In one of the private emails that triggered the latest Wall Street scandal, Goldman Sachs trader Fabrice Tourre, one of those "quants" (quantitative analysts) who were the hottest property in finance during the recent boom, wrote about how he created "all these complex, highly leveraged, exotic trades without necessarily understanding all of the implications of those monstrosities!"
He noted that "the whole building is about to collapse any time now. Only potential survivor, the Fabulous Fab (himself)..." Then his message turned ironic: "Not feeling too guilty about this, the real purpose of my job is to make capital markets more efficient and ultimately provide the US consumer with more efficient ways to leverage and finance himself, so there is a humble, noble and ethical reason for my job; amazing how good I am in convincing myself!" (1).
These quotes summarise the goings-on in the world of high finance – the claptrap about the virtues of financial innovation, the cynicism, the positive reinforcement and self-righteousness of the creators of Frankenstein monsters that turn against their creators.
Theoretical finance was born in 1973 with the work of Fischer Black and Myron Scholes, linking the implicit value of an option to the value of the underlying asset. Shortly afterwards, Robert Merton developed the mathematical aspects of the model. The Black-Scholes formula – sometimes referred to as Black-Scholes-Merton (BSM) – and its many variants formed the foundations of an infinite number of derivatives.
These works were inspired by the 1900 dissertation of French mathematician Louis Bachelier. It is worth noting two other influences, Milton Friedman and Eugene Fama. Friedman, the best-known figure of the Chicago school of economics and an ardent defender of free markets, propagated the idea that a model need not be based on realistic assumptions; all that mattered was that its conclusions be considered true. Fama, also of the University of Chicago, is the father of the "efficient market hypothesis". Since his initial work in the 1960s, the hypothesis congealed into dogma, imposing tautology as a standard mode of reasoning. And of course any government intervention brought inefficiencies to otherwise efficient markets.
In 1997 theoretical finance obtained the ultimate reward when Myron Scholes and Robert Merton were both awarded the Nobel prize in economics (Fischer Black had died two years earlier but was cited as a contributor). Unfortunately, less than a year later, the hedge fund Long-Term Capital Management (LTCM), based on their work and of which they were partners, collapsed, threatening to bring down with it many of the largest international financial institutions. It took the intervention of the New York Federal Reserve to avert a catastrophe. When John Meriwether, a legendary trader and founder of LTCM, was asked if he thought markets were efficient, he replied: "I make them efficient" (2).
More scares were on the cards with the creation of "rocket scientists". After every crisis, financial innovation would resume its meteoric growth. The new dogmas had invaded financial institutions, business schools and governments (3). The whiz kids, as masters of the universe, believed they had tamed risk, and knew how to calibrate it scientifically. It was a repeat of the "best and brightest" episode during the Vietnam era when an earlier generation of rocket scientists managed the war "scientifically", with disastrous results.
In a May 2000 speech the Federal Reserve chairman Alan Greenspan explained why risk transfer techniques had made the financial system and the economy as a whole stronger.
"Significant developments in technology and in the pricing of assets have enabled innovations in financial instruments that allow risks to be separated and reallocated to the parties most willing and able to bear them and the degree of specialisation by financial intermediaries changed dramatically. ... As we stand at the dawn of the twenty-first century, the possible configurations of products and services offered by financial institutions appear limitless. There can be little doubt that these evolving changes in the financial landscape are providing net benefits for the large majority of the American people. The rising share of financial services in the nation's national income in recent years is a measure of the contribution of the newer financial innovations to America's accelerated economic growth" (4).
'Very bad things would happen'
Opposing voices were marginalised until the 2007-08 financial crisis. In the words of the mathematician Benoit Mandelbrot: "People have taken an inapplicable theory – that of Merton, Black and Scholes, based on the work of Bachelier, which dates back to 1900 – and which makes no sense. I have been saying this since 1960. The theory does not take into account instant price changes that constitute the norm in economics. It sweeps essential information under the carpet ... It was unavoidable that very bad things would happen. Financial catastrophes were often caused by very visible phenomena that experts have refused to see" (5).
The philosopher Nassim Nicholas Taleb, once a trader in New York, has been a consistent critic of the "intellectual swindle that was dressed up with mathematics" (6). Quants pretended to reduce risk at the very time they amplified it – one of the advantages of signs and symbols is that they create a smokescreen and separate the initiates from everyone else. Once upon a time, Latin played that role. Now mastery of mathematics confers high priest status.
The quest for laws that would, as in the physical sciences, explain how the world works proved futile. Andrew Lo, a finance professor at the Sloan School of Management at MIT (Massachusetts Institute of Technology), has famously said that in the physical sciences three laws explain 99% of behaviour: in finance 99 laws would explain at best 3%.
Still, no counter-revolution is in sight. The continuing success of the quants is assured by the vested interests of the financial industry and the promises of alchemy. To quote Mandelbrot again: "Financiers are very attached to this theory: it is marvellously simple, you can learn it in a few weeks and then live off of it your entire life" (7). As for alchemy, it has since time immemorial captured people's imagination. Through equations and algorithms it now promises to turn lead – toxic paper – into AAA securities. Some fictions are useful: as Greenspan explained, value was created in the process, and that justified all the bonuses.
SEE ALSO Goldman Sachs, always the winner
(1) Steve Eder and Karey Wutkowski, "Goldman's 'Fabulous' Fabs' conflicted love letters", Reuters, 26 April 2010.
(2) Ibrahim Warde, "LTCM, a hedge fund above suspicion", Le Monde diplomatique, English edition, November 1998.
(3) Scott Patterson, The Quants: How a New Breed of Math Whizzes Conquered Wall Street and Nearly Destroyed It, Crown Business, New York, 2010.
(4) Alan Greenspan, speech delivered in Chicago, Illinois, 4 May 2000.
(5) Benoit Mandelbrot, Le Monde, 18 October 2009. See also Benoit Mandelbrot and Richard L Hudson, The Misbehavior of Markets: A Fractal View of Risk, Ruin & Reward, Basic Books, New York, 2006.
(6) Nassim Nicholas Taleb, The Black Swan: The Impact of the Highly Improbable, Random House Trade Paperbacks, 2010. (7) Mandelbrot, op cit.
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