Quants' can't-lose ideas sink market

To become a potentially market-destroying "it" group on Wall Street, you need some arrogance, enough brains to justify making huge financial bets, utter cluelessness about lessons learned from finance's booms and busts, and a sincere belief that your unique contributions to Wall Street will mean, ahem, that this time it really is different, so old truths can be ignored.

Such is the profile of Wall Street's nerdy quants, the most recent contingent to reach stardom and then keel over on its pocket protectors when boom turned bust. I learned much about this geek gaggle by reading The Quants, a new book by Wall Street Journal reporter Scott Patterson.

Most of all, I learned that the brainy brigade was no different from any of the groups that, from time to time, take their turns as Wall Street luminaries. True, they can do long division in their heads, and the computer models they stuff with can't-lose trading instructions may even garner a Nobel Prize.

But just like investment bankers, junk-bond kings and other finance superstars who came before them, the quants reached a pinnacle where they figured they alone had The Answer (and the profits) and that no one should question their methods.

History of meltdowns

Take, for example, a market-meltdown scene Patterson describes, when a quant guru is trying to sell. A trader has to inform the guy that he can't sell because "the market's frozen." It's a real Say What? Moment, because the quants had promised that a financial collapse was really, really, really unlikely a 27-standard-deviation event, in quant-speak.

Problem is, this little anecdote dates from the stock market crash of 1987, when geek-designed portfolio insurance helped send the market on a roller-coaster ride. A flurry of they-blew-it books were published in the wake of that meltdown, and a Newsweek cover asked, "Is the party over? A jolt for Wall Street's whiz kids." So the nerds proved to be not too swift at the learning-curve thing mandatory for true Wall Street heroes when you consider it happened all over again at Long Term Capital Management in 1998. And yet again at all the quant-run hedge funds in 2007.

Can't-lose formula

They excelled at persuading their bosses, regulators and the media that some of them were market neutral, meaning that they couldn't lose money because every bet was offset by a counter-bet that would go up if the other went down.

Genius-designed or not, somehow, starting August 6, 2007, the models "were operating in reverse," Patterson writes, depicting a scene at the hedge fund AQR Capital Management LLC with the in-house brainiacs watching in a daze as losses mounted.

Some success

Best of all: Patterson says AQR Capital Management founder Cliff Asness wrote a letter to investors on August 10, 2007, noting that his was a "long-term winning strategy" despite the recent bad performance. So what was the glitch that sent the markets into a tailspin? "The very success of the strategy over time has drawn in too many investors." In other words: We were so darned good at this that everybody tried to copy us, and that messed things up.

OK, you say, so quants can finger-point and dodge responsibility like the best of them. Everybody knows, though, that to really be part of Wall Street's elite, you've got to have contempt for the little people.

— Bloomberg