| NEW YORK
NEW YORK Dec 22 Last week, New York University
and Carnegie Mellon sent a new class of math whizzes out into a
profession that is both blamed for the financial collapse and
charged with preventing it happening again.
Many of these so-called quantitative analysts, or "quants,"
graduating from elite financial engineering courses will end up
writing computer programs that handle an ever greater share of
Because some of their mathematical models failed to take
into account factors that later turned out to be crucial,
quants have been blamed for compounding risk and exacerbating
the crash in financial markets.
But far from going into decline, those with financial
engineering degrees are still in demand as hedge funds and
banks seek ways to measure previously unforeseen risks and
factor them into their models.
The profession's reputation took a beating in August 2007,
when some quant funds -- which try to beat the market by
crunching vast amounts of data at lightning speed -- lost a
third of their value in a matter of days.
Many blamed the math commandos for failing to factor in
extreme events, in this case unprecedented numbers of home
Critics and practitioners alike agree they need to impove
their modeling, and that begins at the elite financial
engineering programs, which have come to be known as "quant
Both New York University and Carnegie Mellon University in
Pittsburgh, which between them minted about 100 new quants this
month, have tweaked their curricula, lest their graduates miss
another brewing disaster.
Meanwhile, at Columbia University, the masters of financial
engineering program has tried to give its students a wider view
of the market outside mathematical models, said program
director Emanuel Derman.
"You have to understand you are dealing with people and
markets, and they don't respond the way physical systems do,"
said Derman, a former managing director at Goldman Sachs
PLUS CA CHANGE
As the mortgage crisis gathered steam last year and
financial markets became volatile, quant funds, which make up
about 7 percent of the hedge fund universe, were caught
To raise cash, they started selling stocks, which created
unusual moves in stock prices, throwing other quant models off.
Finally, the selling snowballed into a full market panic.
"Before you know it, you have a chain reaction and the
whole market dives on the basis of what amounts to a
mathematical prediction," said Peter Morici an economics
professor at the University of Maryland.
"You create a mathematical herd. That's why so often these
schemes based on math models end in tears."
Among those in tears were investors in Goldman Sachs'
Global Opportunities Fund, which lost a third of its value, or
$1.8 billion, in a single week in August 2007. Other big quant
funds also hemorrhaged that month.
In his book "A Demon of Our Own Design," published in April
2007, hedge fund manager Richard Bookstaber made the case that
financial innovation actually adds to risk because it fails to
take emotion into account.
The models increasingly assume rational behaviour, instead
of the way humans really behave, he wrote.
Some institutional investors have said quants become too
enamored of their creations to notice when they turn into
mathematical Frankensteins, especially in new, untested markets
such as securities based on bundled mortgages.
"They get caught up in their religion -- they keep going
merrily along on autopilot," said Matt McCormick, an analyst
and portfolio manager with Bahl & Graynor Investment Counsel in
Cincinnati. "There's no substitution for grey hair and your gut
when you see valuations that are out-of-whack."
Nassem Taleb, a former trader who wrote the best seller
"Black Swan: The Impact of the Highly Improbable," is even more
outspoken. "Quants and quant programs are dangerous to
society," he said.
The failure last year to foresee that subprime borrowers
might default on their mortgages is only the latest example of
mathematical models that rule out possible sets of
circumstances because they were highly unusual.
In 1998, Connecticut hedge fund Long-Term Capital
Management collapsed because its mathematical model failed to
foresee the Russian debt crisis.
"And LTCM was constructed by Nobel laureates," Morici
Those laureates, Robert Merton and Myron Scholes, along
with Fischer Black, are considered the fathers of quantitative
analysis for the Black-Scholes model, developed in 1973, for
predicting option prices.
That model has underpinned countless portfolio management
strategies, including portfolio insurance, which combines
options and market indices to protect a portfolio's value, and
which some blame for worsening the spiral that led to the 1987
In that episode, critics charged, the model failed to
factor in the difficulty of selling stocks as required by the
strategy. As selling grew harder, more stocks were sold,
feeding the panic.
But defenders of the profession say at least some of the
criticism should be directed at the fund managers who come up
with the strategies, rather than the quants who implement
And, as long as the strategy is working, no one wants to
"It's an arms race where no one has an incentive to pull
back on their own," said Andrew Lo, director of the
Massachusetts Institute of Technology's Laboratory for
Financial Engineering, another quant farm.
"When people are making money, it's virtually impossible to
get them to take their hand out of the fire."