March 10, 2009

Physics, quants, and the crash

Posted by Arcane Gazebo at March 10, 2009 11:25 PM

I am pretty much required to blog about this piece in the New York Times entitled "They Tried to Outsmart Wall Street": "they" being physicists who left science for Wall Street. And the not-so-subtle implication of the title is that we failed to outsmart Wall Street (and possibly wrecked the economy in the process). To that I say, in the words of Bart Simpson: it was like that when I got here.

More seriously, while I have no doubt that there were crappy quant models out there that contributed to the current crisis by maximizing short-term gain over long-term risk, this was true all the way up and down the chain and the quants don't deserve any more of the blame than anyone else. Quants respond to incentives the same way everyone else does, and the compensation structure on Wall Street can incentivize immediate profit and deferred risk. (My employer is trying to curb this effect by instituting a clawback provision on bonuses; I don't know how widespread this is, but it seems like a good idea to me.)

The Times article is curiously focused on ex-physicists, as if quants don't come from any other fields. In my ten months on the Street I've met quants from a broad range of science and engineering fields, and physicists aren't a majority. That might be a peculiarity of my department's hiring practices, with physicists being much more common elsewhere, but I'd be surprised. Anyway, Kevin Drum noticed this too and wonders why physicists are so suited to quant roles. He has a theory that it's the culture:

Even among the number crunching set, physics has a reputation as the most aggressive, male dominated branch of geekdom: only 14% of physics PhDs are women, the lowest of any of the sciences. (Math is pretty male dominated too, but pales compared to physics: 29% of math PhDs are women.) If the first thing that "aggressive and male dominated" reminds you of is the big swinging dick world of high finance, give yourself a gold star. Call this the testosterone theory: physicists are attracted to Wall Street because they like the atmosphere.

I don't think this is right: the atmosphere in a typical physics department is nothing like the stereotypical Liar's Poker trading floor that Drum is alluding to. To the extent that the environment I work in is like academia, it's because I'm lucky enough to work with a group run by ex-academics rather than people with a typical trader's background. Instead, what Drum calls the "affinity theory" really is the right one. The work I do now is a lot like the problems I worked on as a physicist. It's not just (as Drum suggests) about math; it's about the ability to work with huge data sets and make sense of them, and to find signals in a noisy system. This is a much bigger factor than testosterone levels.

Tags: Academia, Career, Finance, Physics
Comments

As an aside, the photo at the top of the Times article was taken across the street from the building I work in. That's our Times Square stock ticker reflected in the window.

Posted by: Arcane Gazebo | March 10, 2009 11:26 PM

Another popular pastime seems to be to pin the blame on a specific group even when things like meltdowns means there's usually plenty of it to go around. We had a rather interesting event with the Somerville City Group (containing Somerville alums who work in some form of finance in London---the audience had some quants but others who aren't) that discussed the crisis. I gave a short presentation on what network analysis might have to say, and that was followed by quite a lively panel discussion that built from there.

Posted by: Mason Porter | March 11, 2009 12:56 AM

Not too long ago I heard a guy say there are only two cardinal rules of finance.

1. Don't break the law.
2. Don't mis-match your maturities.

This global financial crisis was brought about by those two rules being broken wholesale by people who should have known better. Damned few of whom had PhD's in anything other than greed.

Posted by: JSpur | March 11, 2009 12:36 PM

Laura particularly liked the following quote from your linked article:

As Dr. Derman put it in his book “My Life as a Quant: Reflections on Physics and Finance,” “In physics there may one day be a Theory of Everything; in finance and the social sciences, you’re lucky if there is a useable theory of anything.”

I've got my own little theory about why this stuff happened - interest rates were set so low that it was 1) too easy to borrow money to take stupid risks with, and 2) it no longer paid enough to play it safe with your money. Both factors encouraged ever increasing levels of risk which got us to where we are today.

Any thoughts?

Posted by: ChrisLS | March 11, 2009 10:57 PM

Laura particularly liked the following quote from your linked article:

As Dr. Derman put it in his book “My Life as a Quant: Reflections on Physics and Finance,” “In physics there may one day be a Theory of Everything; in finance and the social sciences, you’re lucky if there is a useable theory of anything.”

I've got my own little theory about why this stuff happened - interest rates were set so low that it was 1) too easy to borrow money to take stupid risks with, and 2) it no longer paid enough to play it safe with your money. Both factors encouraged ever increasing levels of risk which got us to where we are today.

Any thoughts?

Posted by: ChrisLS | March 11, 2009 10:57 PM

The problem originated in the residential mortgage backed securities market where mortgages were pooled and tranched and the resulting securities sold off to fixed income buyers who were, indeed, starving for yield given the relative low interest rate environment. In this market, risk was severely miscalculated, and therefore mispriced, because the models that were used to price securitized debt did not properly take into account the possibility that housing values could collapse and default rates sky-rocket. When the rating agencies tumbled to this in the summer of '07, they began wholesale downward revisions of the ratings for thousands of classes of securities which forced many holders to sell them for what they could get. This in turn prompted a downward, self-feeding cycle of marks-to-market that led to further forced sales and deleveraging and spread outside the resi market into the markets for LBO, commercial real estate and other debt. What accelerated all this was the CDO market, where non-investment grade tranches of debt were pooled up to create supposedly investment grade "collateralized debt obligations." As these structures came unraveled, those firms that had written credit default swaps (such as AIG) found themselves at risk for performing to the tune of billions of dollars more than they had capacity for. This led to more forced selling and deleveraging and eventual bankruptcy and, to forestall systemic collapse, massive governmental intervention by the Fed and the Treasury.

The interesting question is, when does the securitization market come back, if ever, and on what terms? Securitized debt has been the underpinning of much of finance for the last 5-10 years and yet the very foundations of the market have been essentially destroyed. If it doesn't come back, what takes its place?

No one has a clue just now, and it could be months or years before we know.

Posted by: JSpur | March 12, 2009 7:16 AM

Part 2- knock on effects to the equity markets and the overall economy

As people began to see financial instruments lose value across the board, risk got repriced much more expensively and spreads gapped out, causing the equity markets to look severely overpriced. This effect, combined with huge margin calls as values dropped together with rampant short-selling (especially in the financial sector) caused the stock market to crash from a high of around 14000 in October 2007 to its present day level of less than half that.

This was compounded by the collapse of consumer demand, which depressed forward earnings. Consumer demand collapsed because credit disappeared and people who had been using their home equity like an ATM suddenly went from feeling flush to feeling broke. Their stock portfolios had been hammered as well. The US consumer had been the global engine of growth for years and all of a sudden that engine simply quit- or went in reverse.

We are beginning to see some recovery in financials as banks take the last of their mark-downs and lend cheap money out at huge margins (Warren Buffett said as much on CNBC Monday morning). But a true recovery is probably a year away, after the stimulus has had a chance to start working and the banking sector has finally stabilized.

ChrisLS- aren't you glad you asked?

Posted by: JSpur | March 12, 2009 8:52 AM

Absolutely! I teach economics to my students - I just need to figure out how to get emailed updates when it happens on this blog...

I completely agree that we need to get the banking sector functioning as it should be - I disagree with a lot of the politicians that it was a lack of regulation that really was the culprit. Instead, I think people made rational decisions based upon the market and imperfect information.

The only area I think really could use regulation is any kind of insurance - like the CDOs. From my understanding it was treated more like unregulated betting on the failure of these securities instead of true insurance - the underwriter didn't have to really have the means to cover the bet, and the purchaser didn't really have to have the underlying security. That's a recipe for disaster, IMO.

Posted by: ChrisLS | March 25, 2009 9:30 AM
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