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Coming into 2008, hedge funds were in control of $2 trillion. Soros was estimating that the industry would lose between $1 trillion and $1.5 trillion-through either outright losses or capital flight to safer harbors.
Simons, looking every bit the frumpy professor with his balding pate, chalk-white beard, and rumpled gray jacket, said Renaissance didn't dabble in the "alphabet soup" of CDOs or CDSs that triggered the calamity. His testimony provided little insight into the problems behind the meltdown, though it did offer a rare glimpse into Renaissance's trading methods.
"Renaissance is a somewhat atypical investment management firm," he said. "Our approach is driven by my background as a mathematician. We manage funds whose trading is determined by mathematical formulas. ... We operate only in highly liquid publicly traded securities, meaning we don't trade in credit default swaps or collateralized debt obligations. Our trading models tend to be contrarian, buying stocks recently out of favor and selling those recently in favor."
For his part, Griffin sounded a note of defiance, fixing his unblinking blue eyes on the befuddled array of legislators. Hedge funds weren't behind the meltdown, he said. Heavily regulated banks were.
"We haven't seen hedge funds as the focal point of the carnage in this financial tsunami," said Griffin, clad in a dark blue jacket, black tie, and light blue shirt.
Whether he believed it or not, the statement smacked of denial, overlooking the fact that Citadel's dramatically weakened condition in late 2008 had added to the market's turmoil. Regulators had been deeply concerned about Citadel and whether its demise would trigger even more blowups.
Griffin also opposed greater transparency. "To ask us to disclose our positions to the open market would parallel asking Coca-Cola to disclose their secret formula to the world."
Despite Griffin's warnings, Congress seemed to be heading toward greater oversight of hedge funds, which it saw as part of a shadow banking system that had caused the financial collapse. "When hedge funds become too big to fail, that poses a problem for the financial system," MIT's Andrew Lo, he of the Doomsday Clock, told the Wall Street Journal Wall Street Journal.
Citadel didn't fail, though it came dangerously close. Griffin, who'd once nurtured grand ambitions of a financial empire that could match the mightiest powerhouses of Wall Street, had been humbled. In the first half of the year, he'd been coming into the office late, often around 10:00 a.m. instead of the predawn hours he used to keep, so he could spend time with his one-year-old son. He couldn't help thinking that he was paying for letting his guard down. fail, though it came dangerously close. Griffin, who'd once nurtured grand ambitions of a financial empire that could match the mightiest powerhouses of Wall Street, had been humbled. In the first half of the year, he'd been coming into the office late, often around 10:00 a.m. instead of the predawn hours he used to keep, so he could spend time with his one-year-old son. He couldn't help thinking that he was paying for letting his guard down.
But Griffin knew that the high-flying hedge fund fantasy of the past two decades would never again be the same. The mountain-moving leverage and ballsy billion-dollar bets on risky hands were all consigned to another age.
Griffin put a brave face on. As he said on the conference call that Friday afternoon in October: "We need to face the fact that we need to evolve. We will embrace the changes that are part of that evolution, and we will prosper in the new era of finance."
His investors weren't so sure. Many were asking for their money back. In December, after redemption requests totaling about $1.2 billion, Citadel barred investors from pulling money from its flagship funds. Assets at Citadel had already shrunk to $10.5 billion from $20 billion. To comply with further requests, Griffin would have to unload more positions to raise the funds, a bitter pill to swallow in a depressed market.
Investors had little choice but to comply. But the move had infuriated many, who saw it as a strong-arm tactic by a firm that had already lost them countless millions that year.
Griffin was also suffering a big hit to his mammoth pocketbook. Few outsiders knew exactly how much of Citadel Griffin owned, but some estimated that he held roughly 50 percent of the firm's assets heading into the crisis, putting his personal net worth at about $10 billion, far higher than most believed. The 55 percent tumble by his hedge funds, therefore, hurt no one more than Griffin. Adding to the pain, he'd used $500 million of his own cash to prop up the funds and pay management fees typically borne by investors. Of course, he was also the biggest investor in the firm's high-frequency quant powerhouse, Tactical Trading, which had pulled in $1 billion.
