Quants on Fire: Anatomy of a Bloodbath

[BSD]

Good read:

Click:

"MIT Technology Review

November/December 2007

The Blow-Up

In Wall Street's summer of scary numbers, all eyes were on the mathematically trained financial engineers known as "quants."

By Bryant Urstadt

On Wednesday, August 8, not long after the markets closed, 200 of the smartest people on Wall Street gathered in a conference room at Four World Financial Center, the 34-story headquarters of Merrill Lynch. August is usually a slow month, but the rows of chairs were full, and highly paid financial engineers were standing by the windows at the back, which looked out over black Town Cars below and the Hudson River beyond. They didn't look like Masters of the Universe; they looked like members of a chess club. They were "quants," and they had a lot to talk about, for their work was at the heart of one of the most worrisome summer markets in decades.

The conference was sponsored by the International Association of Financial Engineers (IAFE), and its title asked, "Is Subprime the Canary in the Mine?" "Subprime" borrowers are home buyers whose poor credit history means they don't qualify for market interest rates. Loans to subprime borrowers, which have become more common in recent years, typically have variable interest rates; as those rates rose, many borrowers were failing to meet their mortgage payments. Their defaults, in turn, had triggered unexpected problems in the market for financial instruments known as derivatives.

A derivative is a tradable product whose value is based on, or "derived" from, an underlying security. The classic example of a derivative is the option to buy a stock at some time in the future. In comparison, more recent derivatives are extraordinarily complex, and they had been invented by quants like the ones at the Merrill Lynch headquarters.

Things had started to go wrong in June, when the weakness in the subprime market had led to the collapse of two huge funds at the investment bank Bear Stearns, costing investors some $1.6 billion. When the quants gathered in August, the most pessimistic among them imagined that the collapse of the subprime market could lead to a shortage of credit as banks dealt with defaults. That would chill the economy, causing worldwide job losses, still more defaults, decreased spending, and withdrawals from the stock market, culminating in a global recession, or worse."

Continued...

 

[BSD]

This FT Nassim Nicholas Taleb commentary sums it up perfectly I think, "The Pseudo-Science hurting Markets":

"Too Many Black Swans?

Evidence suggests that the credit-market turmoil of recent months owes as much to bad math, dubious academic theories, false assumptions, and inadequate risk models as it does to speculative excess and an unhealthy reliance on borrowed money.

In fact, some would argue that widespread ignorance about the true nature of the first four played a strong role in fostering the latter two. In sum, they gave the erroneous impression that risky decisions were being made with scientific precision and inspired a false sense of confidence among managers, regulators, and investors."

...cont.

I always run away very quickly when people aren't able to explain in a few words what constitutes the relevant essence of what they are on about, what the 20% of their effort that generates 80% of their results is.

Jack Welch said it, and he "dun" it, "Business is Simple", undue complexity is almost always an attempt to camouflage lack of understanding or an attempt to hoodwink some gullible souls into believing that they're about to be
granted the privilege of purchasing the Holy Grail. ;-)

 

[grantx]

Markus,

Interesting post.

It’s ironic that Taleb refers to ‘pseudo-scientific foundations’. On a philosophical level - Taleb being a “philosopher” - he is a maverick, and what I describe as an “epistemological anarchist” ; his unique philosophy is an eclectic hotch-potch lacking cogency ie a ‘pseudo-philosophy’.

Is this relevant to his reputation as a brilliant trader? Well, he reckons his ‘philosophy’ is the basis for his implied superior knowledge and skill.

There is an hour-long interview with Taleb on YouTube. The first three minutes was a penance. I switched it off.

I’ll check your links out.

I see your in Germany. Are you German? I ask because your English is excellent.

Grant.

 

[BSD]

Hi Grant,

I hear you re Taleb and his philosophical shortcomings, although his ideas on the reasons behind the current financial mess certainly ring a bell with me ;-)

Thank you for the compliment about my English, I'm German but having grown up in lots of different countries abroad as a Third Culture Kid I really didn't have much to do with that, young children just soak up languages without having to exert any effort, unfortunately a skill that doesn't seem to stick around as you're growing older.

We had an interesting experience in one African country when my brother went to the local English school while I visited the American one, can't say one was better or worse than the other, just different. In the other countries we lived in we always visited German schools, but outside of them English was still the language most used.

A lot of that article about third culture kids certainly rings true, I feel right at home wherever I am in the world, and feel more European or even just human, lol, than German, to tell the truth. Matter of fact I believe that we'd have quite a few less problems in the world if people would spend more than just short holidays abroad and with an open minded attitude. At the end of the day I've always felt that the similarities across the cultures, be they an African country or Scandinavia or Japan, etc etc, far outweigh the differences, although a lot of that's probably to do with your approach, in German we have a saying that the way you shout into the forest creates the echo you'll receive ;-)

 

[grantx]

Markus,

Interesting.

All foreigners abroad of the same nationality always form groups. What I can’t understand is why some, for example, the English, possibly the French, seem reluctant to move outside their groups; is this also the case with the Germans?

