The Quants

by Scott Patterson

  Weinstein, meanwhile, decided it was time to break out into the wide world on his own. But he was leaving a tangled mess behind him. By the end of the year, Saba had lost $1.8 billion. In January 2009, the group was officially shut down by Deutsche, which, like nearly every other bank, was nursing a massive hangover from its venture into prop trading and was radically scaling back on it.

  Weinstein left Deutsche Bank on February 5, slightly more than a decade after he’d first come to the firm as a starry-eyed twenty-four-year-old with dreams of making a fortune on Wall Street. He’d made his fortune, but he’d been bruised and bloodied in one of the greatest market routs of all time.

  Paul Wilmott stood before a crowded room in the Renaissance Hotel in midtown Manhattan, holding up a sheet of paper peppered with obscure mathematical notations. The founder of Oxford University’s first program in quantitative finance, as well as creator of the Certificate in Quantitative Finance program, the first international course on financial engineering, wrinkled his nose.

  “There are a lot of people making things far more complicated than they should be,” he said, shaking the paper with something close to anger. “And that’s a guaranteed way to lose $2 trillion.” He paused for a second and snickered, running a hand through his rumpled mop of light brown hair. “Can I say that?”

  It was early December 2008, and the credit crisis was rampaging, taking a horrendous toll on the global economy. Americans’ fears about the state of the economy had helped propel Barack Obama into the White House. The Dow Jones Industrial Average had crashed nearly 50 percent from its 2007 record, having dived 680 points on December 2, its fourth-biggest drop since the average was launched in 1896. The United States had shed half a million jobs in November, the biggest monthly drop since 1974, and more losses were coming. Economists had stopped speculating about whether the economy was sliding into a recession. The big question was whether another depression was on the way. Bailout fatigue was in the air as more revelations about losses at financial institutions from Goldman Sachs to AIG filled the airwaves.

  Taxpayers wanted someone to blame. But the crisis was so confusing, so full of jargon about derivatives and complex instruments, that few of the uninitiated knew who was at fault.

  Increasingly, fingers were pointing at the quants. The tightly coupled system of complex derivatives and superfast computer-charged overleveraged hedge funds that were able to shift billions across the globe in the blink of an eye: It had all been created by Wall Street’s math wizards, and it had all come crumbling down. The system the quants had designed, the endlessly ramifying tentacles of the Money Grid, was supposed to have made the market more efficient. Instead, it had become more unstable than ever. Popular delusions such as the efficient market hypothesis had blinded the financial world to the massive credit bubble that had been forming for years.

  Jeremy Grantham, the bearish manager of GMO, an institutional money manager with about $100 billion in assets, wrote in his firm’s early 2009 quarterly letter to clients—titled “The Story So Far: Greed + Incompetence + A Belief in Market Efficiency = Disaster”—that EMH and the quants were at the heart of the meltdown.

  “In their desire for mathematical order and elegant models,” Grantham wrote, “the economic establishment played down the inconveniently large role of bad behavior … and flat-out bursts of irrationality.” He went on: “The incredibly inaccurate efficient market theory was believed in totality by many of our financial leaders, and believed in part by almost all. It left our economic and government establishment sitting by confidently, even as a lethally dangerous combination of asset bubbles, lax controls, pernicious incentives, and wickedly complicated instruments led to our current plight. ‘Surely, none of this could be happening in a rational, efficient world,’ they seemed to be thinking. And the absolutely worst part of this belief set was that it led to a chronic underestimation of the dangers of asset bubbles breaking.”

  In a September 2009 article titled “How Did Economists Get It So Wrong” in the New York Times Magazine, Nobel Prize–winning economist Paul Krugman lambasted EMH and economists’ chronic inability to grasp the possibility of massive swings in prices and circumstances that Mandelbrot had warned of decades earlier. Krugman blamed “the profession’s blindness to the very possibility of catastrophic failures in a market economy. … As I see it, the economics profession went astray because economists, as a group, mistook beauty, clad in impressive-looking mathematics, for truth.”

  While the collapse had started in the murky world of subprime lending, it had spread to nearly every corner of the financial universe, leading to big losses in everything from commercial real estate to money market funds and threatening major industries such as insurance that had loaded up on risky debt.

  But not every quant had been caught up in the madness. Few were sharper in their criticism of the profession than Paul Wilmott, one of the most accomplished quants of them all.

  Despite the freezing temperature outside, the bespectacled British mathematician was clad in a flowery Hawaiian shirt, faded jeans, and leather boots. Before Wilmott, spread out in rows of brightly colored plastic molded chairs, sat a diverse group of scientists in fields ranging from physics to chemistry to electrical engineering. Members of the motley crew had one thing in common: they were prospective quants attending an introductory session for Wilmott’s Certificate in Quantitative Finance program.

  Wilmott wanted this bright-eyed group to know he wasn’t any ordinary quant—if they hadn’t already picked up on that from his getup, which seemed more beach bum than Wall Street. Most quants, he said, were navel-gazing screwups, socially dysfunctional eggheads entranced by the crystalline world of math, completely unfit for the messy, meaty world of finance.

