By Leah Spiro
The Quants: How a New Breed of Math Whizzes Conquered Wall Street and Nearly Destroyed It
By Scott Patterson
Who is to blame for the market crash of 2008 and the devastating global recession it unleashed? Many defenders of the hedge fund industry have argued that it was all the banks' fault and that hedge funds had little to do with the market mayhem. But in his new book, "The Quants," Wall Street Journal reporter Scott Patterson places the blame squarely on quantitative hedge fund managers and their compatriots within Wall Street firms.
Finance in motion: Did it all add up in the end?
His thesis: The global economic meltdown was caused by the now-discredited belief that markets are efficient and can be understood by a quantitative, scientific approach, just as the hard sciences of mathematics and physics explain the physical world. This intellectually seductive philosophy was embraced by a group of hedge fund managers, dubbed "the quants," who dominated Wall Street in the 2000s. Their mistaken and arrogant belief that they could precisely model and predict the market's behavior was their, and the economy's, downfall, Patterson argues.
To make his case, Patterson recounts the stories of four top quants: AQR Capital Management's Clifford Asness, Deutsche Bank's Boaz Weinstein, Morgan Stanley's Peter Muller and Citadel Investment Group's Ken Griffin. The book focuses on the period from 2006 to 2009, the three years that encapsulated the quants' rise to power, their smackdown in August 2007, and the painful fallout of 2008 and 2009. The opening scene takes place in March 2006 at Manhattan's St. Regis Hotel, where the four men are playing poker in the Wall Street Poker Night Tournament.
Patterson then explains how the quants got to Wall Street in the first place. In 1961, Ed Thorp, known as the godfather of quants, walked into a casino in Reno, Nevada, and won at the blackjack table, using his own trading system based on probability theory. A UCLA mathematician and author of two quant bibles, "Beat the Dealer" and "Beat the Market," Thorp mentored a generation of hedge fund managers, including Griffin.
Quantitative hedge fund managers peddled the notion that their specialized knowledge was the Truth—a secret about the way the market worked that could only be discovered through math—and the money flowed in. But after years of collecting art, winning Maseratis in poker games, building mansions in Greenwich, Conn., and dating fashion models, these high flyers crashed to earth during that hellish week in August 2007, when their esoteric quant theories stopped working. Asness came unglued, and Muller's PDT group lost $300 million in one day. In the market rout of 2008, Patterson argues that Citadel came dangerously close to failing, and Weinstein left his bank after losing $1.8 billion.
Patterson struggles to connect the August 2007 quant meltdown to the bigger market meltdown of 2008, but he makes an intriguing argument. He portrays the earlier quant collapse as a precursor of bigger problems to come, the trigger that led what he calls the money grid of interconnected, correlated, global quant hedge funds, their bankers, and electronic exchanges, to ultimately break down. "What happened if high-frequency quant funds, which had become a central cog of the market, helping transfer risk at lightning speeds, were forced to shut down by extreme market volitility?" speculates MIT's Andrew Lo, a quant and risk management specialist.
Jumping ahead to March 2008, Patterson reveals that Bear Stearns employees blamed two quant funds, Renaissance Technologies and D.E. Shaw, for pushing Bear over the edge by pulling $10 billion in business out of the firm. And he argues that AIG Financial Products, whose quant models failed on a massive scale, was indirectly responsible for the blow up of Lehman by helping underwrite $400 billion in credit default swaps against the firm. He might be onto something there.
"The Quants" is a reportorial tour de force, with Patterson pulling back the curtain on these four high-rolling quant operations, with a chapter on Renaissance as well. He is also a gifted writer who tells a complicated, cerebral story in an engaging and accessible way. The stories he tells challenge the conventional wisdom that banks, not hedge funds, caused the crash. But it's really the entire Wall Street mindset of recent years that is the culprit.