Monday, July 29, 2013
Book Review: The Quants
If you want a fun, non-technical history of quantitative finance, this is your book. It traces the development of quant models, from Ed Thorp and Black-Scholes-Merton all the way through David X. Li. It explains trading strategies like statistical arbitrage in layman's terms, and offers insight into what it's like to run a trading operation, day to day. And it narrates the three-decade-long run-up to the epic finance-industry meltdown of 2007-8, including "warm-ups" like Black Monday and the fall of Long Term Capital Management. The author, Scott Patterson, writes in an accessible, engaging style, making it difficult to put the book down at times. It also does a good job of profiling some of the colorful personalities of the quant world - Peter Muller and Cliff Asness being the most colorful of the bunch.
So I definitely recommend The Quants.
Like (almost) all books, The Quants is not without its flaws. Chief among these is that the book mostly fails to deliver on one of the promises in its subtitle - it fails to give a detailed account of the quants that nearly destroyed Wall Street.
Why was Wall Street almost destroyed? The general story that I buy goes something like this:
1) Wall Street firms, by creating securitized mortgage-backed financial products, increased the demand for housing, which along with other factors helped fuel a nationwide housing bubble.
(Note: This assumes that some initial rapid price increase is needed to "jump-start" a bubble, leading to a spiral of self-reinforcing price increases, either through speculation, herd behavior, or the mistaken inference of underlying structural change, or some combination thereof. That may not be how bubbles really work, but it's currently my best guess, from what I've seen in the lab and read in the literature.)
2) Wall Street firms priced these securities using quantitative models that were fundamentally flawed, leading them to understate the risk of the mortgage-backed securities and derivatives based on these securities. Some of the flaws included eternally rising national house prices, non-time-varying correlations, thin-tailed (less risky) stochastic processes, and omission of counterparty risk.
3) These models lead banks to hold way too many of the aforementioned securities, and to borrow way too much money (leverage) to buy them. Complacent (and possibly captured) regulators and ratings agencies did nothing to stop this.
4) When the bubble popped and prices fell and correlations spiked, banks collapsed.
This story is very similar to the one given in The Quants. So Patterson does, in my view, get the crisis correct.
But four of the six people profiled in The Quants were operators of independent hedge funds - Ed Thorp of Princeton Newport, Ken Griffin of Citadel, Cliff Asness of AQR, and Jim Simons of Renaissance. Though big by historical hedge fund standards, these firms were not nearly as big (or, for the most part, as leveraged) as the banks that were at the center of the crisis - Goldman Sachs, Bank of America, Lehman, etc. And though most of the quant hedge funds suffered in the great 2008 crash, the specter of their collapse did not really threaten the system itself. In fact, as The Quants recounts, the quant hedge funds suffered their own meltdown a year earlier, in the summer of 2007, but this caused far fewer problems for the economy than the near-collapse of the big banks in 2008. Notably, none of the independent quant hedge funds were bailed out by the U.S. government in 2008 - some because they were not in danger, others because they simply weren't systematically important enough to warrant bailouts.
This is not to say that quant hedge funds can't be dangerous to the financial system; Long Term Capital Management clearly was. It's simply the case that this time, in 2008, independent hedge funds were not at the center of the crisis. They mostly sat on the sidelines, watching the carnage and hoping that they didn't die. One of the funds Patterson profiles, Renaissance Technologies, was using strategies so different from the big banks that it gained 80% in 2008. (Disclosure: The founder and some ex-employees of Renaissance Technologies have made large donations to the university where I work!)
The Quants also profiled two men who headed internal hedge funds within big banks - Peter Muller of Morgan Stanley, and Boaz Weinstein of Deutsche Bank. Weinstein's group appears to have bought lots of mortgage-backed securities, and to have lost a lot of money for the firm in the 2008 crash. But this means that only one out of the six protagonists of The Quants could plausibly be described as having "almost destroyed Wall Street".
Personally, I would have liked to have seen The Quants tell the stories of the "pricing quants" and "risk quants" within the big banks, whose models were instrumental in convincing regulators, ratings agencies, and bank executives themselves that mortgage-backed products were safe. Patterson does briefly tell the story of two such quants, Fischer Black David X. Li, but I'd like to have seen a lot more about these guys, and about academics like Myron Scholes and Robert Merton.
Did the quants within big banks know that their models were wrong? Did they try to warn the executives not to apply the models? Did they simply shut up and take a paycheck as greedy, reckless executives misused and over-applied their models? Or did they actively promote blanket and widespread use of the flawed models, encouraging the heavy use of leverage and the holding of huge amounts of mortgage-backed products? I wish The Quants had answered this question, but it did not.
I also think The Quants displays a little too much fear of the unknown. Patterson definitely seems to regard the black-box strategies of companies like Renaissance as creepy and inherently suspicious. But I think this fear is mostly unwarranted. Any assumptions can be wrong, so any algorithm can blow up. No quant model is riskless or foolproof, and none will ever be. But that applies just as much to the intuitive trades of "shoot-from-the-hip" human traders, or to any other investing mechanism. No spooky supercomputers or secretive mathematicians were needed in order to blow up the Japanese financial system in 1989, or the U.S. financial system in 1929.
The key, as Ed Thorp is quoted as saying in the book, is in limiting leverage, so that collapses don't bring down the whole system. Limiting the systemic risk caused by "too big to fail" institutions also seems to be important. The mundane factors of leverage and bigness seem much more scary, to me, than the opacity of quant trading strategies.
Nevertheless, it is a really good book, and if you have any interest in the history of finance, you should check it out.