Citadel, meanwhile, was severely hobbled. The gross assets of its hedge funds had tumbled sharply in the meltdown, falling from $140 billion in the spring of 2008 to just $52 billion by the end of the year. The firm had unloaded nearly $90 billion of assets in its frantic effort to deleverage its balance sheet, a wave of selling that had added further pressure to a panicked post-Lehman market.
Griffin had plenty of company, of course, in the great hedge-fund shakeout of 2008-including Cliff Asness.
Cliff Asness was furious. The rumors, lies, and the cheap shots had to stop. was furious. The rumors, lies, and the cheap shots had to stop.
It was early December 2008. The small town of Greenwich, Connecticut, was in turmoil. The luxury yachts and streamlined powerboats lay moored in the frigid docks of the Delamar on Greenwich Harbor, a luxury hotel designed in the style of a Mediterranean villa. Caravans of limousines, Bentleys, Porsches, and Beamers sat locked in their spacious custom garages. Gated mansions hunched in the Connecticut cold behind their rows of exotic shrubbery, bereft of their traditional lacings of Christmas glitz. Few of the high-powered occupants of those mansions felt much like celebrating. It was a glum holiday season in Greenwich, hedge fund capital of the world.
Making matters worse, a multibillion-dollar money management firm run by a reclusive financier named Bernard Madoff had proved to be a massive Ponzi scheme, one that Ed Thorp had already unearthed in the early 1990s. The losses rippled throughout the industry like shock waves. A cloud of suspicion fell upon an industry already infamous for its paranoia and obsessive secrecy.
Ground zero of Greenwich's hedge fund scene was Two Greenwich Plaza, a nondescript four-story building beside the town's train station that once had housed a hodgepodge of shippers, manufacturers, and stuffy family law firms. That was before the hedge fund crowd moved in.
One of the biggest hedge funds of them all, of course, was AQR. Its captain, Cliff Asness, was on a rampage. He wasn't quite rolling steel balls around in his hand like Captain Queeg on the Caine Caine, but he wasn't far off. The battered computer monitors Asness destroyed in anger were piling up. Some thought Asness was losing his mind. He seemed to be slipping into a kind of frenzy, the polar opposite of the rational principles he'd based his fund upon. Driving his fury was the persistent chatter that AQR was blowing up, rumors such as AQR had lost 40 percent in a single day ... AQR was on the verge of shutting its doors forever ... AQR was melting down and tunneling to the center of the earth in a crazed China syndrome hedge fund catastrophe ...
Many of the rumors cropped up on a popular Wall Street blog called Dealbreaker. The site was peppered with disparaging comments about AQR. Dealbreaker's gossipy scribe, Bess Levin, had recently written a post about a round of layoffs at AQR that had included Asness's longtime secretary, Adrienne Rieger.
"Uncle Cliff is rumored to have recently sacked his secretary of ten years, and as everyone knows, it's the secretaries who hold the key to your web of lies and bullshit and deceit, and you don't get rid of them unless you're about to go down for the dirt nap," she wrote.
Dozens of readers posted comments on Levin's report. Asness, reading them from his office, could tell that many came from axed employees or, worse, disgruntled current employees sitting in their cubicles just outside his office. Some of the posts were just plain mean. "I guess the black box didn't work," read one. Another: "AQR is an absolute disaster."
On the afternoon of December 4, Asness decided to respond. Unlike Griffin, who held a conference call, Asness was going to confront the rumormongers in their den: on the Internet. From his third-floor corner office, he sat before his computer, went to Dealbreaker's site, and started to type.
