Times have changed since Shakeapeare’s era. Although one of his characters proposed killing all lawyers, the fact is that lawyers rarely create a bad situation. They normally just exploit a bad situation created by someone else.
So to fit the modern era and shift focus to the miscreants who create trouble, the quote needs to be updated to: “First, we kill all the quants.” Don’t know what a quant is? Warren Buffet was referring to quants when he warned earlier this year: ” Beware of geeks bearing formulas.”
Quants (from “quantitative”) are the financial “whiz kids” the big investment firms hired fresh out of mathematics doctoral programs to develop risk-managed financial products. Quants believe that a formula can be developed to predict risk in any situation. And what can be more seductive than a cold formula, devoid of emotion, to base your investment decisions on?
For the quants, formula-based risk prediction is a simple as 2+2=4. The certainty of mathematics, along with its predictive power, is the quants’ Holy Grail. It was accepted by many investors as well.
It was the formulas developed by quants that allowed the emergence of collateralized debt obligations (CDOs). And the most popular debt instrument collateralized was the home mortgage.
When the financial meltdown happened, many conservatives reflexively blamed one “liberal” initiative or another. The one I heard about most was the Community Reinvestment Act, and the “proof” was that it encouraged banks to make risky loans even though I never saw any data to back that assertion up. (In other words, it was right up there with the slam dunk case for WMDs in Iraq.) Their ire should have been directed to the Wall Street quants, but many conservatives worship Wall Street as an infallible secular god.
Does it really matter if someone obtained a mortgage which they were marginally, or even not, qualified for? Because for that to be a problem, it assumes that whoever issued the mortgage will bear all, or most, of the financial liability of default. What if we could reduce that liability by spreading out the financial risk?
What if a $100,000 mortgage is sold to an investment firm which then slices and dices it into 200 chunks of $500 which are then resold as CDOs? Now the risk is spread to 200 not just one. And the liability is just $500 not $100,000.
But who is going to buy a $500 mortgage slice? So what we do is bundle 1,000 $500 mortgage slices into one CDO worth $500,000. That can be sold to a large investor or broken into smaller chunks to sell to smaller investors. If sold to multiple investors, the risk and liability of each $500 chunk is further spread out. In that case, what is the probability that enough slices will default to produce an overall loss? Especially if I own parts of 100 $500,000 CDOs?
Enter the quants. Their formulas calculated the probability investors demanded in order to establish risk and, from that, profit information which they needed to make an investment decision. The quants convinced investors that the risk was small and the profits very nice.
That is why no one cared whether mortgages were sound. The quants’ formulas accounted for what percent of mortgages would fail and how the CDOs would still be profitable as a whole.
There was one particular formula which rose to the top because it allowed the calculation to be performed much faster because it relied on correlation rather than analysis. That formula led to an explosion of another financial instrument: credit default swaps (CDS), insurance against default of a CDO.
And for many years, things went along smoothly. Quants made big money; investors made big money. Everyone patted themselves on the back over the power of CDOs and CDSs.
But of course the quants, like everyone else, have their nemesis: the behaviorists. They scoff at the idea that formulas can account for everything. No matter how mathematically correct, no matter how logical, formulas presume the world is logical and rational. And in the quants’ world, that is true.
But in the real world, people often do not behave logically or rationally. Especially in the economy. And that was the Achilles’ heel of the quants’ formulas.
Once some CDOs began faltering, an illogical and irrational variable called fear began to take hold. If folks had stayed calm and logical, perhaps the meltdown would have been minor and fleeting. Instead, a frenzy of fear paralyzed the major financial institutions. Instead of trust, there was doubt and suspicion. A herd mentality developed and I’m convinced it was that mentality, not objective facts, which was the precipitating factor for what followed.
The big financial firms quickly transformed from bulls into lemmings and headed for the cliffs. But “liberal” initiatives got the blame.
The moral of all this? The next time a quant bearing formulas tells you everything’s going to be fine, give him a hard kick in the butt and then ask him to calculate what the probability of your doing that was. Then suggest he start living in the real world.
For an interesting look into the history of the principal formula that led to the financial meltdown, check out this article from Wired: Recipe for Disaster: The Formula That Killed Wall Street. It details David X. Li’s Gaussian copula function, the formula that relied on correlation rather than analysis to determine risk and so allowed the calculation to be performed much quicker, allowing CDOs and CDSs to be priced and issued faster than ever. Which meant even more profit for Wall Street.
And that is what America is all about: fast, big profits.