Acad. Quest. (2010) 23:506–514 DOI 10.1007/s12129-010-9189-4 REVIEW ESSAY

The Quants: How a New Milken, .1 In the Breed of Math Whizzes “quant” revolution on Conquered Wall Street and that took place over the past twenty Nearly Destroyed It, by Scott years, in which mathematical and Patterson. : Crown scientific experts created new high-tech Publishing, 2010, 352 pp., investment strategies, we put the $27.00 hardbound. two together. Everyone from Barney Frank to Ben Bernanke to Fannie My Life as a Quant: Mae to the heads of the Harvard and Reflections on Physics and Yale endowment funds to the chief Finance, by Emanuel Derman. executives of the world’slargest Hoboken, NJ: John Wiley & banks and investment banking Sons, 2007, 292, pp., $16.95 houses—even average investors in paperback. many cases—fell under the spell of . The Crash of the Quants It turns out that Roger Lowenstein’s very fine When Genius Failed was Wight Martindale, Jr. wildly mistaken2—so-called “genius”

Published online: 27 October 2010 did not fail, it returned with a # Springer Science+Business Media, LLC 2010 vengeance to create even greater havoc. These two books, The Quants: Americans have long been mesmerized How a New Breed of Math Whizzes by scientific genius. Think Thomas Conquered Wall Street and Nearly Edison and Albert Einstein. We are Destroyed It, by , and equally fascinated by financial My Life as a Quant: Reflections on wizards: J. P. Morgan, Michael Physics and Finance, by Emanuel Derman, provide contrasting insights Wight Martindale, Jr., is an adjunct professor in both the business school and the college of arts and sciences at Lehigh University, Bethlehem, PA 18015; 1 ’ [email protected]. He began working as a business Randall E. Stross s The Wizard of Menlo Park: journalist, served as finance editor of Business Week, How Thomas Alva Edison Invented the Modern and spent twenty years on Wall Street, largely as a World (New York: Three Rivers, 2007) is a senior vice president in the bond department at popular biography. Dozens of books, many with Lehman Brothers. He left Wall Street to earn a equally grand titles, have been written about the Ph.D. in English literature at New York University other men mentioned in this paragraph, and more and he has taught core humanities courses at Temple no doubt will be written in the future. and Villanova Universities. He is the author of Inside 2Roger Lowenstein, When Genius Failed: The the Cage: A Season at West 4th Street’s Legendary Rise and Fall of Long-Term Capital Management Tournament (Simon and Schuster, 2005). (New York: Random House, 2000). The Crash of the Quants 507 into the financial crisis of 2007–2008 Smart kids spot this nonsense and give us an opportunity to consider immediately. Run the best, the what part education, or the lack of it, brightest, and the most ambitious played in forming the mindset of its students through this transparently enablers. silly process, and you get unrepentant Patterson’s intriguing book arrogance and the 2007–2008 introduces us to the handful of financial crash, the biggest since the mathematical whiz kids who managed collapse of 1929. to legitimize the 30- and 40-to-1 The financial crisis of the past debt-to-asset investing ratios that were few years was fueled by too much eventually taken on by Fannie Mae, borrowing, and the boldest and the subprime mortgage originators, and most confident borrowers—which some commercial banks and brokers. includes the hedge funds but These men are game-players—but also the off-balance sheet financing game-players with an edge. Their of special purpose investment edge is intellectual; they learned vehicles—could only operate by how to beat the dealer when they invoking the authority of the were quite young—while still in super-quants. It could be argued high school. that they provided the intellectual Their college experience did authority—“peer review approval” nothing to change this. Why? in academic circles—for reckless Because college, too, can be a lending that ensued everywhere. game, not about wisdom or attaining Without the intellectual bravado, wisdom, but a game for grades, for or what might better be called certification, and for social climbing. insensibility to risk, that these Far too often humanities and traders flaunted, undergraduate business students are normally financially conservative taught how to play the game by institutions such as teachers who manage their own and the Harvard Management careers through bogus peer review Company Endowment would not publishing no one reads, political have been handing over their advocacy masked as “learning how money without understanding the to think independently,” utterly risks they were taking. trivial classroom discussions, and All of the trading wizards in The by coddling their impressionable Quants are also enthusiastic gamblers young students with inflated grades and all of them have impressive and easy assignments. academic pedigrees. For example: 508 Martindale