"This is Cliff Asness," he began. He sat back, wiped his mouth, then leaned forward into the keyboard: All these inside references, yet so much ignorance and/or lies. Obviously some of these posts are bitter rants by people not here anymore, and obviously some are just ignorance and cruelty. Either way they are still lies. ... For good people we had to let go I feel very bad. For investors who are in our products that are having a tough time I feel very bad and intend to fix it. Frankly, for anyone who is in a tough spot I feel bad. But for liars, and bitter former employees who were let go because we decided we needed you less than the people you now lie about ... and little men who get off on anonymous mendacity on the internet,-YOU and the keyboard you wrote it on. Sorry I can't be more eloquent, you deserve no more and will hear no more from me after this post. I'm Cliff Asness and I approved this message internet,-YOU and the keyboard you wrote it on. Sorry I can't be more eloquent, you deserve no more and will hear no more from me after this post. I'm Cliff Asness and I approved this message.
Asness posted the rant on the site and quickly realized he'd made a terrible mistake-later he'd call it "stupid." It was a rare public display of anger for a widely respected money manager. It became an immediate sensation within AQR and throughout the hedge fund community. Morale at the fund had been on the wane as its fortunes suffered. Now the founder of a firm known for rationality and mathematical rigor seemed to have let his emotions get the best of him.
Investors didn't seem to mind the dustup. What they did mind were the billions of dollars AQR had lost. But Asness was convinced the following year would be better. The models would work again. Decades of research couldn't be wrong. The Truth had taken a shot in the mouth, but it would eventually come back. When it did, AQR would be there to clean up.
The travails of AQR, once one of the hottest hedge funds on Wall Street, and the intense pressures placed on Asness captured the plight of an industry struggling to cope with the most tumultuous market in decades.
The market's chaos had made a hash of the models deployed by the quants. AQR's losses were especially severe in late 2008 after Lehman Brothers collapsed, sending markets around the globe into turmoil. Its Absolute Return Fund fell about 46 percent in 2008, compared with a 48 percent drop by the Standard & Poor's 500-stock index. In other words, investors in plain-vanilla index funds had done just about as well (or poorly) as investors who'd placed their money in the hands of one of the most sophisticated asset managers in the business.
It was the toughest year on record for hedge funds, which lost 19 percent in 2008, according to Hedge Fund Research, a Chicago research group, only the second year since 1990 that the industry lost money as a whole. (In 2002, hedge funds slid 1.5 percent.) The Absolute Return Fund had lost more than half of its assets from its peak, dropping to about $1.5 billion from about $4 billion in mid-2007. AQR in total had about $7 billion in so-called alternative funds and about $13 billion in long-only funds, down sharply from the $40 billion it sat on heading into August 2007, when it was planning an IPO. In a little more than a year, AQR had lost nearly half its war chest.
AQR's poor performance shocked its investors. So-called absolute return funds were supposed to provide positive risk-adjusted returns in any kind of market-they were expected to zig when the market zagged. But Absolute Return seemed to follow the S&P 500 like a magnet.
One reason behind the parallel tracks: in early 2008, AQR had made a big wager that U.S. stocks would rise. According to its value-centric models, large U.S. stocks were a bargain relative to a number of other assets, such as Treasury bonds and markets in other countries. So Asness rolled the dice, plowing hundreds of millions into assets that mirrored the S&P 500.
The decision set the stage for one of the most frustrating years in Asness's investing career. AQR also made misplaced bets on the direction of interest rates, currencies, commercial real estate, and convertible bonds-pretty much everything under the sun.
As the losses piled up, investors were getting antsy. AQR was supposed to hold up in market downturns, just as it had in 2001 and 2002 during the dot-com blowup. Instead, AQR was racing to the bottom along with the rest of the market.
In October and November Asness went on a long road trip, visiting nearly every investor in his fund, traveling in a private jet to locations as far afield as Tulsa, Oklahoma, and Sydney, Australia. For the rare down moments, he pulled out his Kindle, Amazon.com's wireless reading device, which was loaded with books ranging from How Math Explains the World How Math Explains the World to to Anna Karenina Anna Karenina to to When Markets Collide When Markets Collide by Mohamad El-Erian, a financial guru at bond giant Pimco. by Mohamad El-Erian, a financial guru at bond giant Pimco.
But Asness had little time for reading. He was trying to keep his fund alive. His goal was to convince investors that AQR's strategies would eventually reap big returns. Many decided to stick with the fund despite its dismal performance, testimony to their belief that Asness would, in fact, get his mojo back.
