Disingenuous quant bashing

My last post:

Why do scientists go into finance?

started out as an introduction to this post, but grew a life of its own.

I am quite fed up with all the quant bashing we’ve seen in the media since the current crisis began. A recent article by Felix Salmon appeared in Wired Magazine:

Recipe for Disaster: The Formula That Killed Wall Street

I actually thought the article was quite good. I did take a small exception to the last paragraph though:

In the world of finance, too many quants see only the numbers before them and forget about the concrete reality the figures are supposed to represent. They think they can model just a few years’ worth of data and come up with probabilities for things that may happen only once every 10,000 years. Then people invest on the basis of those probabilities, without stopping to wonder whether the numbers make any sense at all.

I think this statement exaggerates the situation. I took it as a minor deviation from an otherwise good article. Unfortunately, he gleefully followed up his article with a reference to Paul Wilmott in:

When Quants Don’t Think

Wilmott is quite right that quants need to stop being so passive. But he also knows full well that they won’t be. It’s far too easy for them to go along with what everybody else is doing — and that’s exactly why the copula function turned out to be so disastrous.

As I alluded to in the last post, it really has nothing to do with going “along with what everybody else is doing”. It is more about doing what your boss tells you to do. It is wrong to point the finger at the quants when the real culprit was upper management. The quants had absolutely no authority and no incentive to reel in excessive risk taking. As I’ve said, the quants know quite well the strengths and the weaknesses of the models they employ. If you asked them if the models satisfactorily represented the risks in CDOs, they would quite plainly say “no”. Did anyone ask? Of course not. They were paid to build models and that is what they did. When the models expressed risk beyond what upper management thought it should be, the quants were forced to dumb down the models. Period. They were making too much money. In fact, as I’ve said in

CDOs and Risk Management,

CDOs were great because they represented a blind spot in existing risk management systems based on VaR. VaR essentially defines what a “tail event” would be given a particular financial model of a portfolio. Typically, this “tail event” is the loss at which you are not likely to exceed on average 1 out of 100 times. One out of 100 times, a CDO is not likely to lose ANYTHING. Hence, it’s risks do not show up on any risk system. This is what I refer to as “risk management arbitrage”. What these models do not tell you is the loss you can expect “if a tail event occurs”. As we now know, if a tail event occurs, a CDO can lose EVERYTHING.

Talking heads like Nassim Taleb are extremely unhelpful and are, in fact, counterproductive. He has been on the war path for years telling us that securities do not follow a normal distribution. HELLO!! We know that already. There is not one risk model I have ever seen (except some third party models that are not worth the disk space they use up) that is based on the assumptions that Nassim Taleb is attacking. This whole idea that quants assume normal distributions is completely bogus. Taleb has always been irritating to quants for his completely content-free rants and his straw man arguments. Now that we see him on Bloomberg almost every day, it is time someone puts him in his place.

It is true that the Black-Scholes model assumes returns are normally distributed, but that is pretty irrelevant. What the Black-Scholes model allows you to do is to convert a price into another number called “implied volatility”. The implied volatility shares a purpose similar to the yield of a bond. It helps you compare related securities. If two similar companies have outstanding bond issues with similar coupons and similar maturities, the yield of the bonds help determine which is the better value. Do people go on rants about how meaningless the “yield” is? No. The yield on a bond is based on a flimsier model than Black-Scholes and no one seems to care. To compute yield, you must assume the issuer is going to make every interest payment and that you can reinvest that interest payment at the same rate throughout the life of the bond. The yield is then the discount rate under this pretty bogus model that matches the theoretical price to the market price of the bond. When you really think about it, the yield of a bond is a pretty bogus concept. However, it does help make informed decisions about the relative valuation of bonds. The implied volatility serves precisely the same purpose. A fairly bogus model spits out a number that helps make informed decisions about the relative value of derivatives.

For Nassim Taleb to go on the media circuit complaining about black swans and the fallacy of normal distributions, it is as if a former bond trader suddenly decided to go on multi-decade crusade against the use of bond yields. Ok. We get it already.

It would be less disturbing if we didn’t see Paul Volcker going on the circuit parroting things that Taleb says. Toward the end of the video I posted on

A Call to all Finance Bloggers

we see Volcker referring to “black swans” and goes on a rant about financial engineers. His words are clearly straight out of Taleb’s mouth. They probably had dinner together at Davos or something. So now that Volcker has been infected by these bogus ideas, that is worrisome because Volcker obviously has a line to President Obama. The last thing we need is to get distracted by going after the quants.

Before leaving, let me turn some attention to Paul Wilmott. His recent turn against his own, i.e. his recent quant bashing, is disturbing. Paul Wilmott wrote some decent books on mathematical finance and derivatives pricing. But what he is probably more known for these days is his quant forum at Wilmott.com. Currently, there are over 66,000 registered users signed up at Wilmott.com. Long ago, I was a member myself and I even published my first finance-related research paper there. At the time, it was a decent place populated by knowledgeable quants. I got my first job on Wall Street due to the help of a friend I met on that forum. Unfortunately, in the last 5 years or so, the place has turned into a zoo. It is impossible to have a decent conversation there anymore as there is no form of moderation. He doesn’t care, just as long as more eyes turn to his web site. It is little more than a PR campaign.

Both Nassim Taleb and Paul Wilmott are opportunistically spouting nonsense about quants that really do a disservice to some really quite intelligent, experienced, and knowledgeable people who happen to be friends of mine.

A Call to all Finance Bloggers

It is clear we are in a financial crisis. If you have any doubt about how serious this crisis is, have a look at Volcker’s statement:

What should we do about it?

I am a mere four years into my finance career, but have been a scientist at top research institutions for a lot longer than that. One of the strengths that I can offer is knowing who to listen to. At this point in history, the best minds and the best analysis is coming from financial blogs. Unfortunately, there remains a stigma about blogs and serious policy makers tend to dismiss this form of media. That is a mistake that is slowly correcting itself, but not fast enough considering the needs of our times.

I propose that all financial bloggers join forces and work together collaboratively in the truest sense of “Web 2.0″ to come up with a plan that can help stabilize the global financial markets. Let’s take President Obama at his word when he said he would listen to all good ideas. Let’s give him a good idea that is endorsed by prominent financial bloggers. All would be welcome, but in particular, I would like to see a plan endorsed by

• Nouriel Roubini (RGE Monitor)
• Barry Ritholtz (The Big Picture)
• Brad Setser (Folow the Money)
• Yves Smith (naked capitalism)
• Calculated Risk
• Michael Panzner (Financial Armageddon)

Let’s be productive and find a solution.