A couple of weeks ago there was an interesting opinion piece in the NYTimes about how physicists are the harbingers of doom, and are responsible for the end times. Or, more specifically, it’s because of physicists that the financial markets are in tatters all around us.
The basic idea is that greedy physicists have gone to Wall Street, cooked up all sorts of arcane derivative products, and subsequently unleashed these weapons of mass destruction on the financial markets. This sentiment is best epitomized by a statement from none other than Warren Buffett (perhaps the world’s most successful investor, and certainly the world’s richest): “beware of geeks bearing formulas”
Undoubtedly there is some truth underlying this sentiment, in the sense that there are plenty of (mostly lapsed) physicists working on Wall Street. And these physicists have indeed helped develop fairly mathematical and esoteric models for the markets. These models made it possible to leverage excessively (i.e., invest significantly with very little money down), and made it exceedingly difficult to evaluate risk. And it sure is convenient to find scapegoats on which to blame the global recession. But, fundamentally, the markets are in free-fall because of rampant and unfettered greed. And it turns out there was plenty of that to go around. For the last few years it was simply too easy to make huge sums of money by taking on large risk. So long as the markets went up, all was good. But when there’s the possibility to make vast sums of money, there’s an equal and opposite possibility of losing vast sums of money. Newton’s 3rd law of finance, I suppose. And this law has been much in evidence as of late.
March 22nd, 2009 at 4:33 pm
I think there is some truth to it. The models modeled some aspects of the financial systems very well and people forgot over that that that aspect is not the all of reality. There were essential effects not captured by them but that remained little discussed (though some people did point this out and build their strategies on the over reliance of others on such models, e.g.: http://en.wikipedia.org/wiki/Black_swan_theory).
And this is a theoretical physicists prejudice. We are used to our theories being exhaustive. The difficulty merely being to analyze the theories rather than question them. Economists who should have been the scientists to point out that the models were incomplete failed completely. Maybe because the models described the parts of the system that agrees best with their preconceptions, or because economy is too often too dogmatic and not empirical enough.
March 22nd, 2009 at 4:52 pm
So, people blame Einsten for atomic bombs. That’s silly. It is not the underlying “theories” that is responsible for the current mess. I’d be surprised if those “quants” didn’t know the limitations of their models. The problem was giving the credibilities to those financial products that few cared to really understand how they were made, what their assumptions were, etc. In the culture of making money, whatever generates profits make their way onto the world and create all those bubbles.
March 22nd, 2009 at 5:07 pm
Not only greed, but I suspect that the executives with the ultimate authority to make the hard calls weren’t nearly as smart as the physicists who work for them.
A friend of mine who left physics for finance told me once that the hardest thing he had to adjust to after leaving academia was the fact that, unlike in academia, he couldn’t take it for granted that his superiors were even of average intelligence.
March 22nd, 2009 at 5:37 pm
Clearly, they should have been investing in spherical cows.
March 22nd, 2009 at 5:38 pm
To this non-expert’s eye, it seems to me that there was essentially one bad assumption: That real-estate prices would climb indefinitely. If you make this assumption, all of the crazy mortgages make sense; if you don’t, they look crazy.
Another interpretation of that: If you assume fluctuations from the trend in real-estate value in different regions are random and uncorrelated, the law of large numbers may appear to provide a cushion that is not really there.
The issue here is not model limitations, but systematic errors (i.e., common sense). Unfortunately, common sense often does not stand a chance against opportunistic greed; even though there were respectable voices (such as The Economist magazine) pointing out this error.
March 22nd, 2009 at 6:13 pm
I am not a fan of Taleb and The Black Swan and I won’t offer my own comments on this mess, however, I do think that before people start getting to philosophical about stats, I recommend reading the following review of The Black Swan by David Aldous
http://www.stat.berkeley.edu/~aldous/157/Books/taleb.html
March 22nd, 2009 at 6:19 pm
Oh, so the fault is with Greedy People, and not with those virtuous academics who cooked up the means whereby the Greedy People could go out and destroy the world.
In short, to adapt the favourite catch-phrase of the NRA: *mathematics* doesn’t kill stocks, *people* kill stocks.
Actually, the people I blame most are not the quants themselves, but the “mathematical finance” and [snicker!] “mathematical economics” people in academia. Having failed as mathematicians/physicists, they turned to cooking up this bullshit; when things were going well, they were all too eager to claim the credit; now when their intellectual phoniness is exposed, the fault lies with Somebody Else.