By December, as the market continued to spiral lower, the pressure ratcheted up on Asness. He'd become obsessed with a tick-by-tick display that tracked Absolute Return's dismal performance. The stress in AQR's office became intense. Asness's decision to lay off several researchers as well as Rieger, his secretary, raised questions about the firm's longevity.
Chatter about AQR's precarious state became rampant in hedge fund circles. Asness and Griffin frequently exchanged rumors they'd heard about the other's fund, tipping each other off about the latest slander.
Both onetime masters of the universe knew the glory days were over. In a telling sign of his diminished, though defiant, expectations, Asness coauthored a November article for Institutional Investor Institutional Investor, with AQR researcher Adam Berger, called "We're Not Dead Yet." The article was a response to a question from Institutional Investor Institutional Investor about whether quantitative investing had a future. about whether quantitative investing had a future.
"The fact that we have been asked this question suggests that many people think the future of quantitative investing is bleak," Asness and Berger wrote. "After all, upon seeing a good friend in full health-or even on death's doorstep-would you really approach the person and say, 'Great to see you-are you still alive?' If you have to ask, you probably think quant investing is already dead."
Asness knew the quants weren't dead. But he knew they'd taken a serious blow and that it could take months, if not years, before they'd be back on their feet and ready to fight.
Ken Griffin was also fighting the tide. But the bleeding was relentless. By the end of 2008, Citadel's primary funds had lost a jaw-dropping 55 percent of their assets in one of the biggest hedge fund debacles of all time. At the start of January, the firm had $11 billion left, a vertiginous drop from the $20 billion it had had at the start of 2008. was also fighting the tide. But the bleeding was relentless. By the end of 2008, Citadel's primary funds had lost a jaw-dropping 55 percent of their assets in one of the biggest hedge fund debacles of all time. At the start of January, the firm had $11 billion left, a vertiginous drop from the $20 billion it had had at the start of 2008.
What is perhaps more remarkable is that Citadel lived to trade another day. Griffin had seen his Waterloo and survived. His personal wealth fell by an estimated $2 billion in 2008. It was the biggest decline of any hedge fund manager for the year, marking a stunning fall from the heights for one of the hedge fund world's elite traders.
Not every hedge fund lost money that year. Renaissance's Medallion fund gained an astonishing 80 percent in 2008, capitalizing on the market's extreme volatility with its lightning-fast computers. Jim Simons was the hedge fund world's top earner for the year, pocketing a cool $2.5 billion.
Medallion's phenomenal surge in 2008 stunned the investing world. All the old questions came back: How do they do it? How, in a year when nearly every other investor got slaughtered, could Medallion rake in billions?
The answer, at the end of the day, may be as prosaic as this: The people in charge are smarter than everyone else. Numerous ex-Renaissance employees say that there is no secret formula for the fund's success, no magic code discovered decades ago by geniuses such as Elwyn Berlekamp or James Ax. Rather, Medallion's team of ninety or so Ph.D.'s are constantly working to improve the fund's systems, pushed, like a winning sports team's sense of destiny, to continue to beat the market, week after week, year after year.
And that means hard work. Renaissance has a concept known as the "second forty hours." Employees are each allotted forty hours to work on their assigned duties-programming, researching markets, building out the computer system. Then, during the second forty hours, they're allowed to venture into nearly any area of the fund and experiment. The freedom to do so-insiders say there are no walledoff segments of the fund to employees-allows for the chance for breakthroughs that keep Medallion's creative juices flowing.
Insiders also credit their leader, Jim Simons. Charismatic, extremely intelligent, easy to get along with, Simons had created a culture of extreme loyalty that encouraged an intense desire among its employees to succeed. The fact that very few Renaissance employees over the years had left the firm, compared to the river of talent flowing out of Citadel, was a testament to Simons's leadership abilities.
Renaissance was also free of the theoretical baggage of modern portfolio theory or the efficient-market hypothesis or CAPM. Rather, the fund was run like a machine, a scientific experiment, and the only thing that mattered was whether a strategy worked or not-whether it made money. In the end, the Truth according to Renaissance wasn't about whether the market was efficient or in equilibrium. The Truth was very simple, and remorseless as the driving force of any cutthroat Wall Street banker: Did you make money, or not? Nothing else mattered.
