Great article on Quants (and their role in the subprime mess)

[ChemEng]

f youve ever wondered about Quants, how they work, how they think, and their role on our markets, this is a great article to walks you through the process in baby steps.

Enjoy!
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Technology Review

"CDOs had functioned as the collateral on the quants' short positions. When the subprime crunch squeezed the financial markets, the value of those CDOs declined, forcing quants to increase the collateral in margin accounts, buy back the shorted stocks, or both. But in either case, in order to supplement their shrinking collateral, quant funds were forced to sell strong blue-chip stocks, whose prices consequently fell. At the same time, as quants bought back shorted stocks, the prices of those stocks increased, demanding the posting of yet more collateral to margin accounts at the very time that the value of CDOs was suffering. That the quants were, apparently, long on the same strong stocks and short on the same weak stocks was a result of a number of strategies, pairs trading among them."

 

[Nords]

f youve ever wondered about Quants, how they work, how they think, and their role on our markets, this is a great article to walks you through the process in baby steps.

Typical-- blame it all on the freakin' engineers.

If any of the blamers actually understood any financial engineering then maybe they'd be forced to accept personal responsibility.

They're still blaming the last Black Monday on program trading, they blamed LTCM's implosion on quants & leverage, and the problems with limited partnerships of the 1980s and CDOs of the 1990s were blamed on quants. Heck, they'll probably blame the next Black Monday (the one scheduled for two days from now) on the quants.

What about the hyperactive-trading overeager fueled-on-cheap-debt morons who where snorkeling up this toxic waste as fast as the investment banks could shovel it out?

Speaking of program traders, Poyet, are you still with us? What's the latest?

 

[HFWR]

"Math is hard."

Barbie

 

[jazz4cash]

Typical-- blame it all on the freakin' engineers.

Give me a break, Nords...........those guys are NOT engineers.....they're just called that because nobody REALLY know what the hell they do and it sounds cool.

 

[Maurice]

Some of these guys are engineers - the ones I deal with mostly have PhDs in quantitative fields such as applied math or physics, but often their undergrad degrees were in engineering or computer science.

I'm speaking as a guy who works in the industry, doing pricing and risk management of derivatives. I'm also a BSEE, but for years I've used the BS much more than the EE.

 

[Nords]

Give me a break, Nords...........those guys are NOT engineers.....they're just called that because nobody REALLY know what the hell they do and it sounds cool.

And you're saying that this is somehow different from the way that all the other engineers do their jobs?

Again, no one's forcing anyone to purchase these investments. Not even Barbie.

 

[twaddle]

This is the part the bugs me:

The value of over-the-counter derivatives, one shorthand measure of activity in the market, went from $298 trillion in December 2005 to $415 trillion a year later, according to statistics kept by the Bank for International Settle­ments

Those numbers are hard to get my head around. $415 tillion is 30 times the size of our entire economy. How could this get so big? What level of leverage does that imply?

 

[Texas Proud]

This is the part the bugs me:

The value of over-the-counter derivatives, one shorthand measure of activity in the market, went from $298 trillion in December 2005 to $415 trillion a year later, according to statistics kept by the Bank for International Settle*ments

Those numbers are hard to get my head around. $415 tillion is 30 times the size of our entire economy. How could this get so big? What level of leverage does that imply?

Hmmm... how much does the stock market trade in share value per day I would think it was in the trillion range..

And I know that the large banks transfer a trillion or two dollars every day...

So, what is the measure I doubt is is originations (but I could be wrong)...

 

[twaddle]

Total NASDAQ dollar volume in 2005 was $8 trillion. So, $415 trillion still seems gignormous to me.

If nothing else, it makes me want to invest in brokerage houses who take a small piece of each trade.

 

[jazz4cash]

And you're saying that this is somehow different from the way that all the other engineers do their jobs?

Again, no one's forcing anyone to purchase these investments. Not even Barbie.

Actually, it was a joke......BUT......yes I do! They need better back-up systems, circuit breakers, etc. in place........especially since they are basically ignoring the fact that liar loans funded during a housing bubble don't offer much value as collateral, but if you treat them like hot potatoes, maybe YOU don't get burned.

 

[saluki9]

Give me a break, Nords...........those guys are NOT engineers.....they're just called that because nobody REALLY know what the hell they do and it sounds cool.

Hmmmm. Most of the Quants I've met have graduate degrees in engineering. Lots of doctorates in physics and math.

The last quant that taught me had a PhD in EE from Johns Hopkins

 

[haha]

To say anything meaningful about this area of quantitative finance one would have to be a very well trained and very smart mathematician, and work in the industry. And if you are one of these, you really would not like to go back to wearing tweed coats with patches on the elbows and dating Radcliffe girls, once you have ridden around in limos and had all the New York prime girls you could ever imagine.

So, you aren't going to say anything negative, no matter what you might think. Maybe retiring guys who have already milked the cow as long as they need to might say a little about what they really think. The recent book by Richard Bookstaber, A Demon of Our Own Design, may be one such truthful look.

Meanwhile, this quote from the article caught my eye:

Unfortunately for quants, the life span of an algorithm is getting shorter. Before he was at RiskMetrics, Gregg Berman created commodity­-trading systems at the Mint Investment Management Group. In the mid-1990s, he says, a good algorithm might trade successfully for three or four years. But the half-life of an algorithm's viability, he says, has been coming down, as more quants join the markets, as computers get faster and able to crunch more data, and as more data becomes available. Berman thinks two or three months might be the limit now, and he expects it to drop.

