Quants Did It?

Scientific American says quants need to learn more economics and history before deploying their mathematical tools:

After the Crash, SciAm: If Hollywood makes a movie about the worst financial crisis since the Great Depression, a basement room in a government building in Washington will serve as the setting for a key scene. There investment bankers from the largest institutions pleaded successfully with Securities and Exchange Commission (SEC) officials during a short meeting in 2004 to lift a rule specifying debt limits and capital reserves needed for a rainy day. This decision, a real event described in the New York Times, freed billions to invest in complex mortgage-backed securities and derivatives that helped to bring about the financial meltdown in September.

In the script, the next scene will be the one in which number savvy specialists that Wall Street has come to know as quants consult with their superiors about implementing the regulatory change. These lapsed physicists and mathematical virtuosos were the ones who both invented these oblique securities and created software models that supposedly measured the risk a firm would incur by holding them... Without the formal requirement to maintain debt ceilings and capital reserves, the commission had freed these firms to police themselves using risk tools crafted by cadres of quants.

The software models in question estimate the level of financial risk of a portfolio for a set period at a certain confidence level. As Benoit Mandelbrot, the fractal pioneer who is a longtime critic of mainstream financial theory, wrote in Scientific American in 1999, established modeling techniques presume falsely that radically large market shifts are unlikely and that all price changes are statistically independent... Here is where reality and rocket science diverge. Try Googling “financial meltdown,” “contagion” and “2008,” a search that reveals just how wrongheaded these assumptions were. ...

In aviation, controlled flight into terrain describes the actions of a pilot who, through inattention or incompetence, directs a well-functioning airplane into the side of a mountain. Wall Street’s version stems from the SEC’s decision to allow over reliance on risk software in the middle of a historic housing bubble. The heady environment permitted traders to enter overoptimistic assumptions and faulty data into their models, jiggering the software to avoid setting off alarm bells.

The causes of this fiasco are multifold ... but the rocket scientists and geeks also bear their share of the blame. ... The regulators must ensure that the many lessons of this debacle are not forgotten by the institutions that trade these securities. One important take-home message: capital safety nets (now restored) should never be slashed again, even if a crisis is not looming.

For its part, the quant community needs to undertake a search for better models—perhaps seeking help from behavioral economics, which studies irrationality of investors’ decision making... These number wizards and their superiors need to study lessons that were never learned during previous market smashups involving intricate financial engineering...

Systems with agents who can respond to changes in their economic environment are very different from the types of physical systems quants are used to working with. Starting with reduced form techniques rather than strucural/behavioral models and attempting to exploit trends that are uncovered from backward looking procedures runs the risk of going very wrong if the response of agents in the model drives the economy away from its historical precedent. Much of what was done amounted to this approach no matter how dressed up it was mathematically. When the economy did, in fact, diverge from past trends as agents responded to the changed economic environment brought about by those attempting to exploit trends in the data, the models, unsurprisingly, failed.