March 22nd, 2009 at 6:27 pm
I believe ex physicists or quants in general were only directly involved in this mess through designing some derivatives (mainly CDOs) which propagated risk to different organizations, but as you have mentioned, the main cause of the crisis comes from the excess greed in the financial market. The real geek is actually the quant trader who made 40% return for Citadel last year, while the market was in a downward spiral. In such a market when all the parties are loosing, it’s absolute intelligence that can make a penny out of such unpredictable volatility. But, alas, the layman doesn’t see this and tries to blame everyone including the geek for the failure.
March 22nd, 2009 at 6:40 pm
“beware of geeks bearing formulas”
Surely a more appropriate version would be “Beware of geeks bearing Greeks.”
March 22nd, 2009 at 6:51 pm
I say tax physicists 90%…
March 22nd, 2009 at 7:19 pm
The article in the NY times was full of errors and it amounted to an ad hominem attack which does not explain anything. Appeals to excessive greed don’t either. The incentive structures prevailing throughout the financial system are perverse:-bonuses based on revenues even though the revenues are tainted with contingent liabilities; non recourse mortgages, 100% securitization of mortgages where issuers do not have any skin in the game so to speak; credit rating agencies paid by the issuers of the debt to be rated; Basil One rules for bank reserves which provided powerful incentives to create insurance contracts such as credit default swaps so that banks could reduce reserves. Bad economic policies:-everyone should have a home (everyone should have a Porsche too!!); crippling the investigative staff at the SEC by placing he decisions to start investigations in the hands of political appointees.
Those two things loaded the gun. Cheap money pulled the trigger. To blame people with backgrounds in the natural sciences, math and economics is just plain ignorance.
March 22nd, 2009 at 7:21 pm
Ever seen the Arronvsky film Pi, about the Numbers Theorist who tries to figure out the Stock Market?
I might watch it tonight, after reading this article…
March 22nd, 2009 at 7:48 pm
Physicist? Well, physicists, mathematicians, and other analytical specialists who developed financial derivative products.
But it was the managers who hired them, gave them the assignments, and the executives who approved the resulting products for sale who are responsible for creating the systemic Ponzi finance.
And the rating agencies who put their stamp of AAA approval to fake products.
But, alas, it was the top executive CEOs who approved and actually ran the Ponzi businesses who bear the ultimate highest responsibility. They are the one who sold trillions dollar worth of credit-default swaps with only a few percent of capital, who reaped billions of profits from the scheme, knowing full well they were play fast and dangerous. No advanced math required to understand CDS, the biggest gambler of which being AIG. Even a high school dropout, or a Mafia foot solder, should have no problem understanding that if you have only $1 on hand and sold $1,000,000 of insurance coverage you are a criminal running a racket.
Hey when mafia boss Gotti was arrested for drug trafficking, was he so low and stupid as to blame the whole thing on the chemist who decoded the chemical structure of heroin? No, he took it like a man, a dapper mafia boss, with pride. Unlike these coward CEO rats.
March 22nd, 2009 at 9:05 pm
Daniel, did you actually read the article? I thought it was pretty even-handed and specifically DIDN’T resort to blaming quants for the financial crisis. The quants, being pointy-headed, where probably well aware of the assumptions/limitations built into the models that were used to develop new derivative products. Unfortunately, after the new derivative products were developed, they were handed over to the monkeys at the trading desk, where the only concern has ever been: “How can I sell as much of this product as quickly as possible?”
March 22nd, 2009 at 9:42 pm
Greed was always there and will always be there, it’s completely ridiculous to blame excessive greed in the market. The real problem was lack of proper regulation and oversight. If proper regulation and laws are in place greed can be turned into a positive force, but unchecked it will quickly wreck havoc.
What killed banks and financial institutions was rampart speculation allowed by savings market deregulation and emergence of financial tools which allowed for an excessive leverage. This allowed traders to leverage the hell out of their investments and what’s more while they shared in profits they didn’t share in losses. Obviously a sick arrangement and that it was even allowed to take place speaks volumes about the ignorance of business leaders and corruption of politicians.
Now government has to implement safeguards into the system: no speculation with peoples savings, no hard to value derivatives, no loans to those who won’t pay them back and limited consolidation. No firm should ever be allowed to reach ‘too big to fail’ state as it will eagerly exploit it. Many small firms are always better then a single huge one, this is what builds robustness into the system as 100 CEOs are way less likely to make the same mistake then 10 CEOs.
March 22nd, 2009 at 9:46 pm
Greed, like gravity, is a constant so it explains no changes by itself.
It’s best if we look towards “principal-agent” type issues. The incentives of the managers were badly misaligned from those of the shareholders/owners.
