On Wednesday, August 8, not long after the markets closed, 200 of the smartest people on Wall Street gathered in a conference room at Four World Financial Center, the 34-story headquarters of Merrill Lynch. August is usually a slow month, but the rows of chairs were full, and highly paid financial engineers were standing by the windows at the back, which looked out over black Town Cars below and the Hudson River beyond. They didn’t look like Masters of the Universe; they looked like members of a chess club. They were “quants,” and they had a lot to talk about, for their work was at the heart of one of the most worrisome summer markets in decades.
The conference was sponsored by the International Association of Financial Engineers (IAFE), and its title asked, “Is Subprime the Canary in the Mine?” “Subprime” borrowers are home buyers whose poor credit history means they don’t qualify for market interest rates. Loans to subprime borrowers, which have become more common in recent years, typically have variable interest rates; as those rates rose, many borrowers were failing to meet their mortgage payments. Their defaults, in turn, had triggered unexpected problems in the market for financial instruments known as derivatives.
A derivative is a tradable product whose value is based on, or “derived” from, an underlying security. The classic example of a derivative is the option to buy a stock at some time in the future. In comparison, more recent derivatives are extraordinarily complex, and they had been invented by quants like the ones at the Merrill Lynch headquarters.
Things had started to go wrong in June, when the weakness in the subprime market had led to the collapse of two huge funds at the investment bank Bear Stearns, costing investors some $1.6 billion. When the quants gathered in August, the most pessimistic among them imagined that the collapse of the subprime market could lead to a shortage of credit as banks dealt with defaults. That would chill the economy, causing worldwide job losses, still more defaults, decreased spending, and withdrawals from the stock market, culminating in a global recession, or worse.
The panel was moderated by Leslie Rahl, an MIT graduate and the founder of Capital Market Risk Advisors. Her job is to advise companies on risk and help them understand the products quants invent. But understanding was in short supply in August. Some of the quants’ financial products had collapsed in price, with unexpected consequences in another financial sector: the trading of equities.
The stock market had plunged in July and had been behaving erratically since. In the weeks after the conference, an organizing narrative of sorts would develop. But at the time, the economic view was dizzying. The market would drop precipitously over the course of a day, then rebound nearly to its previous level in the last 45 minutes of trading. Stranger still, stocks with strong financial reports and a good outlook were falling; these were the blue chips, which normally rose in uncertain times. Stocks with weak financials and a gray future were rising. These were normally the dogs that got dumped.
No one quite knew why, yet, but the market’s odd behavior would turn out to be closely linked to the work of the quants. In addition to creating arcane financial products, quants have been pushing the frontiers of computer-driven trading systems, and not enough of those systems were working the way they were supposed to–or, to put it more precisely, the way they were supposed to work turned out to be counterproductive in volatile times like these.
Quants like the ones at the August conference were knee deep in the troubles threatening the global financial system. It all raised two very good questions: Who exactly are the quants? And what do they really do?