  “The hard part is the human side,” he said. “We’re modeling humans, not machines.”

  It was a message Wilmott had been trying to pound into the fevered brains of his number-crunching colleagues for years, mostly in vain. In a March 2008 post on his website, Wilmott.com, he lambasted Wall Street’s myopic quant culture. “Banks and hedge funds employ mathematicians with no financial-market experience to build models that no one is testing scientifically for use in situations where they were not intended by traders who don’t understand them,” he wrote. “And people are surprised by the losses!”

  Wilmott had long been a gadfly of the quants. And he had the mathematical firepower to back up his attacks. He’d written numerous books on quantitative finance and published a widely read magazine for quants under his own name. In 1992, he started teaching the first financial engineering courses at Oxford University. Single-handedly he founded Oxford’s mathematical finance program in 1999.

  He’d also warned that quants might someday blow the financial system to smithereens. In “The Use, Misuse and Abuse of Mathematics in Finance,” published in 2000 in Philosophical Transactions of the Royal Society, the official journal of the United Kingdom’s national academy of science, he wrote: “It is clear that a major rethink is desperately required if the world is to avoid a mathematician-led market meltdown.” Financial markets were once run by “the old-boy network,” he added. “But lately, only those with Ph.D.’s in mathematics or physics are considered suitable to master the complexities of the financial market.”

  That was a problem. The Ph.D.’s might know their sines from their cosines, but they often had little idea how to distinguish the fundamental realities behind why the market behaved as it did. They got bogged down in the fine-grained details of their whiz-bang models. Worse, they believed their models were perfect reflections of how the market works. To them, their models were the Truth. Such blind faith, he warned, was extremely dangerous.

  In 2003, after leaving Oxford, he launched the CQF program, which trained financial engineers in cities from London to New York to Beijing. He’d grown almost panicky about the dangers he saw percolating inside the banking system as head-in-the-clouds financial engineers unleashed trillions of comple
x derivatives into the system like a time-release poison. With the new CQF program, he hoped to challenge the old guard and train a new cadre of quants who actually understood the way financial markets worked—or, at the very least, understood what was and wasn’t possible when trying to predict the real market using mathematical formulas.

  It was a race against time, and he’d lost. The mad scientists who’d been running wild in the heart of the financial system for decades had finally done it: they’d blown it up.

  On a frigid day in early January 2009, several weeks after addressing the crowd of hopeful quants at the Renaissance Hotel, Wilmott boarded a plane at Heathrow Airport in London and returned to New York City.

  In New York, he met with über-quant Emanuel Derman. A lanky, white-haired South African, Derman headed up Columbia University’s financial engineering program. He was one of the original quants on Wall Street and had spent decades designing derivatives for Goldman Sachs, working alongside legends such as Fischer Black.

  Wilmott and Derman had become alarmed by the chaotic state of their profession and by the mind-boggling destruction it had helped bring about. Derman believed too many quants confused their elegant models with reality. Yet, a quant to the core, he still held firmly that there was a central place for the profession on Wall Street.

  Wilmott was convinced his profession had run off track, and he was growing bitter about its future. Like Derman, he believed that there was still a place for well-trained, and wise, financial engineers.

  Together that January, they wrote “The Financial Modelers’ Manifesto.” It was a cross between a call to arms and a self-help guide, but it also amounted to something of a confession: We have met the enemy, and he is us. Bad quants were the source of the meltdown.

  “A spectre is haunting markets—the spectre of illiquidity, frozen credit, and the failure of financial models,” they began, ironically echoing Marx and Engels’s Communist Manifesto of 1848.

  What followed was a flat denunciation of the idea that quant models can approximate the Truth:

  Physics, because of its astonishing success at predicting the future behavior of material objects from their present state, has inspired most financial modeling. Physicists study the world by repeating the same experiments over and over again to discover forces and their almost magical mathematical laws. … It’s a different story with finance and economics, which are concerned with the mental world of monetary value. Financial theory has tried hard to emulate the style and elegance of physics in order to discover its own laws. … The truth is that there are no fundamental laws in finance.

  In other words, there is no single truth in the chaotic world of finance, where panics, manias, and chaotic crowd behavior can overwhelm all expectations of rationality. Models designed on the premise that the market is predictable and rational are doomed to fail. When hundreds of billions of highly leveraged dollars are riding on those models, catastrophe is looming.

  To ensure that the quant-driven meltdown that began in August 2007 would never happen again, the two über-quants developed a “modelers’ Hippocratic Oath”:

  I will remember that I didn’t make the world, and it doesn’t satisfy my equations.

  Though I will use models boldly to estimate value, I will not be overly impressed by mathematics.

  I will never sacrifice reality for elegance without explaining why I have done so.

  Nor will I give the people who use my model false comfort about its accuracy. Instead, I will make explicit its assumptions and oversights.

  I understand that my work may have enormous effects on society and the economy, many of them beyond my comprehension.

  While the manifesto was well-intentioned, there was little reason to believe it would keep the quants, in years to come, from convincing themselves that they’d perfected their models and once again bringing destruction to the financial system. As Warren Buffett wrote in Berkshire Hathaway’s annual report in late February 2009, Wall Street needs to tread lightly around quants and their models. “Beware of geeks bearing formulas,” Buffett warned.