Meanwhile, a fund with ties to Nassim Taleb, Universa Investments, was also hitting on all cylinders. Funds run by Universa, managed and owned by Taleb's longtime collaborator Mark Spitznagel, gained as much as 150 percent in 2008 on its bet that the market is far more volatile than most quant models predict. The fund's Black Swan Protocol Protection plan purchased far-out-of-the-money put options on stocks and stock indexes, which paid off in spades after Lehman collapsed as the market tanked. By mid-2009, Universa had $6 billion under management, up sharply from the $300 million it started out with in January 2007, and was placing a new bet that hyperinflation would take off as a result of all the cash unleashed by the government and Fed flooding into the economy.
PDT also had a strong run riding the volatility tiger, posting a gain of about 25 percent for the year, despite its massive liquidation in October. Muller's private investment fund, Chalkstream Capital Group, however, had a very bad year due to its heavy investments in real estate and private equity funds, losing about 40 percent, though the fund rebounded solidly in 2009. Since Muller had a great deal of his personal wealth in the fund, it was a doubly hard blow.
Weinstein, meanwhile, decided it was time to break out into the wide world on his own. But he was leaving a tangled mess behind him. By the end of the year, Saba had lost $1.8 billion. In January 2009, the group was officially shut down by Deutsche, which, like nearly every other bank, was nursing a massive hangover from its venture into prop trading and was radically scaling back on it.
Weinstein left Deutsche Bank on February 5, slightly more than a decade after he'd first come to the firm as a starry-eyed twenty-four-year-old with dreams of making a fortune on Wall Street. He'd made his fortune, but he'd been bruised and bloodied in one of the greatest market routs of all time.
THE DEVIL'S WORK
Paul Wilmott stood before a crowded room in the Renaissance Hotel in midtown Manhattan, holding up a sheet of paper peppered with obscure mathematical notations. The founder of Oxford University's first program in quantitative finance, as well as creator of the Certificate in Quantitative Finance program, the first international course on financial engineering, wrinkled his nose. stood before a crowded room in the Renaissance Hotel in midtown Manhattan, holding up a sheet of paper peppered with obscure mathematical notations. The founder of Oxford University's first program in quantitative finance, as well as creator of the Certificate in Quantitative Finance program, the first international course on financial engineering, wrinkled his nose.
"There are a lot of people making things far more complicated than they should be," he said, shaking the paper with something close to anger. "And that's a guaranteed way to lose $2 trillion." He paused for a second and snickered, running a hand through his rumpled mop of light brown hair. "Can I say that?"
It was early December 2008, and the credit crisis was rampaging, taking a horrendous toll on the global economy. Americans' fears about the state of the economy had helped propel Barack Obama into the White House. The Dow Jones Industrial Average had crashed nearly 50 percent from its 2007 record, having dived 680 points on December 2, its fourth-biggest drop since the average was launched in 1896. The United States had shed half a million jobs in November, the biggest monthly drop since 1974, and more losses were coming. Economists had stopped speculating about whether the economy was sliding into a recession. The big question was whether another depression was on the way. Bailout fatigue was in the air as more revelations about losses at financial institutions from Goldman Sachs to AIG filled the airwaves.
Taxpayers wanted someone to blame. But the crisis was so confusing, so full of jargon about derivatives and complex instruments, that few of the uninitiated knew who was at fault.
Increasingly, fingers were pointing at the quants. The tightly coupled system of complex derivatives and superfast computer-charged overleveraged hedge funds that were able to shift billions across the globe in the blink of an eye: It had all been created by Wall Street's math wizards, and it had all come crumbling down. The system the quants had designed, the endlessly ramifying tentacles of the Money Grid, was supposed to have made the market more efficient. Instead, it had become more unstable than ever. Popular delusions such as the efficient market hypothesis had blinded the financial world to the massive credit bubble that had been forming for years.