March 22nd, 2009 at 9:52 pm
The basic issues have to do with distancing the hens from the watchdog.
In the case of the subprime mortgages, Fannie and Freddie were too far away from the eligibility of the debtor process.
While, in the case of CDS and CDOs, quants provided the obfuscation distancing, or the glittering packaging containing foul meat which was branded AAA and sold to dumbfounded buyers. I’m more inclined to believe that physicists were used rather than wholehearted participants in the fleecing ploy.
Sadly, the worst of the players, AIG and others, with their good name and unrelenting low debt insurance premium prices, from unlawful nil backings to cover their insurance, concentrated what was supposed to be a disperse global risk.
March 23rd, 2009 at 12:38 am
There is a most interesting asymmetry among physicists and mathematicians when it comes to the financial world.
When the going is good, it is unquestionably clear that people with manly tools from stochastic differential equations are the only ones who can take on the job of designing the fantastic new world where it is finally possible to have low-risk controlled profits.
When the music stops, of course, the fault is entirely that of the not-too-smart managers who hired these innocent people.
Some questions:
(a) Does anyone see a problem with this asymmetry?
(b) When it is clear that adopting a certain point of view (in a mathematical sense, within bounds of parameter uncertainty) implies a better year end bonus and a better car for the wife’s Christmas gift, are you actually telling me that physicists are too virtuous to push things around a bit?
(c) What is the behaviour of a large collection of such interacting particles (physicists)?
March 23rd, 2009 at 1:36 am
Actually none of this gets to the point. There is an economic crash about once every 10 years and this has been the case since the start of modern capitalism. The last crash was blamed on overhyping dot.coms, the one before on something else, ad infinitum. During the booms the politicians pretend that the boom-bust cycle has ended forever which it hasn’t. Its the system itself that is the problem, not even regulation prevents the destructive cycle
March 23rd, 2009 at 1:50 am
You mean when the going gets tough people like to find scapegoats to their problems? Shocker!
And IRC, Warren Buffet’s comment refers more to the fact that he has a mantra whereby he doesn’t invest in things he doesn’t understand. He’s probably smarter than most of his colleagues in that respect!
March 23rd, 2009 at 2:39 am
The film Pi? Meh. I’d rather take a power drill to my head.
March 23rd, 2009 at 3:40 am
It wasn’t physicists that made the credit crunch, it was the :
(Karl Marx, Das Kapital , written 1867)
March 23rd, 2009 at 5:39 am
You guys have it all wrong. What really happened was that a particle accelerator unleashed a stable strangelet that drifted through Wall Street and caused the implosion.
You remember that the LHC started up and then “mysteriously” developed problems and had to be shut down in September? And the stock market crashed almost immediately after that?
The so-called ‘quenching’ problem was actually the cover up for the release of a strangelet.
I read all about it in Dan Brown’s new book.
March 23rd, 2009 at 5:41 am
The problem in a nutshell.
The bankers thought they could predict the future with the help of math and science.
No amount of science or math can do this trick.
The future is not allways like the past…
March 23rd, 2009 at 5:45 am
[...] note: Scientists are being blamed for the stock market collapse: A couple of weeks ago there was an interesting opinion piece in the NYTimes about how physicists [...]
March 23rd, 2009 at 5:48 am
About 10-12 years ago, there were programs designed to bring mathematicians into Wall Street. Fortunately for me, they only wanted good ones, hence I wasn’t tempted with an offer.
One of the biggest problems is that models are always incomplete and that, when situations are relatively new and unknown, there simply isn’t enough data to anticipate every possible fatal “rare event” and take it into account.
I recommend N. Taleb’s book Fooled by Randomness.
March 23rd, 2009 at 6:07 am
I hope the author is not suggesting that the collapse of the financial markets is due in any part to the greed of the bankers, brokers, investors or any of the other wall street players and NOT physicists or mathematicians who suggested ways to mathematically predict markets and returns, etc. Ha. I think that is pretty laughable.
March 23rd, 2009 at 6:15 am
physicists indeed killed ws, a slow and prolonged death but eventually it will happen, but not how the article states. instead, the physicists have created forward looking asset mgmt tools, like the ones used by the large investment firms (did you think that they made naked calls?) that will now be available to main-street which will obliterate the ws model. the only question that remains is whether main-street will open their eyes to the benefits of correlating returns versus risk, kinda technical so we shall see.
