Introducing the new villain of financial meltdown: the lowly quantitative analyst.
From Scientific American:
These lapsed physicists and mathematical virtuosos were the ones who both invented these oblique securities and created software models that supposedly measured the risk a firm would incur by holding them in its portfolio… The software models in question estimate the level of financial risk of a portfolio for a set period at a certain confidence level. As Benoit Mandelbrot, the fractal pioneer who is a longtime critic of mainstream financial theory, wrote in Scientific American in 1999, established modeling techniques presume falsely that radically large market shifts are unlikely and that all price changes are statistically independent; today’s fluctuations have nothing to do with tomorrow’s – and one bank’s portfolio is unrelated to the next’s. Here is where reality and rocket science diverge.
The article’s got it right in one sense. Models were backward-looking. As FT Alphaville noted in September, when Libor-OIS spreads were blowing up, normal, historical distributions aren’t necessarily a great way of predicting future market events. Purely numerical models also ignore the irrational element of the markets — the fear and greed that can dominate investors’ minds. But, Scientific American is also ignoring a behavioural aspect of the biz — the tensions that can exist between quants themselves and the rest of the operations.
Internet blogger Brad Hicks pick up on some of that tension, citing the experiences of Michael Lewis, of Liar’s Poker fame.
When Michael Lewis was first hired, right out of college, as a salesman at Solomon Brothers, his instinctive belief that things have an actual value was something that got relentlessly mocked by his coworkers. In his early days on Wall Street, they explained to him that there is a pecking order in the financial services industry.
For a variety of cultural and regulatory reasons, investment firms are required to have people working for them who are experts at calculating the actual value of an investment based on current mathematical models and best available data. Their department is called ‘Quantitative Analysis,’ and the people who work there are derisively called ‘quants.’ Quants have the lowest prestige jobs in the entire industry, draw remarkably low salaries considering the level of education you have to have to get those jobs and the long hours and the awful working conditions, and Lewis says that they are routinely and cruelly and ruthlessly snubbed by the other half of the business. Those are the people whose specialty is sales.
And at the absolute top of the pecking order, Lewis taught us, are the people who were called the Big Swinging Dicks, people who demonstrated the superiority of their manhood by being able to sell anything, however worthless the quants said it was, for however much the company needed it to sell for.
In one sense the BSDs here are correct here — products are worth however much the market is willing to pay for them. However, as we’ve seen from the recent financial fall-out, unsustainable bubbles exist.
Flash forward to a particular bubble — housing — when, as Michael Lewis himself noted in his recent Portfolio article “The End,” punters who clearly couldn’t afford five speculative mortgages (yet had somehow got them) were beginning to fall behind on their payments. Hicks notes:
… somewhere in some windowless cubicle in the basement, there was at least one quantitative analyst screaming his head off in emails about this, about how the mathematical modeling that underlaid the calculations that determined pricing on collateralized debt obligations was based on statistical analysis of customers who were buying their primary home, not as an investment vehicle but to live in, and pricing those homes based on reasonable expectations of what someone in their social class could afford to live in and paying no more for them than three times their income.
And no BSD in the entire industry wanted to hear that caveat. He didn’t dare. He almost certainly paid people to intercept those emails and keep them from him. Because if he let himself get drawn into what must have seemed to him like an arcane and wrong-headed argument about what something is ‘actually worth,’ when there really is no such thing, when everybody knows that the only accurate way to value something is to put it in the hands of a talented salesman and see what he can sell it for? He wouldn’t have made his numbers.
Ok, so investment banking has changed a lot since Michael Lewis’s days — quant models have arguably become more important as trades become more and more computerised and more and more illiquid investments (which depend on model-based valuations) are bought and sold. But, you can’t ignore the tensions between quant models and the rest of the business. Quants are there to attempt to price risk. Sales, by definition, are there to largely try to ignore it — and that’s what ultimately leads to bubbles, and conversely, financial crises.
Related link:
After the crash: How software models doomed the markets – Scientific American
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