By Arnold Kling
The Quants, by Scott Patterson, is the latest indulgence in my taste for financial crisis porn. It reminds me a lot of Roger Lowenstein’s When Genius Failed. Lowenstein’s book, which narrates the rise and fall of the infamous hedge fund Long Term Capital Management, is highly readable, but ultimately it fails to explain why the firm failed. Did it hold unsound positions, or did it suffer from an excess of temporary losses on what were basically good bets (sometimes this is known as the gambler’s ruin problem)?
Patterson seems tempted to lump all of the quants together and to blame the gambler’s ruin problem. Early in the book, he offers an anecdote in which Ed Thorpe, an early quant, sets out to use card counting to win at blackjack. A key is to avoid the gambler’s ruin problem by reducing the size of your bets as you run low on capital.
Still, the gambler’s ruin story has some problems. First, not all quant firms followed the same strategy. Some firms’ strategies actually succeeded to during the market meltdown. Second, if it was a gambler’s ruin problem, then the losses in the quant positions should have turned around by now. It does not appear that they have.
For me, the most interesting take-away from the book was just how fragile the financial system has become. For example, Patterson says that the stock market crash of October 1987 very nearly caused the Chicago Mercantile Exchange to go under. I wonder how many of the people who think that putting derivatives trading on an exchange is a cure-all are aware of that episode.
My favorite chapter in the book is called “The August factor.” It describes a near-implosion in quant firms that took place in August of 2007. On August 10, Patterson suggests, the financial system might have collapsed, except for two decisions. First, Cliff Asness of the hedge fund AQR decided to fight the trends in the market by taking on more risk. Second, Goldman Sachs added liquidity to its stressed quant funds. Patterson writes,
If the selling had continued–which likely would have happened if Goldman Sachs hadn’t bailed out its GEO fund–the results could have been catastophic, not only for the quants but for everyday investors…Just as the implosion of the mortgage market triggered a cascading meltdown of quant funds, the losses by imploded quant funds could have bled into other asset classes, a crazed rush to zero that could put the entire financial system in peril.
The picture I get is of a financial trading system that has grown far too large and far too complex for anyone to understand. I came away from the book with even less confidence in the ability of regulators to ensure its safety. By the same token, it reinforces my view that we need to make the system easy to fix, because we will never be able to make it impossible to break.