March 23rd, 2009 at 6:25 am
http://arxiv.org/abs/physics/0506027
March 23rd, 2009 at 6:39 am
Salesmen will overstate whatever needs to be overstated to get the deal. No matter what the product, from securities to software to diesel trucks. From derivative salesmen, to Presidents of corporations, to leaders of nations.
That facts are the math guys were probably a little appalled at how their work was portrayed. Some did speak up and were ignored, or worse. When you’re all sharing in the billions of dollars, who needs that noise?
In a concentrated, non durable product like anything finance, the ability to fudge an “assumption’ (which is what all financial products are, in fact)is way too easy. And there’s no way that regulation can cover all the “assumptions” being made in finance. Particularly in a complicated derivative.
The products are too complicated and contain too many variables, more than a few of which are by definition extremely dodgy. This is where people like Taleb have it nailed. It’s not just an underestimation of risk, it’s a massive underestimation of the consequences of risk.
The total notional value of all derivative securities worldwide is a multiple of the world’s entire annual product. Got to love those salesmen.
March 23rd, 2009 at 8:17 am
Hi Daniel,
Thanks for the post to this amazing blog.
What I find most fascinating is that the most important story here is almost exactly opposite to the thrust of the piece: that Physicists, Mathematicians, and others with scientific training were among the tiny few warning the public about the coming problem in 2001-2006. For example, those of us who embraced a quantum analogy by first replacing ‘spot prices’ with ‘wave functions’ which collapse to point estimates under ‘price discovery’ observations were publishing on the threat in 2002:
http://www.eric-weinstein.net/Papers/Weinstein_Abdulali_RISK_Vol_15_No._6_June.2002.pdf
or talking directly about fraud using straightforward analytics:
http://en.wikipedia.org/wiki/Bias_ratio_(finance)
http://www.cfe.columbia.edu/seminars/financialengineering/2005-2006/spring/Abdulali_Adil/seminar.html
So this is actually rather incredible; in what would seem to be a most transparent move, the public is being taught to distrust the exact group who tried to explain the problem to them before the catastrophe. I wish Georges Carlin and Orwell were here to share the wonder of it all, as it’s hard to make this stuff up.
Best,
Eric Weinstein
March 23rd, 2009 at 9:13 am
Now someone will accuse physicists, not video for killing the radio star.
March 23rd, 2009 at 11:58 am
Count Iblis: nice.
March 23rd, 2009 at 12:53 pm
Most of the comments made illustrate all too well the American rush to scapegoat while being totally ignorant of the issue. Seems all too American!!
March 23rd, 2009 at 5:59 pm
[...] The physicists killed Wall Street – Cosmic Variance [...]
March 23rd, 2009 at 9:12 pm
As a (lapsed) physicist who toils in engineering land I agree that physicists should be help accountable for part of the issue. They surely knew that markets are not Gaussian, but it is also pretty likely that few of them attempted to bite the hand that fed them and proclaim loudly — I am making a model for you, but it is just a model, it only operates well in equilibrium, and here is what happens when the assumptions are violated.
But let’s be realistic. Anyone in finance who does not know that markets are not Gaussian should be fired on the spot. The most spectacular pre-bubble example? LTCM, well documented in the book “When Genius Fails”. There is plenty of blame to go around…
March 24th, 2009 at 3:15 am
Wow, I don’t think the OPs post has anything to do with why the markets crashed. Greed has been rampant and part of capitalism since the onset, thats part of the point and why it works at all! Its actually a good thing most of the time.
As for quants, be sure they knew exactly the limitations of their models, I know many of them had been excellent physicists, one even was a roommate in college. In fact their risk assessment models had fallbacks for just about everything, except that all the indicators failed more or less at the same time within the span of a day somewhere around the time where Bear Sterns crashed. The models became strongly coupled and predictability was lost. This contingency had been know and warned about, but its always easy to forget about technicalities like that when you are seeing unprecedented accuracy and returns (and they had been working great for over 8 years).
They even managed to convince the economists at the Fed and SEC, so its not like it was complete mumbo jumbo.
I marvel at how proffesional physicists can be so dismissive of what those guys accomplished without even knowing what they are talking about.
March 24th, 2009 at 6:58 am
Where is the value ? To think that these houses – so badly built were going to go up up up – is with out a doubt the result of some crazy calculations. There is much to be said for smaller – hands on – look you in the eye -banks and businesses.
Integrity is a good thing no matter who you are.
