Craters
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The news from credit markets was getting worse and worse. Wave after wave of mortgage defaults left craters where credit desks had been just a few weeks before. Suddenly I felt smart for being in the equity division. After all, the trouble in the credit markets was a great reason to buy stocks. And for a while it seemed like the problems might stay contained where they had started.
Equity trading boomed throughout 2008. Elsewhere, the quants were getting burned by their own magic, and as far as I could tell it was well deserved. Mortgage Backed Securities, the flagship product of Quant Tower, were increasingly being considered as “toxic assets” to institutional money managers. What made them toxic was the fact that their value depended heavily on the probability that a given mortgage in a pool would default. Depending on who you asked, those values had either been calculated incorrectly, or they were changing.
In the first case the quants had merely been wrong in their calculations. But the second case would also mean that they had been wrong, but on a deeper, more philosophical level. This is something I was beginning to understand from my forays into finance textbooks; their formulas were always based on constant averages.
For an example, take Modern Portfolio Theory, which formed the theoretical foundation for the long-only portion of the asset-management business. Applying it was a simple matter of reducing each stock to a mean and a variance around that mean, and then building a spreadsheet full of mean returns and their variances. Then you would just sprinkle a little quant dust (the correlation matrix) onto your spreadsheet and BOOM!
You would get a portfolio with great returns and low risk. It works great as long as the means and variances and the correlations in your spreadsheet are both accurate and immutable.
As it turned out, the quants did something even more remarkable than making the banking system disappear. They made time itself disappear!
If that isn’t real magic, I don’t know what is.