Edward Thorpe (b. 1932), Princeton- father worked the graveyard shift at Newport Partners, author of Beat the San Pedro shipyards while his the Dealer: A Winning Strategy mother worked the swing shift at for the Game of Twenty-One Douglas Aircraft. He was alone for (1962), the godfather of quants; many hours and Patterson writes that BS in physics, Ph.D. in “he had the freedom to let his mathematics, UCLA; imagination roam wild. Blowing things up was one diversion. He Jim Simons (b.1938), founder of tinkered with small homemade ; BA in explosive devices in a laboratory in mathematics, MIT, Ph.D. in his garage.” mathematics, University of grew up in fashionable California, Berkeley; Roslyn Heights on Long Island. Patterson writes of his high school Peter Muller (b. 1963), Morgan days: “In school Asness received good Stanley private hedge fund, pianist grades, but his interest in Wall Street and songwriter; BA in mathematics, didn’t extend beyond the dark towers Princeton; of Gotham in the pages of Batman. Obsessed with little other than girls Cliff Asness (b. 1966), Goldman and comic books, Asness was listless Sachs Global Alpha fund; BS in as a teenager, without direction and economics and electrical engineering, somewhat overweight. At times he University of Pennsylvania, Ph.D. in showed signs of a violent temper that finance, University of ; would erupt years later when he sat at the helm of his own hedge fund.” Ken Griffin (b. 1970), Citadel Ken Griffin spent his youth in Investment Group; BA in economics, Boca Raton, Florida, where he took Harvard; an early interest in computer programming. “His mother would (b. 1974), Deutsche ferry him to the local Computerland, Bank, chess life master at 16; BA in where he would spend hours chatting philosophy, . up the salespeople about new gizmos and software,” Patterson recounts. Most of these men grew up as if Considered a math whiz, Griffin they were intellectual latch-key kids started managing other people’s money with plenty of time on their hands. In while he was an undergraduate at Lomita, California, Ed Thorpe’s Harvard. The Crash of the Quants 509

Peter Muller grew up in Wayne, point of view, Patterson explains, New Jersey. He showed an early Simons realized that “the ability to aptitude for math and loved to play predict what will happen tomorrow, all kinds of games, from Scrabble or the next few hours, is far better to chess to backgammon. As a than the ability to predict what senior in high school he designed will happen a week or two down a computer program that could play the road.” Simons also pushed backgammon. beyond mere algorithms; he hired Boaz Weinstein was raised, as code-cracking cryptographers as well Patterson tells us, “in the privileged as speech recognition experts—this neighborhood of the last group because speech recognition Upper East Side. He seemed to have programs try to guess what sound is money all around him.” In addition to coming next in order to keep up with playing chess he won a stock-picking the speaker. contest while a student at New York While all of these super-quants City’s elite . were intensely secretive, the field soon became overpopulated. When Beating the House this happened, returns fell. For example, Ken Griffin’s Citadel Thereissomeparallelbetween Investment Group, which began in the quantitative trading these men late 1990, racked up returns in its perfected and card-counting at the first three years of 43 percent, 41 blackjack table: in both cases the percent, and 24 percent. But in 2002 bets increase when the odds improve. its flagship fund was up only 13 Quantitative trading required super-high percent, slipping below 10 percent speed computers that would not only for the next three years. As detect patterns before competitors performance slipped, managers could see them, but also execute could only boost returns by adding trades instantly. This last technical more leverage, that is, by borrowing achievement is often referred to as more money to finance their trading “high frequency trading,” and it positions. was pioneered by Jim Simons at The speculative crash of 2007– Renaissance Technologies. 2008 might have been anticipated Speed as a factor in getting into because quantitative trading and out of trades was important meltdowns occurred twice recently, because positions often were not and they both occurred for the same held for long. From a statistical reason. The first event was the 510 Martindale

October 1987 equity market collapse, mortgages were extended to people when portfolio insurance, the new with very little equity who could not quant device of the time, accelerated really afford them. Indeed, Weinstein the stock market’sdeclinerather made his firm $250 million by than slowed it down. The second shorting the subprime mortgage was the failure of Long Term Capital market, that is, selling subprime Management (LTCM). LTCM was bonds they did not own, planning to populated with Ph.D.’s (even two buy them back at a lower price after Nobel Prize winners in economics), their value collapsed. Citadel, Asness but after initial returns of 40 percent at AQR, and Peter Muller at per year, investors lost $4.6 billion believed they had in less than four months in 1998. dodged the subprime bullet. A few The firm had to be bailed out by the days before the crash Weinstein New York Fed and by fourteen other threw a lavish celebration party at dealers and banks that had been his Southampton summer home; he trading with them. had gotten the subprime trade right In both cases the collapses occurred and he knew it. because market liquidity could not Then events suddenly took a absorb all the selling that hit the vicious turn. On Friday, August 3, market at the same time, and the funds TV host Jim Cramer ranted about a were heavily leveraged. At such fixed-income Armageddon (shouting moments even good trading positions “They know nothing”—still played appear to be losers. As Lord Keynes before each of his daily shows). He explained many years ago, “Markets had been tipped off that hedge