

How a swashbuckling breed of computer scientists nearly destroyed Wall Street - jakarta
http://online.wsj.com/article/SB10001424052748704509704575019032416477138.html?mod=WSJ_hps_MIDDLESecondNews

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JCThoughtscream
Oh, sure, blame the guy that made you the billions in the first place for not
knowing that you were fucking around with the underpinning factors. Real
mature, Wall Street. Real mature.

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joe_the_user
There's enough blame in this situation to cover everyone involved.

On the level of modeling, the fundamental flaw was assuming that stock prices
could be equated to _independent_ , normalized, random variables. When these
assumptions break down, you can still _"make money most of the time"_ but
you're downside becomes _unlimited_. Ponzi schemes make money most of the time
too...

But on the level of the banks, investment houses and large investors, the
problem was not realizing that an investment model is a _leaky abstraction_.
You can't leave your investing to people who only see random variables.
_Prudence_ , the watch-word of traditional investing, encompasses more than
probabilistic expectation (just as causation is more than correlation).
Leaving fundamental decisions about investing to the quants is _imprudent_.
Anyone not blinded by the shine of the new models realized this but that was a
minority.

Of course, along with quant-investing in particular, one must include the
whole Alan Greenspan school of "Market Rationality", including the move to
"fair value" accounting. And that's a big elephant.

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Dilpil
So lets see. A bunch of people bought stock. Stock rises and a bunch of people
get rich. Somebody sells stock. A bunch of people get nervous and sell their
stock, sending prices plummeting.

This story is as old as Wall Street itself. That quants were involved was
incidental, thought it makes for some interesting twists.

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yummyfajitas
Regular people overvalue houses, with the encouragement of the government.
Banks cash in and some buy into the hype. Who to blame? I know, blame those
geeks who crunched some numbers.

But whatever you do, don't blame the women who caused this problem in the
first place:

<http://www.youtube.com/watch?v=Ubsd-tWYmZw>

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aaronblohowiak
Regular people are incentivized to pay as much in interest on their homes
through tax deductions. With the tax deductions, paying an interest-only
mortgage become MUCH less expensive than rent, so "buying" a house and
planning to flip it after the interest-only period is up was an economically
sound decision (and a lot of people still stand to gain.) This did drive up
the price of housing as more people were entering home ownership.

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cynicalkane
No, tax deductions simply make home ownership competitive with rental
companies, who can also deduct their interest expense.

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lolcraft
Sure, let's blame the computer scientists, not the dangerous Wall Street
culture of getting rich quick with essentially regulated gambling. That'll fix
things ;)

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rdtsc
That is a general tendency of blaming whatever cannot be explained or
understood.

The primitive men blamed natural phenomena and diseases on the gods and
witches. Today we blame it on the nerdy guys with glasses and pocket
protectors.

When they make money, the financial giants quickly take credit for it: "oh
look we are making money, _we_ are so awesome", when the nerdy guys screw up,
then they are scapegoated, "oh look, it is those damn nerds and their voodoo,
that screwed us."

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whyenot
Some of the "nerdy guys" actually did screw up. They deserve some of the
blame. Hopefully in the future quants will be more careful about checking the
assumption of their models, especially if it may have repercussions on their
reputations and careers. That doesn't mean you don't also blame the others
that were involved. There is more than enough blame to go around.

~~~
BrentRitterbeck
Yes, some of them did screw up, the same way that early physicists screwed up.
Quantitative finance, as we know it, is still a very young field. There are
going to be hiccups along the way. Knowledge is not developed in a vacuum.

We had Archimedes looking at physics over 2000 years ago. It took until the
late 17th century for Newton to develop the calculus, a tool that allowed us
to really start advancing physics. Whether you want to start "quantitative
finance" with Black and Scholes, Markowitz, or even Bachelier, we have had at
most a little over 100 years of trying to pin this beast down. I think people
fail to realize that.

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spazz
The problem isn't the quants, it's the people that doesn't understand what the
quants do and that a model is only a model.

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carbocation
This is much like saying that Smith & Wesson shoots people.

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fauigerzigerk
No, it's like saying the architect who built the house that collapsed in an
earth quake must take some blame, not just the company that funded the
building.

And I agree with that. The models were brittle and the math/CS people who
created them will have to take responsibility for that. Obviously there are
others who must share that responsibility.

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aaronblohowiak
The decision to massively dump positions was a human one. This is just another
example of what happens when you get a bunch of independent agents with
imperfect information scared -- they cut their losses. In a market, this
triggers a spiral effect of lowering prices, encouraging more people to cut
their losses. Wether this is automated or manual, this is not a new thing.

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nkassis
I dunno if it's just me or where they not clear as to what they meant by
complex systems. Where they talking about just complicated things or more
like: <http://en.wikipedia.org/wiki/Complex_systems>. I know it's not a really
important point of the article but I can see how this type of stuff would make
no sense to everyone but people who have knowledge of what complex systems
are. Basically I can see how the management of these companies didn't want to
interfere with what they didn't understand but seemed to work. But now it's
easy to say that stuff was all crap and cause us billions. I hope that some of
the science these guys were working on can be salvaged (the good parts at
least).

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zitterbewegung
Couldn't we model business cycles and also economic downturns / recessions
also? Attempt to quantify bubbles if they possibly exist? Or would that be too
computationally hard?

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BrentRitterbeck
How would you model something like 9/11? There are too many random events that
occur every trading day. Some are good. Some are bad. The best we can really
hope for is that we notice things are going to hell before everyone else does.
That allows us to get out early and save our own ass. That's the truth about
the markets. The models we have help us to understand things during relatively
normal times, but they are just models. You can't rely on them 100% of the
time. At some point, you have to ask yourself, "Does this make sense here?"

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noname123
I don't get it , don't most high frequency trading shops not hold overnight
positions?

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BrentRitterbeck
Not all quant work deals with high-frequency trading.