Jeremy Grantham, the bearish manager of GMO, an institutional money manager with about $100 billion in assets, wrote in his firm's early 2009 quarterly letter to clients-titled "The Story So Far: Greed + Incompetence + A Belief in Market Efficiency = Disaster"-that EMH and the quants were at the heart of the meltdown.
"In their desire for mathematical order and elegant models," Grantham wrote, "the economic establishment played down the inconveniently large role of bad behavior ... and flat-out bursts of irrationality." He went on: "The incredibly inaccurate efficient market theory was believed in totality by many of our financial leaders, and believed in part by almost all. It left our economic and government establishment sitting by confidently, even as a lethally dangerous combination of asset bubbles, lax controls, pernicious incentives, and wickedly complicated instruments led to our current plight. 'Surely, none of this could be happening in a rational, efficient world,' they seemed to be thinking. And the absolutely worst part of this belief set was that it led to a chronic underestimation of the dangers of asset bubbles breaking."
In a September 2009 article titled "How Did Economists Get It So Wrong" in the New York Times Magazine New York Times Magazine, Nobel Prizewinning economist Paul Krugman lambasted EMH and economists' chronic inability to grasp the possibility of massive swings in prices and circumstances that Mandelbrot had warned of decades earlier. Krugman blamed "the profession's blindness to the very possibility of catastrophic failures in a market economy. ... As I see it, the economics profession went astray because economists, as a group, mistook beauty, clad in impressive-looking mathematics, for truth."
While the collapse had started in the murky world of subprime lending, it had spread to nearly every corner of the financial universe, leading to big losses in everything from commercial real estate to money market funds and threatening major industries such as insurance that had loaded up on risky debt.
But not every quant had been caught up in the madness. Few were sharper in their criticism of the profession than Paul Wilmott, one of the most accomplished quants of them all.
Despite the freezing temperature outside, the bespectacled British mathematician was clad in a flowery Hawaiian shirt, faded jeans, and leather boots. Before Wilmott, spread out in rows of brightly colored plastic molded chairs, sat a diverse group of scientists in fields ranging from physics to chemistry to electrical engineering. Members of the motley crew had one thing in common: they were prospective quants attending an introductory session for Wilmott's Certificate in Quantitative Finance program. freezing temperature outside, the bespectacled British mathematician was clad in a flowery Hawaiian shirt, faded jeans, and leather boots. Before Wilmott, spread out in rows of brightly colored plastic molded chairs, sat a diverse group of scientists in fields ranging from physics to chemistry to electrical engineering. Members of the motley crew had one thing in common: they were prospective quants attending an introductory session for Wilmott's Certificate in Quantitative Finance program.
Wilmott wanted this bright-eyed group to know he wasn't any ordinary quant-if they hadn't already picked up on that from his getup, which seemed more beach bum than Wall Street. Most quants, he said, were navel-gazing screwups, socially dysfunctional eggheads entranced by the crystalline world of math, completely unfit for the messy, meaty world of finance.
"The hard part is the human side," he said. "We're modeling humans, not machines."
It was a message Wilmott had been trying to pound into the fevered brains of his number-crunching colleagues for years, mostly in vain. In a March 2008 post on his website, Wilmott.com, he lambasted Wall Street's myopic quant culture. "Banks and hedge funds employ mathematicians with no financial-market experience to build models that no one is testing scientifically for use in situations where they were not intended by traders who don't understand them," he wrote. "And people are surprised by the losses!"
Wilmott had long been a gadfly of the quants. And he had the mathematical firepower to back up his attacks. He'd written numerous books on quantitative finance and published a widely read magazine for quants under his own name. In 1992, he started teaching the first financial engineering courses at Oxford University. Single-handedly he founded Oxford's mathematical finance program in 1999.
He'd also warned that quants might someday blow the financial system to smithereens. In "The Use, Misuse and Abuse of Mathematics in Finance," published in 2000 in Philosophical Transactions of the Royal Society Philosophical Transactions of the Royal Society, the official journal of the United Kingdom's national academy of science, he wrote: "It is clear that a major rethink is desperately required if the world is to avoid a mathematician-led market meltdown." Financial markets were once run by "the old-boy network," he added. "But lately, only those with Ph.D.'s in mathematics or physics are considered suitable to master the complexities of the financial market."