So maybe this area will just come to an entropy death, a gridlock of too many clever algorithms arrayed against too many other similarly clever algorithms. Or maybe it will one day spin completely out of control. Even Big Ben seems to have paltry weapons to deal with something of this magnitude and speed and complexity.

Ha

 

[twaddle]

Seems like a great time for a "black swan" trader to make some bets. The quants are making the market more efficient and less volatile in the short term, but they need to use more and more leverage to get their small-change bets to pay off big.

So, we should see low-volatile markets punctuated by rare BIG swings. Maybe.

 

[Maurice]

This is the part the bugs me:

The value of over-the-counter derivatives, one shorthand measure of activity in the market, went from $298 trillion in December 2005 to $415 trillion a year later, according to statistics kept by the Bank for International Settle*ments

Those numbers are hard to get my head around. $415 tillion is 30 times the size of our entire economy. How could this get so big? What level of leverage does that imply?

This is incredibly misleading. The 'value' (as in PV) is nowhere near that. BIS is tracking 'notional value'. HUGE difference.

I'll illustrate:

You and I enter into a typical interest rate swap agreement. I'll pay you a fixed rate (say 5%) and you'll pay me floating (libor flat) every six months for the next 5 years on a notional value of 10MM. All that means is every six months we use 10MM to figure out the coupon pmt (my fixed and your floating) - but the actual payments between you and me are in all probablility quite small and mostly net out. In fact, by definition when we enter into the agreement the PV is 0.

 

[Gumby]

Excellent illustration Maurice (assuming net cash settlement, which is the case for most but not all swaps).

 

[Nords]

Excellent illustration Maurice (assuming net cash settlement, which is the case for most but not all swaps).

This should have occurred to me a lot sooner, but as the subprime train screeches off the rails I can suddenly appreciate all the [-]wreckage-picking[/-] lifetime-employment opportunities that must have been hurtling your way like shrapnel outside the blast perimeter.

No wonder you leaped to the sidelines!

How's life without the 14-hour workdays? Is picking up the moderator reins a reflection of all the vast untapped hours of free time stretching in front of you like a desert plains vista?

 

[deserat]

"Human behavior, as manifested in the financial markets, simply resists quantification, at least for now."

Best quote, I think, from the article. Human behavior in general is hard to quantify. As I read the article, I sensed that there was a belief that the only side of the equation was that high risk leads to high reward (profits)....yes....and no. High risk can also lead to high loss, witness what happened this summer. Another amazing thing to me was that the article also implies that people are not asking to have explained to them what is being done with their money, as in the hedge funds that are "secretive." Most people would not even understand most of the information in that article, let alone what the algorithms are being used in the hedge funds. The black box theory of "hey, they've made that much money for x number of years, I can't lose" prevails. Yes, I guess most are sheople.

I've found in general over the years, if someone can't explain something well, then perhaps I should shy away from some type of engagement either personally or with my money. I've also found that some basic principles apply - if you think you can't afford, you usually can't (run the numbers); if it sounds too good to be true, it usually is; if there is an aspect you don't understand, that may come back to bite you in the butt.

Interesting article though - as an engineer who works as an engineer, those guys were typical - they thought they could model something and it worked for awhile, but then it didn't work. Unfortunately, too many gullible people believed the 'quants' had all the answers. I fault both the 'quants' and the sheople.

 

[Gumby]

This should have occurred to me a lot sooner, but as the subprime train screeches off the rails I can suddenly appreciate all the [-]wreckage-picking[/-] lifetime-employment opportunities that must have been hurtling your way like shrapnel outside the blast perimeter.

No wonder you leaped to the sidelines!

How's life without the 14-hour workdays? Is picking up the moderator reins a reflection of all the vast untapped hours of free time stretching in front of you like a desert plains vista?

Actually, the subprime meltdown has produced far less work than one might think. As the WSJ noted this morning, consumer Chapter 13 filings have picked up as people try to stave off foreclosure, but there is not yet a corresponding pickup in business filings (which is what I have been doing). When subprime lenders such as New Century fold up the tent, there is usually not a lot of strictly "bankruptcy" work to be done -- they sell off the loan origination and loan servicing platforms, the banks providing the warehouse lines take all the loans which constitute their collateral, and there is nothing left but litigation against the insiders. The SIV's that issue the CDO's cannot be debtors in bankruptcy, and hedge funds who may have lost big buying CDO's are rarely going to be debtors (they will just liquidate or sell their remaining assets to a bigger fund).

For bankruptcy lawyers, the ideal case is a large operating company that will continue to operate but needs to restructure both its business and its capital structure. Doing all that restructuring requires platoons of highly paid lawyers and investment bankers. In the past 7 years, I have worked on bankruptcies driven by the dotcom fall out, the big asbestos driven bankruptcies (W.R. Grace, Owens Corning etc), the big airline bankruptcies (Northwest, Delta), the criminal activity driven bankruptcies (e.g. Enron); the automotive industry bankruptcies (Dana, Delphi etc) and bankruptcies caused by deregulation of the electric industry (e.g. PG&E, Calpine). I don't currently see the next trend that will drive large bankruptcies and I note that bond defaults are at historic lows right now.