The Quants - Scott Patterson Book on the Geniuses Who Sunk Wall Street

Wall Street Journal reporter Scott Patterson has written an interesting book called "The Quants" that suggests a new breed of mathematicians and computer scientists took over much of the financial system—and the damage they inflicted in the 2007 meltdown.

He's written a teaser article that was published today on the WSJ that sets up the book. I think the entire topic is fascinating and read a good article on the same topic by Felix Salmon in Wired: Recipe for Disaster: The Formula That Killed Wall Street.

The basic premise of these articles/books is that quantitiative geniuses were the real goats in the financial meltdown. Their formulas and complicated models traded huge quantities of securities and that as the housing market began to crash, the models turned bad and turned into doomsday formulas. As Patterson writes:

"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!"

Here's another interesting paragraph which shows just how clueless most of the mainstream press and the public was to what was going on:

"Authorities, meanwhile, had little idea about the massive losses taking place across Wall Street. That Tuesday afternoon, the Federal Reserve said it had decided to leave short-term interest rates alone at 5.25%.Investors on Main Street had little idea that a historic blowup was occurring on Wall Street. AQR risk-management guru Aaron Brown had to laugh watching commentators on CNBC discuss in bewilderment the strange moves stocks were making, with no idea about what was behind the volatility. Truth was, Mr. Brown realized, the quants themselves were still trying to figure it out."

Despite all of this, while I think the quants helped enable the problem, I don't believe they were the primary cause. After all, bank failures and busts occurred in the past without the help of the quants. Government policies designed to promote home ownership, lax lending standards, low interest rates, greed, and the belief that housing prices never go down, were the logs of the pyre. The quant models were the gasoline to start and grease the conflagration.

Still the book looks like an interesting birds-eye-view into some of the hidden/secretive mechanisms that move the markets.