That was a problem. The Ph.D.'s might know their sines from their cosines, but they often had little idea how to distinguish the fundamental realities behind why the market behaved as it did. They got bogged down in the fine-grained details of their whiz-bang models. Worse, they believed their models were perfect reflections of how the market works. To them, their models were were the Truth. Such blind faith, he warned, was extremely dangerous. the Truth. Such blind faith, he warned, was extremely dangerous.
In 2003, after leaving Oxford, he launched the CQF program, which trained financial engineers in cities from London to New York to Beijing. He'd grown almost panicky about the dangers he saw percolating inside the banking system as head-in-the-clouds financial engineers unleashed trillions of complex derivatives into the system like a time-release poison. With the new CQF program, he hoped to challenge the old guard and train a new cadre of quants who actually understood the way financial markets worked-or, at the very least, understood what was and wasn't possible when trying to predict the real market using mathematical formulas.
It was a race against time, and he'd lost. The mad scientists who'd been running wild in the heart of the financial system for decades had finally done it: they'd blown it up.
On a frigid day in early January 2009, several weeks after addressing the crowd of hopeful quants at the Renaissance Hotel, Wilmott boarded a plane at Heathrow Airport in London and returned to New York City. frigid day in early January 2009, several weeks after addressing the crowd of hopeful quants at the Renaissance Hotel, Wilmott boarded a plane at Heathrow Airport in London and returned to New York City.
In New York, he met with uber-quant Emanuel Derman. A lanky, white-haired South African, Derman headed up Columbia University's financial engineering program. He was one of the original quants on Wall Street and had spent decades designing derivatives for Goldman Sachs, working alongside legends such as Fischer Black.
Wilmott and Derman had become alarmed by the chaotic state of their profession and by the mind-boggling destruction it had helped bring about. Derman believed too many quants confused their elegant models with reality. Yet, a quant to the core, he still held firmly that there was a central place for the profession on Wall Street.
Wilmott was convinced his profession had run off track, and he was growing bitter about its future. Like Derman, he believed that there was still a place for well-trained, and wise, financial engineers.
Together that January, they wrote "The Financial Modelers' Manifesto." It was a cross between a call to arms and a self-help guide, but it also amounted to something of a confession: We have met the enemy, and he is us We have met the enemy, and he is us. Bad quants were the source of the meltdown.
"A spectre is haunting markets-the spectre of illiquidity, frozen credit, and the failure of financial models," they began, ironically echoing Marx and Engels's Communist Manifesto Communist Manifesto of 1848. of 1848.
What followed was a flat denunciation of the idea that quant models can approximate the Truth: Physics, because of its astonishing success at predicting the future behavior of material objects from their present state, has inspired most financial modeling. Physicists study the world by repeating the same experiments over and over again to discover forces and their almost magical mathematical laws. ... It's a different story with finance and economics, which are concerned with the mental world of monetary value. Financial theory has tried hard to emulate the style and elegance of physics in order to discover its own laws. ... The truth is that there are no fundamental laws in finance.
In other words, there is no single truth in the chaotic world of finance, where panics, manias, and chaotic crowd behavior can overwhelm all expectations of rationality. Models designed on the premise that the market is predictable and rational are doomed to fail. When hundreds of billions of highly leveraged dollars are riding on those models, catastrophe is looming.
To ensure that the quant-driven meltdown that began in August 2007 would never happen again, the two uber-quants developed a "modelers' Hippocratic Oath": [image]I will remember that I didn't make the world, and it doesn't satisfy my equations.
[image]Though I will use models boldly to estimate value, I will not be overly impressed by mathematics.
[image]I will never sacrifice reality for elegance without explaining why I have done so.
[image]Nor will I give the people who use my model false comfort about its accuracy. Instead, I will make explicit its assumptions and oversights.
[image]I understand that my work may have enormous effects on society and the economy, many of them beyond my comprehension.