For the English, as the geographic origin of an individual becomes more focused, ie from national to regional, city, town, street this still endures. The “north/south divide” is a good example but this is possibly based more on misperceived differences.

At the extreme, in my experience, one sees individuals in a local pub who seem reluctant to talk with strangers. However, in most cases it is a matter of making first contact – if you talk to a stranger, they’ll respond. And despite possible preconceptions, the majority are friendly.

I’ve always enjoyed meeting other nationalities whenever I go abroad, indeed it is part of the holiday.

That aside, I've printed the links you provided and will read them later.

Grant.

 

[BSD]

Grant, one thing I've found is that the group forming thing seems stronger with holiday makers, also Germans, oddly enough, after all what's the attraction of mingling with those you see every day anyway at home, but that's less pronounced amongst the expats in a socialising context outside of the inevitable job / school contacts, in the former context most contacts won't but in the latter context most will indeed be mostly from your own country.

At the extreme, in my experience, one sees individuals in a local pub who seem reluctant to talk with strangers. However, in most cases it is a matter of making first contact – if you talk to a stranger, they’ll respond. And despite possible preconceptions, the majority are friendly.

That's absolutely true imo and also applies more or less for all the countries I've been in, I think most people are rather shy but more than willing to respond when you make the first effort, after all, more funs to be had having a blab than nursing your drink in splendid isolation what :cheesy:

 

[Pat494]

Aren't we getting a bit off the point - more Anglo-German relations really ?

never mind
Markets seem particually hard to tie down to fixed rules. Computers are only good at fixed rules and commands

The best analyst is still that mechanism located between the ears imho ( better with some than others too )

 

[grantx]

Pat,

Being the cultural attache for T2W, international relations is within my remit.

I still haven’t read in full the links/article cited by Markus. However, the author of “Too many Black Swans” criticises and questions the validity of the academic bases underlying market models and by extension, practise.

Good or bad science is irrelevant in this context. What we have is the “best” (which may well be bad). Selling to institutional clients an investment strategy backed by Ph D’s but based on bad science has more credibility than a strategy based on a gut-feeling, even if superior. Any theoretical basis is better than none.

Grant.

 

[BSD]

Being the cultural attache for T2W, international relations is within my remit.

Hi Grant,

and doing a very good job at that may I add, I will be most pleased to hear that Mr. Miliband has instructed his FO planners to offer you a fittingly senior Ambassadorship at the next revirement

Concerning the "best science on offer", I'd say that's like comparing the decidedly enthusiastic sell side analysts in the Web 1 bubble madly promoting any and every start-up that hadn't managed to escape up a tree by a count of three to the buy side and unassuming public on the one hand, with the very unenthusiastic Warren Buffet who firmly refused to listen to anything even remotely resembling NewSpeak on the other hand.

The sell side geeks used their admittedly formidable intelligence to drum up ever more complex theories to explain why companies no longer needed to produce profits in order to be valued at a gazillion times earnings in the prevailing new paradigm of affairs, while good old down-to-earth Buffett wasn't fooled by fancy formulas and inventive theories and instead relied on good old fashioned common sense to decipher that as the obvious Perpetuum Mobile that it was.

Many people who have great intelligence but are unfortunately severely lacking in the wisdom department demonstrate great skills at in-depth analysis of individual trees while failing with great aplomb to even realise, let alone see, that there is an entire forest out there.

Think that's the definition of an Idiote Savante.

Harvard did a rather well known complexity experiment where two groups of students had to come up with explanations to simple problems. The first group got the correct evaluation from the professors, ie if they had come up with a logical and rational explanation they received a "correct", if not they got a "wrong", while the second group got random evaluations, so that even if they were right they might have received a "wrong" and vice versa.

The first groups solutions were all admirably simple, while the second groups explanations became increasingly complex as they tried desperately to fit theory around inexpliacble fact.

The second group strongly resembles much of what seems to be standard fare in the corporate rut of things these days. Outside of High Finance another sector that excels at producing what at first glance sounds clever but on closer examination rapidly loses that status would be the Consulting Sector...

"Much of the distrust toward McKinsey can be categorized as:
Misguided or unimaginative analysis, such as its alleged recommendation in 1983 to AT&T that cellular phones would be a niche market

Lack of originality in coming up with ideas; restating the obvious with business jargon

Groupthink, as its consultants strive under time pressure to converge on a unified set of findings and recommendations

Emphasis on "current thinking" that may amount to little more than forcing the latest business theories on clients without taking a longer-term view

Emphasis on shareholder value, often at the price of investment and long-term strategy. For example, this may have doomed the British railway company Railtrack, which collapsed after a series of accidents, allegedly after following McKinsey's advice to reduce spending on infrastructure and return cash to shareholders instead

Concern that it aims to become an expensive permanent presence with clients, rather than focusing on solving a clear set of problems, thereby functioning as a substitute for proper leadership and organization. This is an increasing concern in the public sector, where McKinsey has become involved with agencies such as the British National Health Service"