funds can remain irrational longer than you all had the same big trades on and can remain solvent.” It is a mistake to they were all moving against them. think that buyers will always be The financial tsunami actually hit on present to accommodate sellers. But August 6, the Monday following the brainiest traders in world, or at Cramer’s rant. Subprime borrowers least most of them, seemed to have were defaulting on their loans, thus learned nothing from these lessons. triggering waves of selling in The details of the collapse of the everything else as over-leveraged mega-hedge funds in August 2007 managers sought cash wherever they remind us that truth can be stranger could get it. A global deleveraging than fiction. None of the managers we was taking place, and it would take have been following got caught up all the quant funds down with it. in the mortgage bubble, in which That is, with no bids or very low The Crash of the Quants 511 bids for mortgage derivatives, fund with the major brokerage firms, managers sold whatever else they the first of which to collapse was owned and could get a bid on, which Bear Stearns. Then, in September turned out to be what the other hedge 2008 Lehman Brothers filed for funds owned. bankruptcy. Fannie Mae and Freddie The whiz kids’ first hope was that Mac were nationalized. AIG had to there was just one big seller, perhaps be taken over. Chaos returned. Goldman’s Global Alpha fund, and Citadel’s flagship fund lost 20 that eventually that selling would percent in September alone, and stop. One manager at the time was down 35 percent for the year. recalled, “Quant managers tend to Boaz Weinstein, age 35, was now be kind of secretive; they don’t managing $30 billion in assets at reach out to each other. It was a Deutsche Bank. He, too, believed little bit of a poker game.” So the the worst of the credit crisis was quants continued to devour each other. over. But in September, as bank Muller’s fund lost $300 million lending froze, the swaps market and Asness lost $500 million—in a ceased to function, Deutsche Bank single day. In the first six trading management had had enough: they days of August, Goldman’s Global would advance Weinstein’s group Alpha fund had lost $1.5 billion. As no more money; they wanted to Patterson reminds us, “the carnage see sales. When the selling stopped was taking place beneath the surface, Weinstein had lost $1.8 billion, the billions in hedge fund money causing hundreds of his fellow evaporating.” employees in other departments to The crisis ended as suddenly as it lose their jobs and their bonuses. had appeared. At the end of the week In the spring of 2008 Cliff Asness put $3 billion of its continued to believe that the stock own money into Global Alpha, and market would recover, so he was badly on the following Monday Goldman positioned for the September declines. held a conference call to explain For the year his Absolute Return fund what they had done. Temporarily, was down 46 percent, about in line confidence was restored, and the quant with the Standard & Poor 500 index, funds began to recoup their losses. which was down 48 percent. The markets and the regulators Peter Muller lost about 40 percent thought the worst was behind them. for the year. Like Asness and Griffin, But it was not. In March of the he had a huge amount of personal following year the crisis caught up wealth invested in his fund. 512 Martindale

The two older guys did better. who did not blow up the financial John Simons’s Medallion fund was markets—he simply wanted to solve up 80 percent for 2008, and Ed complex mathematical problems. Not Thorpe, who had toned down his surprisingly, he’s back at Columbia, operation and switched to a new where he teaches quantitative finance. strategy using no leverage, was up Derman is a scientist in the purest 18 percent. One might say that with sense. He has a mature curiosity, not age comes wisdom, and wisdom is idle, adolescent insatiability. He loved not something we can do without. the history and the traditions of the Columbia physics department (which Adding Value? had more than its share of Nobel Prize winners), where “brilliance seemed Eventually we must ask ourselves, paramount” and where “the classes I what is the value of what these liked best were taught by people who quants actually do for capital gave you a feel for what it was like to markets, for society, and for the discover something new, as well as the world? They do not finance new sense of how it had been done.” There businesses as venture capitalists do. is no sense of dominance or power Nor are they activists seeking to over others involved in his thinking. replace or improve managements. He is not beating the dealer. They are not credit men or workout Derman is always conscious of the specialists, guiding companies through predecessors in his field; he knows he the bankruptcy process. They are is laboring within an august tradition. not accounting experts. How much “The essence of theoretical physics is value is added in the attempt to look at the universe and arbitrage trading within a company? then mentally apprehend its structure,” It is at this point that it is he writes. “If you are right, you useful to read Emanuel Derman’s emulate Newton and Einstein: you autobiography My Life as a Quant, find one of the Ten Commandments. which provides an instructive contrast You write down a simple set of to the activities of Patterson’squants. laws that, plucked from nowhere, Derman, a South African native who miraculously