While the manifesto was well-intentioned, there was little reason to believe it would keep the quants, in years to come, from convincing themselves that they'd perfected their models and once again bringing destruction to the financial system. As Warren Buffett wrote in Berkshire Hathaway's annual report in late February 2009, Wall Street needs to tread lightly around quants and their models. "Beware of geeks bearing formulas," Buffett warned.
"People assume that if they use higher mathematics and computer models they're doing the Lord's work," observed Buffett's longtime partner, the cerebral Charlie Munger. "They're usually doing the devil's work."
For years, critics on the fringes of the quant world had warned that trouble was brewing. Benoit Mandelbrot, for instance, the mathematician who decades earlier had warned the quants of the wild side of their mathematical models-the seismic fat tails on the edges of the bell curve-watched the financial panic of 2008 with a grim sense of recognition.
Even before the fury of the meltdown hit with its full force, Mandelbrot could tell that the quantitative underpinnings of the financial system were unraveling. In the summer of 2008, Mandelbrot-a distinctly European man with a thick accent, patchy tufts of white hair on his enormous high-browed head, and pink blossoms on his full cheeks-was hard at work on his memoirs in his Cambridge, Massachusetts, apartment, perched on the banks of the Charles River. As he watched the meltdown spread through the financial system, he still chafed at the quants' failure to listen to his alarums nearly half a century before.
His apartment contained bookshelves packed with his own writings as well as the weighty tomes of others. One day that summer he pulled an old, frayed book from the shelf and, cradling it in his hands, opened the cover and proceeded to leaf through it. The book, edited by MIT finance professor Paul Cootner, was called The Random Character of Stock Market Prices The Random Character of Stock Market Prices, a classic collection of essays about market theory published in 1964. It was the same book that helped Ed Thorp derive a formula for pricing stock warrants in the 1960s, and the first collection to include Bachelier's 1900 thesis on Brownian motion. The book also contained the essay by Mandelbrot detailing his discovery of wild, erratic moves by cotton prices.
The pages of the copy he held in his hand were crisp and ochered with age. He quickly found the page he was looking for and started to read.
"Mandelbrot, like Prime Minister Churchill before him, promises us not utopia but blood, sweat, toil, and tears," he read. "If he is right, almost all of our statistical tools are obsolete. ... Surely, before consigning centuries of work to the ash pile, we should like to have some assurance that all our work is truly useless."
The passage, by Cootner himself, was a stern rebuke to Mandelbrot's essay detailing strange characteristics he'd observed in the behavior of cotton prices. Market prices, Mandelbrot had found, were subject to sudden violent, wild leaps. It didn't matter what caused the jumps, whether it was self-reinforcing feedback loops, wild speculation, panicked deleveraging. The fact was that they existed and cropped up time and again in all sorts of markets.
The upshot of Mandelbrot's research was that markets are far less well behaved than standard financial theory held. Out at the no-man's-land on the wings of the bell curve lurked a dark side of markets that haunted the quants like a bad dream, one many had seemingly banished into subconsciousness. Mandelbrot's message had been picked up years later by Nassim Taleb, who repeatedly warned quants that their models were doomed to fail because unforeseen black swans (which reputedly didn't exist) would swoop in from nowhere and scramble the system. Such notions threatened to devastate the elegant mathematical world of quants such as Cootner and Fama. Mandelbrot had been swiftly attacked, and-though he remained a mathematical legend and created an entire new field known as fractal geometry and pioneering discoveries in the science of chaos-was soon forgotten in the world of quants as little more than a footnote in their long march to victory.
But as the decades passed, Mandelbrot never changed his mind. He remained convinced the quants who ignored his warnings were doomed to fail-it wasn't a question of if, only when. As he watched the markets fall apart in 2008, he saw his unheeded warnings manifest themselves in daily headlines of financial meltdowns that presumably no one-or almost no one-could have foreseen.
If vindication gave him any pleasure, Mandelbrot didn't show it. He wasn't so cavalier about the pain caused by the meltdown as to enjoy any sort of last laugh.