The Quants

By SCOTT PATTERSON

Quants are a small group of brainy math whizzes are emerging as the unlikely group who nearly brought down the finance industry. As WSJ's Scott Patterson reports, a group called "The Quants" developed complex systems to trade securities such as mortgage derivatives, which were at the heart of the crisis.

President Barack Obama recently proposed new rules to curb a number of Wall Street's risky—and highly profitable—trading activities. One target: The secretive trading operations within banks that use large doses of leverage, or borrowed money, to make huge bets on the market. Wall Street says the regulations are unnecessary, and since the financial crisis struck, most banks have cut back on these trading outfits. But when the downturn first hit in the summer of 2007, several of them were among the first to suffer, and collectively they lost billions over a matter of days.

In his new book, "The Quants," Wall Street Journal reporter Scott Patterson suggests how this new breed of mathematicians and computer scientists took over much of the financial system—and the damage they inflicted in the 2007 meltdown.

On Wall Street, they were all known as "quants," traders and financial engineers who used brain-twisting math and superpowered computers to pluck billions in fleeting dollars out of the market. Instead of looking at individual companies and their performance, management and competitors, they use math formulas to make bets on which stocks were going up or down. By the early 2000s, such tech-savvy investors had come to dominate Wall Street, helped by theoretical breakthroughs in the application of mathematics to financial markets, advances that had earned their discoverers several shelves of Nobel Prizes.

Enter the Black Swan: ...few quants realized what was happening, but over the next few days a theory would emerge: The U.S. housing market was unraveling, leading to big losses in the mortgage portfolios of banks and hedge funds. One or more of those hedge funds needed to raise cash quickly to make up for the losses, and needed to sell assets quickly to do so. And the easiest-to-sell assets of all were stocks, those held in portfolios highly similar to quant funds across Wall Street.

The result was a catastrophic domino effect. The rapid selling scrambled the models that quants used to buy and sell stocks, forcing them to unload their own holdings. By early August, the selling had taken on a life of its own, leading to billions in losses. The meltdown also revealed dangerous links in the financial system few had previously realized—that losses in the U.S. housing market could trigger losses in huge stock portfolios that had nothing to do with housing. It was utter chaos driven by pure fear. Nothing like it had ever been seen before. This wasn't supposed to happen!

Investors on Main Street had little idea that a historic blowup was occurring on Wall Street. ...commentators on CNBC discuss in bewilderment the strange moves stocks were making, with no idea about what was behind the volatility. Truth was the quants themselves were still trying to figure it out.

Every  quant fund was selling in a panicked rush for the exits. ...what had started as a series of bizarre, unexplainable glitches in quant models turned into a catastrophic meltdown the likes of which had never been seen before in the history of financial markets. Nearly every single quantitative strategy, thought to be the most sophisticated investing ideas in the world, was shredded to pieces, leading to billions in losses.


It was deleveraging gone supernova.


*Black Swan is an idea credited to:
The Black Swan Theory is used by Nassim Nicholas Taleb to explain the existence and occurrence of high-impact, hard-to-predict, and rare events that are beyond the realm of normal expectations. Unlike the philosophical "black swan problem", the "Black Swan Theory" (capitalized)refers only to unexpected events of large magnitude and consequence and their dominant role in history. Such events are considered extremeoutliers.