single time without an exceptions, they have shown me one or two in my price bracket, and then try to sell me up by showing me house after house after house of great stuff above my bracket and telling me how to afford it. People should be strict with the dealer.

Now I am a rather frugal thriftspend. And hard headed. I always made it work even when we bought up. The last venture in that probably caused my divorce to a degree not through financial dificulties but through difference in opinion about such.

Then again, as already stated on this blog, I am the person who wants to die breaking even, not broke or rich. What i give to my kids or heirs should be mostly complete before the time i die anyway.

Lance said...

@dtl...

From the Wired article: "His method was adopted by everybody from bond investors and Wall Street banks to ratings agencies and regulators. And it became so deeply entrenched—and was making people so much money—that warnings about its limitations were largely ignored." (emphasis mine)

"In hindsight, ignoring those warnings looks foolhardy. But at the time, it was easy. Banks dismissed them, partly because the managers empowered to apply the brakes didn't understand the arguments between various arms of the quant universe. Besides, they were making too much money to stop."

Ignorance: If willful, it's fraud. Otherwise it's incompetence.

El Presidente said...

DTL,

I've never met a lazy black quant.

Up till then I was with you.

El Presidente said...

The rules for derivatives and the rules of poker are very similar.

1) It ain't gambling.

2) Look around the table and if you don't see the sucker, you're it.

3) If you change the rules a little you change the game a lot. The use of models changes the rules, and in ways the model can't appreciate.

El Presidente said...

Lance,

Un-rebutted hearsay from Wired Magazine very convincing. I wouldn't even throw you in Combinado del Este based on that.

Eddie said...

I'm curious why anyone thinks that it matters that derivatives are zero-sum games. If they are mispriced, then there will be a misallocation of resources. Madoff's ponzi scheme was a zero-sum game too, but that doesn't make it harmless.

rhhardin said...

Whenever there's a system designed that prevents everybody from losing money, the real system always kicks back at the weakest link, namely will violate the assumptions.

People making money have to be able to lose money because nobody is going to hand them free money.

If you can't lose money, you've overlooked a possibility, is all.

Put another way, you can't design a system that runs uphill against human motivations.

Socialism would be another example.

It's quite general.

rhhardin said...

The financial system this time was designed to move capital from where it was not wanted to where it was wanted; the way it got capital was by offering low risk for slightly higher return.

The middlemen were rewarded handsomely, but that isn't bad. Middlemen contribute possibilities to economic transactions that the parties otherwise wouldn't have been able to find for themselves. Both parties and the middleman are all better off for the middleman's activities.

What you had here was a mistake: there was a systemic instability that could explode exponentially that had gone unnoticed in the construction and its consequences.

The Lockheed Electra had a nice instability that nobody had noticed in the engine mount design, that occasionally resulted in tearing the wing off in flight.

Sooner or later a bad design hits the perturbation that sets it off, and then everybody wonders what the hell happened, including and foremost the designers.

Scapegoaters move in right away to take their rewards, as another fine example of human motivation in action.

rhhardin said...

They're talking about reinstating short sale rules on financial institution stocks.

Betting against the stock is bad, is the populist idea.

But shorting the stock is what you do when you're owed money by that same institution and you can no longer buy default insurance. It's a risk reducing strategy for the short seller, not a wild bet.

Probably the short seller hopes the sale loses money, because he makes more than that up by getting his original asset repaid.

Quayle said...

Paul Wilmott wrote that "the correlations between financial quantities are notoriously unstable." Wilmott, a quantitative-finance consultant and lecturer, argued that no theory should be built on such unpredictable parameters. And he wasn't alone.

dowtownlad, the wired article was sourced by sheep that follow and couldn't do their own thinking, and consequently failed their investors.

Now that they have failed their investors and now want sooth their own consciences and hide under the guise of "everyone else was using it it."

Everyone did not use Li's formula, as the quote above proves.

You are having trouble separating the leaders and the independent workers from the dumb, blind herd.