describes and predicts received his Ph.D. in theoretical how God’s world works. This is the physics from Columbia in 1973 and struggle to which I aspired....Even then migrated to the Quantitative mathematical beauty is not enough.” Strategies Group at Goldman Sachs, On his move to finance: “When is the story of a very smart man I moved to Wall Street, I found The Crash of the Quants 513 quantitative finance to resemble or at mathematics purely as a trader or phenomenology much more than it gambler. He believes life is about more resembled pure theory. Quantitative than outsmarting other people. It is also finance is concerned with the about understanding what we are doing techniques that people use to value and who we are. He takes an interest in financial contracts, and given the the most profound questions of life. fluctuations of the human psyche, it Unlike Derman, Patterson’s quants is a pragmatic study of surfaces are essentially thrill-seekers who rather than a principled study of love gadgets, poker, card counting, depths. Physics, in contrast, is and mental competitions of all sorts. concerned with God’s canons, which In hindsight, it appears that they seem to be more easily captured in may have confused their avocation the simple broad statements that (gambling) with their vocation (wisely characterize profound physical laws.” managing other peoples’ money). Emanuel Derman grew up in the They often appear as rootless old-European culture of Cape Town. eccentrics and yet they conned Foreigners were common in the their bosses and their investors into Columbia physics department and believing they could make huge academic expectations were high. profits with little risk. Alan Greenspan, The chapter titles of Derman’s book who also prided himself on his are drawn from authors he has read, intelligence, supported them, as did and it is a serious list: Goethe, the United States Congress and Flaubert, Kafka, Simone de Beauvoir, eventually many of the biggest banks Graham Greene, and Gregor von around the world. What they all Rezzori. He later speaks of reading should have remembered is that the Tolstoy, Nabokov, and Robert Musil. misuse of someone else’s money is Few American high schools or morally wrong. As ’s colleges can boast of such a reading pioneering editor, Walter Bagehot, list. Derman contributed his share explained a century ago, savers must of quantitative strategizing and be respected; they are entitled to a risk-taking at Goldman Sachs, but the reasonable return on their money, overall impression is of a man whose and to prudent lending by their background, education, and native bankers. This principle is true for thoughtfulness enabled him to develop people, for companies, and for nations. more fully as a human being and One of these aggressive traders’ consequently to keep finance in blind spots was the proper appreciation perspective. He does not look at life of debt—other people’smoney— 514 Martindale without which they could not build wisdom, it can only be because it was their castles in the air. The leverage never wisdom that they sought. foolishly granted them by irresponsible The defenders of these traders will supervisors allowed them to bully say that their job is simply to maximize more modest traders in the markets return, and it is the job of the regulators and to demand excessive fees. Their to restrain them. But this is an pay was based on absolute returns, not oversimplification. Derman illustrates risk-based returns. But all that extra the virtue of having a bit of a regulator leverage, as we now know, is risk writ inside each one of us. Individually, large. Compensation should be less for no one of these money managers a leveraged manager, not more. would have created a problem, but collectively, they mattered very much. It’s Time to Get Serious When everyone rushes the regulators at once, we should not be surprised if Aristotle warned us that the the regulators fail. We also need perversion of the best thing is the personal internal constraints—the most worst thing (the best state is run by a valuable constraint being to reign in good king, the worst state is run by a our pride, and the greed which often tyrant). Thus, the best use of money follows close behind it. can feed a family, build a home, or A proper education should address roads—even a nation. The worst use these essential issues of life, which of money buys momentary thrills and are contained in the Hebrew Bible, in then squanders it away. Should our the philosophies of the ancient “best and the brightest” devote their Greeks, in the people created by time and energy to beating the dealer Shakespeare, and in the characters and running up commodity prices? of Dostoevsky’s novels. A serious Our society celebrates these whiz look at life should not lead one to kids because they make so much strive for Napoleonic supremacy, but money, but if we pause, we discover to humility and a respect for the past. that these new masters of the This is what wisdom is all about, universe are often quite trivial people. and the elite schools these traders We see that they overpay for modern attended should not forget it. What all art, give themselves lavish parties, these very smart young men needed in and throw temper tantrums at their fancy schools was what everyone trembling employees. If they did not needs; they needed someone who learn from their recent experiences, wanted them to be serious about life and if they do not retire with greater and to expect more from themselves.