BOOK REVIEW: 'The Quants': How Math Geeks Helped Create the Great Recession

By David M. Kinchen
BOOK REVIEW: 'The Quants': How Math Geeks Helped Create the Great Recession
Beware of geeks bearing formulas. --Warren Buffett

Right after I finished reading Scott Patterson's "The Quants: How a New Breed of Math Wizards Conquered Wall Street and Nearly Destroyed It" (Crown Business paperback, 352 pages, $16.00) I came across a story on the left-wing (they prefer to call it "progressive") AlterNet news and opinion site asking the question: "Why Do People Who Work in Finance Earn So Much More Than the Rest of Us?"

The story by Les Leopold questioned, rightly in my opinion,  the bloated paychecks and bonuses  given to the so-called "smartest people in the room"  who've delivered the biggest financial meltdown since the Great Depression.

Leopold, in his Jan. 21 AlterNet piece, questions the logic of paying financial people like the quants the kind of money they've become accustomed to: "Let's try a back-of-the envelope calculation of Wall Street's net social value. Compare their bonuses and profits for roughly the last five years (about $500 billion) with the economic losses produced in the financial crisis the bankers caused (about $4 trillion in value destroyed, not counting the ongoing travails of the 22 million people who haven't yet been able to find a full-time job). For every dollar "earned" on Wall Street, about 8 dollars were destroyed. (In case you're suffering from financial amnesia and forgot how the financial sector single-handedly caused the economic crisis....There's plenty of room for argument about this kind of calculation. But even Wall Street wizards would have trouble defending the billions they've acquired by profiting from a bubble that blew up the economy. What's the real value of junk CDOs that were rated AAA and then sold for enormous profits before they blew up? We could make a strong case that those who profited from such bubble investments - like the people who sold synthetic CDOs to Wisconsin school districts -- should pay back their fraudulent profits. (In fact, the school districts have filed a lawsuit toward that end.)"

BREAKING: On Sunday, Jan. 23, Fox News Channel reported record bonuses at Goldman Sachs and other Wall Street banks. I found this commentary by Lisa Gilbert on Huffington Post: "In the U.S., five big Wall Street banks -- Bank of America, JPMorgan, Citigroup, Goldman Sachs and Morgan Stanley -- have already set aside more than $91 billion for salaries and bonuses this year. However, we have an immediate opportunity to fix our corrupt system of runaway pay for bankers by creating strong rules on pay under the Dodd-Frank legislation."

(Good luck on that...Long overdue is bringing back the Glass-Steagall act that was repealed in 1999 during the Clinton Administration. G-S separated investment banks, like Goldman Sachs, from less risky commercial banks. More than a few commentators trace the Great Recession at least in part to the repeal of Glass-Steagall. In 2009 former Fed Chairman Paul Volcker, who was just replaced by Jeff Immelt of GE as an advisor to President Obama, is an outspoken advocate of legislation separating commercial banking and investment banking. A good argument can be made that excessive risk-taking and a “too big to fail” mentality stems, at least in part, from lack of separation of these two functions since the Glass-Steagall Act was rescinded.)

There's something about financial crises that bring about the best in writers on the subject and "The Quants" -- published in hardcover last year -- is no exception. (It's too bad that said writers can't warn us in advance, but that's life!).

In the manner of books like "Liar's Poker" by Michael Lewis,  "Barbarians at the Gate" by Bryan Burrough and John Helyar  and "The Predator's Ball" by Connie Bruck,  Patterson tells the story of the transformation of financial markets by what one traditional "big swinging dick" trader called "kids who couldn't get a date in high school": a  new breed, the quants.  Starting in the mid 1980s this species of math whiz -- technocrats who make billions not with gut calls or fundamental analysis but with formulas and high-speed computers -- had usurped the testosterone-fueled, kill-or-be-killed risk-takers who’d long been the alpha males the world’s largest casino.

The quants believed that a dizzying, indecipherable-to-mere-mortals cocktail of differential calculus, quantum physics, and advanced geometry held the key to reaping riches from the financial markets.  And they helped create a digitized money-trading machine that could shift billions around the globe with the click of a mouse.

Many of these math whiz kids were also die-hard poker players.  Patterson recreates a March 2006 poker tournament at an opulent New York City hotel that saw the quantest of the quants gathered to compete in a tournament with million-dollar stakes. Million dollar stakes were sofa money to these guys, men -- and they were all men -- who were accustomed to risking billions.

At the card table that night was Peter Muller, an eccentric, whip-smart whiz kid who’d studied theoretical mathematics at Princeton and now managed a fabulously successful hedge fund called PDT…when he wasn’t playing his keyboard for morning commuters on the New York subway. Not that he rode the subway cars: he just greeted straphangers at the stations.

With him was Ken Griffin, who as an undergraduate trading convertible bonds out of his Harvard dorm room had outsmarted the Wall Street pros and made money in one of the worst bear markets of all time.  Now he was the tough-as-nails head of Chicago-based Citadel Investment Group, one of the most powerful money machines on earth. There too were Cliff Asness, the sharp-tongued, mercurial founder of the hedge fund AQR, a man as famous for his computer-smashing rages as for his brilliance, and Boaz Weinstein, chess life-master and king of the credit default swap, who while juggling $30 billion worth of positions for Deutsche Bank found time for frequent visits to Las Vegas with the famed MIT card-counting team.  

On that night in 2006, these four men and their cohorts were the new kings of Wall Street.  Muller, Griffin, Asness, and Weinstein were among the best and brightest of a  new breed, the quants.
The quants believed that a dizzying, indecipherable-to-mere-mortals cocktail of differential calculus, quantum physics, and advanced geometry held the key to reaping riches from the financial markets.  And they helped create a digitized money-trading machine that could shift billions around the globe with the click of a mouse.  

Few realized that night, though, that in creating this unprecedented machine, men like Muller, Griffin, Asness and Weinstein had sowed the seeds for history’s greatest financial disaster.  

Drawing on unprecedented access to these four number-crunching titans, Wall Street Journal reporter Patterson
tells the inside story of what they thought and felt in the days and weeks when they helplessly watched much of their net worth vaporize – and wondered just how their mind-bending formulas and genius-level IQ’s had led them so wrong, so fast.  Had their years of success been dumb luck, fool’s gold, a good run that could come to an end on any given day?  What if The Truth they sought — the secret of the markets — wasn’t knowable? Worse, what if there wasn’t any Truth?

Patterson tells the story not just of these men, but of Jim Simons, the reclusive founder of the most successful hedge fund in history; Aaron Brown, the quant who used his math skills to humiliate Wall Street’s old guard at their trademark game of Liar’s Poker, and years later found himself with a front-row seat to the rapid emergence of mortgage-backed securities; and gadflies and dissenters such as Paul Wilmott, Nassim Taleb, and Benoit Mandelbrot.  

"The Quants" is a very readable example of explanatory journalism, a gripping tale of ambition and hubris…and an ominous warning about Wall Street’s future.

Well, you say, we don't have to worry about quants any more; they were discredited in the last three years. Not so fast! Patterson predicts that the quants will rise again. He tells why in the book's final chapter "Dark Pools." Read it and weep, but basically quants and their theories are so well established in the financial industry that they will be banned from the industry when civil engineers are banned from bridge building.
As the late, great Kurt Vonnegut said (in "Slaughterhouse-Five"): "So it goes."

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