April 7, 2009

Quants Carry Some Blame In Economic Crisis

The ongoing economic rollercoaster ride taking place on Wall Street has caused some to cast blame upon quantitative analysts who developed the instruments and computer programs that caused the markets to boom in the first place.

"They thought they could make it easier to make money," an anonymous New York investment manager told AFP.

"They thought you don't need to do your homework anymore."

The analysts, also known as "Ëœquants,' came into the market in the 1970s. Demand for their analysis grew in the 1990s. They use physics to analyze risk and understand trends.

Some quants are in charge of hedge funds and others design securities and derivatives, according to AFP.

Peter Kolm, a former quant at Goldman Sachs and now associate professor at New York University's prestigious Courant Institute of Mathematical Sciences, told AFP atoms and dollars aren't so different.

"The mathematics, the structure is similar," he said.

"Any fusion process, heat flow, how heat spreads in a room, or spreads on a particular surface ... there's similar behavior in the probability of how prices change over time."

Thousands of hedge funds relied completely on products devised by quants.

Nobel economic science prize-winning quants Robert Merton and Myron Scholes ran the Long Term Capital Management hedge fund that collapsed just one year after they won the prize.

In 2003, Warren Buffet described quant instruments as "financial weapons of mass destruction," according to AFP.

"Everybody in the world thought they could come up with a model," said economics analyst Joel Naroff.

"People knew they were taking larger bets, but the assumption was the bets were backed by mathematics."

Analysts began to see quants as a way to beat the system and provide an unprecedented, reliable glimpse into the future of the market.

"The hottest quant products were Collateralized Debt Obligations (CDOs) and similar instruments like CMOs that turned high-risk toxic housing debt into seemingly safe bonds," said AFP.

"You put chicken in the grinder and out comes sirloin," quant Michael Osinski told New York magazine.

However, the quants left out perhaps the most crucial factor to their predictions: the possibility of a stagnant housing market. As house prices fell, subprime mortgage holders defaulted and the economy dwindled to the condition it is currently in.

"It was like putting a plane on automatic pilot. Everything is great while it works," said Marc Pado, a US market strategist at Cantor Fitzgerald.

"But as with anything computerized, it doesn't have human judgment. It's all based on what has been plugged into the formula. People say they thought it was a science, but (trading) is not a science -- that's the point."


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