The discipline of quantitative finance has really taken a beating this year. With so many economists blaming risk management techniques, and the roles financial engineers played in the credit bubble, this sector of the financial industry has suffered a major decline in confidence.
Nassim Taleb’s recent podcast interviews with Bloomberg’s Tom Keane couldn’t hold back his disdain for quantitative finance models. Rely on Taleb to be an iconoclast, especially since his funds have prospered during the downturn, and expect him to pitch his latest work, but what he says is of great pertinence to folks in mathematical finance, and to the rest of the workforce, as corporations retool and respond to drastic turns of fortune.
First of all, to sum up Taleb quickly (something he will detest), his point is, the use of historical analysis to predict present and future markets is impossible (history is different from the present). Also, the prevalence of thirty-somethings running huge funds using mathematical models is also not good. (Quantitative finance, or quants, are responsible here). Taleb’s latest work states that the more scientific a person’s reasoning is, the more unreliable it is. And he affirms that in the trading industry, where the eggheads, or quants, of the younger generation come up with brilliant theories on trading, and more established ‘fat Tony’ characters use their intuition and life experience in traditional banking. Traditionally, banks trust their money to Fat Tony types, who rely on their veteran instincts; the eggheads, instead, rely on theoretical means to understand the economy, using academic theory.
The failure of recent quants to survive their own bets with other people’s money is a sorry proof for Taleb. And you would think that quantitative finance would be taking a major backseat, having lost its driving privileges. But I doubt that quant-fi will be making its way out the doors of any wall street trading house. Not with the advances made during this period.
A buddy of mine at a large investment firm asked me if our firm, Next Acropolis, would be helping banks to recruit students in math, finance, econ, and their jewel recruits in computer science and financial engineering.
I told him that this was our purpose, and that so long as banks needed skilled graduates, that we were there to help.
A few thoughts I wanted to impart to graduates in finance, who are unnerved by this crisis, as well as students preparing to graduate in the next 24 months, is that the economy still depends on them. This bears true with financial engineers, whose metier suffers from blame in the media, as well as students in all other disciplines.
Truth be told, many banks have lost the deposits of their customers. This underlies the frozen nature of global finance. Credit depends on banks’ lending to each other, and so long as they fail to do so, the rest of the economy is unable to fund its own expansion. Most businesses depend on taking loans to finance their inventories, and help their consumers fund purchasing that inventory. But so long as banks are tied up in paper losses stemming from loans they cannot refund, then the global system is tied up in knots, consumer credit does not flow, and buying does not take place.
Germany, China and the US are the world’s biggest exporters. The US, the world’s preeminent consumer. Get used to this fact: if banks can’t untie these knots, and make their own money move around the globe, they will fold. Simply put.
The sale of Merrill Lynch to Bank of America, or the sale of major pieces of major investment banks to the US treasury means that old management answers to new owners. Let’s put it this way: say you bought a car, and learned that it was broken, what would you do? You’d fix it. And that’s what’s going to happen this quarter, as mortgages get worked out, so that banks don’t have to become real estate investment trusts, with thousands of sagging residential assets on its books. These are public companies — and the leadership is paid to make things profitable.
Phase two comes when CEOs open up the trading book, and learn how to unravel the financial engineering that got them into trouble. It will require working between banks to forgive and delay many debt repayments (since many banks borrowed from eachother to fund trading). This will create new types of confidential third party courts where banks can submit an appeal akin to bankruptcy, but only in the case of a single loan gone bad.
What you will see is banks doing for each other, what they had to do for consumers duped with alt-A, subprime, and other toxic mortgages. Instead of having consumers pay for obscene, and illegally packaged loans that cause foreclosure (and bank closure!), they will allow for consumers to get a workout, and receive terms they can afford. This keeps the home in the hands of paying debtors, who’ll stay in their homes. The banks will get into the habit of doing a similar workouts between eachother, so that they can gradually repay eachother for funds related to trading losses.
Our president will preside over a large cleanup period, that will likely proceed much faster than the entire term of his presidency. This much I believe: for the US, and other nations to avoid mass chaos and near-term depression, they will have to declare their troubles, then work them out in some confidential way, with some government enforcement.
We are in an era of Bretton Woods II. And out of it, we’ll craft ad-hoc financial institutions that will mend the global financial system. And in the process, we will not throw out the emergent disciplines of mathematical finance with the bath water. Instead, we will simply create more flexible, and fault-redundant ways to support ‘risk management’ — formal, institutionalized risk taking.
And for all those quants out there worried about the future. Truth is, we can’t do it without you. We need the dark pool algorithms, the proprietary, automated, intelligent tools to render trading more reliable, and help us transition more safety into stock markets. Stocks aren’t as reliable as other investment vehicles, but for us to create better retirement systems, we need them to work for us in a civilized way.
So moral to the story: just because a discipline isn’t performing well in the real world, it doesn’t mean that the discipline will disappear. This certainly didn’t happen to my discipline after the dot-com crash (computer science & software engineering). Society needs its educated members, and will place them wherever they are needed the most. It is endemic of our populace to think that an apolcalyptic future awaits us; truth be told, the more we collaborate, come together, agree to help out then create transparency into each other’s problems, we succeed. Be prepared for a roller coaster 2009, with a strong recovery, as we reengineer a stronger, more resilient new economy.
Recent quant grads buck trends, despite aspersions cast on their discipline