  “People assume that if they use higher mathematics and computer models they’re doing the Lord’s work,” observed Buffett’s longtime partner, the cerebral Charlie Munger. “They’re usually doing the devil’s work.”

  For years, critics on the fringes of the quant world had warned that trouble was brewing. Benoit Mandelbrot, for instance, the mathematician who decades earlier had warned the quants of the wild side of their mathematical models—the seismic fat tails on the edges of the bell curve—watched the financial panic of 2008 with a grim sense of recognition.

  Even before the fury of the meltdown hit with its full force, Mandelbrot could tell that the quantitative underpinnings of the financial system were unraveling. In the summer of 2008, Mandelbrot—a distinctly European man with a thick accent, patchy tufts of white hair on his enormous high-browed head, and pink blossoms on his full cheeks—was hard at work on his memoirs in his Cambridge, Massachusetts, apartment, perched on the banks of the Charles River. As he watched the meltdown spread through the financial system, he still chafed at the quants’ failure to listen to his alarums nearly half a century before.

  His apartment contained bookshelves packed with his own writings as well as the weighty tomes of others. One day that summer he pulled an old, frayed book from the shelf and, cradling it in his hands, opened the cover and proceeded to leaf through it. The book, edited by MIT finance professor Paul Cootner, was called The Random Character of Stock Market Prices, a classic collection of essays about market theory published in 1964. It was the same book that helped Ed Thorp derive a formula for pricing stock warrants in the 1960s, and the first collection to include Bachelier’s 1900 thesis on Brownian motion. The book also contained the essay by Mandelbrot detailing his discovery of wild, erratic moves by cotton prices.

  The pages of the copy he held in his hand were crisp and ochered with age. He quickly found the page he was looking for and started to read.

  “Mandelbrot, like Prime Minister Churchill before him, promises us not utopia but blood, sweat, toil, and tears,” he read. “If he is right, almost all of our statistical tools are obsolete. … Surely, before consigning centuries of work to the ash pile, we should like to have some assurance that all our work is truly useless.”

  The passage, by Cootner himself, was a stern rebuke to Mandelbrot’s essay detailing strange characteristics he’d observed in the behavior of cotton prices. Market prices, Mandelbrot had found, were subject to sudden violent, wild leaps. It didn’t matter what caused the jumps, whether it was self-reinforcing feedback loops, wild speculation, panicked deleveraging. The fact was that they existed and cropped up time and again in all sorts of markets.

  The upshot of Mandelbrot’s research was that markets are far less well behaved than standard financial theory held. Out at the no-man’s-land on the wings of the bell curve lurked a dark side of markets that haunted the quants like a bad dream, one many had seemingly banished into subconsciousness. Mandelbrot’s message had been picked up years later by Nassim Taleb, who repeatedly warned quants that their models were doomed to fail because unforeseen black swans (which reputedly didn’t exist) would swoop in from nowhere and scramble the system. Such notions threatened to devastate the elegant mathematical world of quants such as Cootner and Fama. Mandelbrot had been swiftly attacked, and—though he remained a mathematical legend and created an entire new field known as fractal geometry and pioneering discoveries in the science of chaos—was soon forgotten in the world of quants as little more than a footnote in their long march to victory.

  But as the decades passed, Mandelbrot never changed his mind. He remained convinced the quants who ignored his warnings were doomed to fail—it wasn’t a question of if, only when. As he watched the markets fall apart in 2008, he saw his unheeded warnings manifest themselves in daily headlines of financial meltdowns that presumably no one—or almost no one—could have foreseen.

&
nbsp; If vindication gave him any pleasure, Mandelbrot didn’t show it. He wasn’t so cavalier about the pain caused by the meltdown as to enjoy any sort of last laugh.

  “The only serious criticism of my work, expressed by Cootner, was that if I am right, all of our previous work is wrong,” Mandelbrot said, staring out his window at the Charles. “Well, all of their previous work is wrong. They’ve made assumptions which were not valid.”

  He paused a moment and shrugged. “The models are bad.”

  In February 2008, Ed Thorp gazed out of the windows of his twelfth-floor corner office in the exclusive city of Newport Beach, California. The glistening expanse of the whitecapped Pacific Ocean stretched far into a blue horizon past Newport Harbor toward the green jewel of Catalina Island. “Not a bad view,” he said to a reporter with a smile.

  Thorp was angry even though the full fury of the crisis was yet to strike. The banks and hedge funds blowing up didn’t know how to manage risk. They used leverage to juice returns in a high-stakes game they didn’t understand. It was a lesson he’d learned long before he founded his hedge fund, when he was sitting at the blackjack tables of Las Vegas and proving he could beat the dealer. At bottom, he learned, risk management is about avoiding the mistake of betting so much you can lose it all—the mistake made by nearly every bank and hedge fund that ran into trouble in 2007 and 2008. It can be tricky in financial markets, which can exhibit wild, Mandelbrotian swings at a moment’s notice. Banks juggling billions need to realize the market can be far more chaotic over short periods of time than standard financial models reflect.