March 24th, 2009 at 7:03 am
I think Overbye was pretty evenhanded in the piece Dan is talking about. If you want to read the opinions of a true over-the-top wacko on the subject, go back a few months in the NYT archives:
http://www.nytimes.com/2008/10/12/opinion/12dooling.html
In his discussion of “geeks bearing formulas,” this guy unironically quotes the Unabomber. The UNABOMBER! And follows the quote with:
“Yes, Theodore Kaczynski was a homicidal psychopath and a paranoid kook, but”
But what?! He made the trains run on time? I had to read the piece several times to convince myself it wasn’t a joke.
March 24th, 2009 at 11:36 am
They were no real physicists… First lesson on first year lab courses teach undergrads how to estimate and propagate errors. If Warren Buffett, used to pay more attention to real-physicists equations he would not lost 1st place on bilionaires list!
March 24th, 2009 at 9:35 pm
Warning: excessive verbiage follows
“And these physicists have indeed helped develop fairly mathematical and esoteric models for the markets. These models made it possible to leverage excessively (i.e., invest significantly with very little money down), and made it exceedingly difficult to evaluate risk. ”
No, no, and no. Those directly involved in science research bitch when laymen simplify their fields and make misstatements and I think you are just as guilty of doing so now with the financial industry.
Lets start with models. Anything involving more than simple addition or multiplication is ‘fairly mathematical and esoteric’ to Wall St. Black Scholes, the basis of the simplest equity option pricing models (and around for decades) is ‘esoteric’ to 99% of the people who see it and many who use it. And these models are typically very narrow. I don’t use a currency option pricing model to predict the course of exchange rates. I don’t use a model that calculates the value of a RBMS or estimates prepayment risk to predict the yield on the 10 year treasury note.
What you may have meant to say is “risk models” which attempt to aggragate the daily $ risk of a portfolio of differing assets to movements in the various underlying markets. One that is frequently used is VaR or Riskmetrics. And while it may not have been used or understood properly by everyone responsible for risk decisions on trading desks on up to senior management, VaR did not make possible excessive leverage – management made possible high leverage by authorizing high position limits. The Federal Reserve made possible high leverage by keeping interest rates low by inflating hte money supply. Pension and other funds made high leverage possible by chasing every last basis point of yield. That nobody wanted to consider the events outside a 1% or 5% move and the possible ramifications (liquidity crisis) is not a fault of the model, it is a fault of managers more concerned with making money (and bonus) than losing their job and the bank as well. That some were willing to ignore other inputs, such as common sense or trading/business accumen and rely only on VaR is not the fault of VaR or its shortcomings.
I suspect now what you meant to write was: “”And these physicists have indeed helped develop fairly mathematical and esoteric pricing models for many fincial derivative products. Some of these products make it possible to use speculative leverage excessively (i.e., speculate significantly with very little money down), but large moves in the underlying market made determining their risk exceedingly difficult.”
The NYT article you linked had some amazing statements. I found this one the most galling: “But with Black-Scholes, it doesn’t matter where the stock is going. Assuming that the price of the stock fluctuates randomly from day to day, the model provides a prescription for you to still win by buying and selling the underlying stock and its bonds. “If you’re a trading desk,” Dr. Derman explained, “you don’t care if it goes up or down; you still have a recipe.”
That is patently false. BS provides a risk-neutral valuation. One is *not* suppose to ‘win’ its simply a statement of no-arbitrage. In addition, one doesn’t buy/sell the
underlying corporate bonds one speaks of the risk-free asset, ie tbills. The ‘dont care if it goes up or down’ refers to a volatility trader who attempts to hedge away the effect of movements in the price of the underlying security on his position profit/loss. And every trader knows that these hedges are imperfect and that they are non-linear and apply for relatively small movements only. Likewise that ‘black swans’ exist is counted for (priced in) by the volatility smile.
There is no way to go into all of this here (an already exceedingly long comment!) but suffice it to say that it was not the quants or their models that did in the various banks, brokers, insurers and hedgefunds. It was greed and a lack of common sense. Derivatives of all kinds are like recreational drugs. Used them on a limited basis and wisely and its all fun. Go on a binge and it all ends in tears.
March 25th, 2009 at 2:06 am
The comments here prove that most physicists don’t have any clue about how financial modeling is done.
March 26th, 2009 at 10:30 am
To Peter Coles:
That supposed Marx quote is a hoax that has been repeatedly debunked. See:
The Atlantic
http://meganmcardle.theatlantic.com/archives/2009/01/faux_marx.php
International Herald Tribune
http://www.iht.com/articles/2009/02/25/business/col26.1-437515.php
March 30th, 2009 at 9:34 pm
[...] been on a little bit of a Wall Street rant as of late (here and here). But I can’t help throwing out a couple more things, in case you somehow missed [...]