Linkage is one of Bookstaber’s favorite topics. He believes that quants’ instruments have “linked markets together that wouldn’t normally be linked,” and that such linkages are dangerous because they are unforeseen.
Berman and others I spoke to agreed with many of Bookstaber’s concerns. “The products are getting an order of magnitude more complex,” says Berman. “Things change slightly, and get correlated where they weren’t correlated before.” Or, as he put it a little less gnomically, “You can’t make it without understanding it, but you can buy it.”
Beneath all this beats the great hope of the quants: namely, that the financial world can be understood through math. They have tried to discover the underlying structures of financial markets, much as academics have unlocked the mysteries of the physical world. The more quants learn, however, the farther away a unified theory of finance seems. Human behavior, as manifested in the financial markets, simply resists quantification, at least for now.
Emanuel Derman remembers dreaming of such a unified financial theory in the early 1990s, a little after he had made the leap from the university to the Street. But those dreams, he says, are dead. Quantitative finance “superficially resembles physics,” he says, “but the efficacy is very different. In physics, you can do things to 10 significant figures and get the right answer. In finance, you’re lucky if you can tell up from down.”
So up was down and down was up this summer, and Bookstaber and others hope it is a warning that will be heeded, rather than the beginning of a major systemic crisis.
And was subprime the canary in the mine? It was a question the panelists and the audience who showed up at Four World Financial Center last August are only beginning to answer. Leslie Rahl, for instance, cautiously told me in a follow-up e-mail that it is “looking more and more like the answer is yes.” Many signs have suggested so, from job losses to a continuing credit drought to a weakening dollar, but that history has not yet been written.
As a prelude to the panel discussion, Rahl asked the audience to predict whether credit spreads would shrink or widen in the coming months. She was talking about the difference between the price of a treasury bond and the price of a riskier corporate bond, a standard Wall Street gauge for the health of the economy. A widening credit spread is generally seen as a sign of uncertainty, and a narrow spread as a sign of optimism.
“How many think spreads will widen?” she asked.
The hands of about half the smartest people on Wall Street shot up.
“And how many think they’ll narrow?”
The other half–equally smart–raised their hands.
“Well,” she said. “That’s what makes a market.”
If they didn’t know, nobody could.
Bryant Urstadt is a freelance writer based in New York. His work has appeared in Harper’s and Rolling Stone.