The Quants who killed Wall Street

NY Times:

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“Options theory is kind of deep in some way. It was very elegant; it had the quality of physics,” Dr. Derman explained recently with a tinge of wistfulness, sitting in his office at Columbia, where he is now a professor of finance and a risk management consultant with Prisma Capital Partners.

Dr. Derman, who spent 17 years at Goldman Sachs and became managing director, was a forerunner of the many physicists and other scientists who have flooded Wall Street in recent years, moving from a world in which a discrepancy of a few percentage points in a measurement can mean a Nobel Prize or unending mockery to a world in which a few percent one way can land you in jail and a few percent the other way can win you your own private Caribbean island.

They are known as “quants” because they do quantitative finance. Seduced by a vision of mathematical elegance underlying some of the messiest of human activities, they apply skills they once hoped to use to untangle string theory or the nervous system to making money.

This flood seems to be continuing, unabated by the ongoing economic collapse in this country and abroad. Last fall students filled a giant classroom at M.I.T. to overflowing for an evening workshop called “So You Want to Be a Quant.” Some quants analyze the stock market. Others churn out the computer models that analyze otherwise unmeasurable risks and profits of arcane deals, or run their own hedge funds and sift through vast universes of data for the slight disparities that can give them an edge.

Still others have opened an academic front, using complexity theory or artificial intelligence to better understand the behavior of humans in markets. In December the physics Web site arXiv.org, where physicists post their papers, added a section for papers on finance. Submissions on subjects like “the superstatistics of labor productivity” and “stochastic volatility models” have been streaming in.

Quants occupy a revealing niche in modern capitalism. They make a lot of money but not as much as the traders who tease them and treat them like geeks. Until recently they rarely made partner at places like Goldman Sachs. In some quarters they get blamed for the current breakdown — “All I can say is, beware of geeks bearing formulas,” Warren Buffett said on “The Charlie Rose Show” last fall. Even the quants tend to agree that what they do is not quite science.

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Buffet must speak from experience. While the theories are interesting and they can be somewhat effect as long as their assumptions don't fail them, in the case of the risk analysis on derivatives the default assumptions failed them big time and managed to kill some of the giants of Wall Street.

The basic problem is that Wall Street is closer to von Clausewitz's description of war where you are not dealing with a finite object, but with people who think and react to different stimulus to try to beat you or through friction just screw up. You can see certain trends and rhythms, but there is always a human element like the guy who can't make his mortgage payment who becomes like a butterfly flapping his wings and creating a storm that sweeps over their calculations.