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How a New Breed of Math Whizzes
Conquered Wall Street and Nearly Destroyed It
By Scott Patterson
Crown Business; $27; 337 pp
On Aug. 7, 2007, Matthew Rothman of Lehman Brothers Holdings got off a red-eye flight in San Francisco and went to see a potential client. "Oh my God, Matthew," the trader said, pulling Rothman toward his office. "Have you seen what's going on?" His portfolio was tanking, and the bloodletting continued as Rothman visited other quant funds that Tuesday, writes Scott Patterson in his sometimes overheated yet valuable book, The Quants.
Rothman, a quantitative strategist, was baffled: "Events that models only predicted would happen once in 10,000 years happened every day for three days." Suddenly, the quant math didn't add up.
The rise of quantitative investing is one of the great financial developments of our times. Equipped with advanced degrees and superfast computers, quants revolutionized Wall Street. They also hastened meltdowns ranging from Black Monday in 1987 to the collapse of Long-Term Capital Management in 1998 and the Great Credit Crackup of 2007.
Most investors know little about the quants' intellectual zealotry, arcane models, and power to pump money into—and out of—the system. Patterson, a Wall Street Journal reporter, sheds light on their secretive world by tracking the turbulent lives of four quants. Kenneth Griffin is the best known of the quartet—the math whiz who began trading convertible bonds in his Harvard dorm room and founded Citadel Investment Group at age 22. The others are Clifford Asness of AQR Capital Management, Peter Muller of Morgan Stanley's (MS) Process Driven Trading unit, and Boaz Weinstein of Saba Capital Management.
The story radiates with hubris, high stakes, and pricey toys, giving glimpses of poker tournaments at the St. Regis Hotel in Manhattan; a stretch limo ride to a paintball fight outside Las Vegas; and Griffin's garage full of Ferraris. With so much money to be made, the quants didn't heed warnings from gadflies such as Nassim Nicholas Taleb, who pounds a table in one scene, agitated by Muller's confidence. "You will be wiped out!" Taleb shouts. "I swear it!"
Patterson is fond of clichés, and the book opens with "gem-studded dresses," "testosterone-fueled competition," and "well-heeled players." Ignore the hype and press on. The prose grows less breathless as he explores the origins of quantitative finance.
The quants, it turns out, could have spared us a world of grief by heeding their godfather, Edward Thorp. A mathematics professor, Thorp began using math to make money in the 1960s, first at blackjack tables, then on Wall Street. His writings influenced a generation of quants, building on an observation from Frenchman Louis Bachelier in 1900 that prices on financial markets seemed to oscillate as randomly as pollen particles.
To some, that meant it was impossible to beat the market. Thorp saw something different—a way of calculating whether stock warrants were correctly priced. His conclusion: Most warrants cost too much, given the amount you could win and your odds of doing so. Before long, Thorp was making so much money off these derivative securities that he set up a hedge fund.
The quants who copied him, however, ignored a vital piece of his strategy. Thorp, like Taleb, was keenly aware that nonrandom events can wreak havoc on models. So he scaled his bets to his bankroll, committing only a prescribed fraction.
The bubble eventually burst, of course. By October 2008, Citadel was on the verge of collapse, and Muller's PDT was in crisis mode at Morgan Stanley (MS), Patterson says. AQR was out billions, he writes, and Asness was out of control, smashing chairs and punching computer screens. Losses were mounting at Weinstein's Saba group at Deutsche Bank (DB). (He kept the name Saba when he left Deutsche.)
What did Thorp make of his followers? Patterson visited him in Newport Beach, Calif., to find out. It was February 2008, and Thorp was angry. Banks and hedge funds were blowing up because they ignored what risk management is all about: never betting so much that you can lose it all. They were overbetting and using borrowed money to do it. "Any good investment, sufficiently leveraged, can lead to ruin," Thorp said. It's a lesson that's forgotten in every boom.