First you creatively come up with what sounds like an impressive solution, then you go find a problem and a client to go with it ;-)

 

[BSD]

PS: two excellent reads:

Liar's Poker: Rising Through the Wreckage on Wall Street

and

When Genius Failed: The Rise and Fall of Long-Term Capital Management

 

[Pat494]

imho it has long been a lofty pose by British academics that the masses should not have too much knowledge. For knowledge used to represent power and prestige. As we all know old maps, chemical formulas, religious ideas etc were the basis of that knowledge/power and many paid with their lives to try and acquire it.
So "pulling the wool over the eyes" of the ignorant is a long established tradition.
Largely blown away now with universal education.
However it still holds good in finance and science to some extent. There are those that can make loads of money trading and the majority that obviously can't.
So the knowledge of "how to" is still relevent. There is a thread about having the edge.............

 

[BSD]

Hi Pat,

I think there is definitely truth in what you say.

I'm also trying to think up the best way to share the knowledge with Mr. Miliband that he is about to appoint a new Ambassador :cheesy:

 

[Hoggums]

imho it has long been a lofty pose by British academics that the masses should not have too much knowledge. For knowledge used to represent power and prestige. As we all know old maps, chemical formulas, religious ideas etc were the basis of that knowledge/power and many paid with their lives to try and acquire it.
So "pulling the wool over the eyes" of the ignorant is a long established tradition.
Largely blown away now with universal education.
However it still holds good in finance and science to some extent. There are those that can make loads of money trading and the majority that obviously can't.
So the knowledge of "how to" is still relevent. There is a thread about having the edge.............

Yes - but this thread is about those who thought they had the knowledge - and convinced others that they had - but actually didn't - or they had the wrong knowledge.

I don't subscribe to the idea that there's this elite out there who cream money of the suckers that will never learn - anyone can make money in the markets - it's ignorance rather an inability that makes them lose money. And the so called elite get it wrong too - but they are prepared for it.

 

[Pat494]

Hi Pat,

I think there is definitely truth in what you say.

I'm also trying to think up the best way to share the knowledge with Mr. Miliband that he is about to appoint a new Ambassador :cheesy:

Hi Markus,
Lets hope Mr. Millipede doesn't put all his feet into it ! LOL

 

[BSD]

Hehe Pat

 

[BSD]

Bit old, but still relevant in the general context of things ;-)

"FORBES

The Sleaziest Show On Earth

Hedge funds will suck in $100 billion this year from an ever-broader swath of investors. Pretty good for a business rife with exorbitant fees, phony numbers and outright thievery.

It's amateur hour in the hedge fund business. This sideshow of sometimes bizarre (and always costly) investing is on a tear like never before. It's attracting some of the shrewdest and sharpest minds on Wall Street--and also shills, shysters, charlatans and neophytes too crooked or too stupid to make any money for you. In 1990 only 600 or so U.S. hedge funds were in business. When we last surveyed the genre (FORBES, Aug. 6, 2001) there was $500 billion on the table globally. Now $800 billion is invested, says Hedge Fund Research, a hedge fund tracker, divided among 6,300 funds--900 of them less than a year old. Besides growth, there is a lot of coming and going in this business. More than 10% of hedge funds tracked in the past year by HedgeFund.net are now defunct.

...What is driving this red-hot industry: fees that would be outlandish or even illegal if extracted from a plain old mutual fund. "It's obscene," says Alice Handy, who invested in hedge funds for over a decade while running the University of Virginia endowment. "The fee structure is so compelling that everyone and his brother want to run a hedge fund now."

For customers the illusion is that the high fees go hand in hand with high returns. Do they? Hedge funds exist in a lawless and risky realm, exempt from the rules governing mutual funds, equities and most other investments. Hedge funds aren't even required to keep audited books--and many don't. These risky funds often are guilty of inadequate disclosure of costs, overvaluation of holdings to goose reported performance and manager pay, and cozy ties between funds and brokers that often shortchange investors. As for tales of pots of gold at the end of some rainbows, you have to be skeptical. Yes, some funds have racked up stunning results. Others have gone bust. The winners you hear about. The others just disappear from the performance databases. No surprise there: Reporting of performance is voluntary.

...But even when hedge funds are legit, the way their returns are rated is rife with abuse. The charade begins when managers start up several funds but report results only for the winners, leaving out the losers entirely. This convenient maneuver was present at over half the 3,600 funds tracked by TASS, the industry's largest tracking service and a unit of Oppenheimer Acquisition, according to "A Reality Check on Hedge Funds Returns," a working paper published by Free University in Amsterdam.

It gets worse. At the tail end of their lives, hedge funds that suffer lousy returns often stop reporting them long before closing."

Of course, in spite of all that starting a hedge fund is still a pretty brilliant business idea.

 

[Pat494]

Yep seems like every crook and his pet canary has jumped into the hedge fund racket.

Needless to say I'm not investing in any of these er "businesses".