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The Quants

Like his Wall Street Journal colleague Gregory Zuckerman who wrote The Greatest Trade Ever, Scott Patterson tells a compelling story about the epicenter of the financial crisis in The Quants. The big difference between the two books is that Zuckerman spins a yarn about a man that made billions from the sub-prime implosion while Patterson's tale is about those who lost and lost big time. Young gunslingers at the quantitative hedge funds were unstoppable in the new gilded age racking up huge gains for years on end, but failed to program in the appropriate amount of risk in their complicated financial models. They didn't account for the fat tails of the bell curve which happens more than you'd think in investing. The result is now history of a bygone era with fortunes forever lost.

Big Iron. That's what it was all about. The quiet hum of mainframe computers churning out eons of high frequency trades with little or no regard to fundamental analysis. As Patterson so aptly puts it: "They used brain-twisting math and super-powered computers to pluck billions in fleeting dollars out of the market...These computer driven investors couldn't care less about a company's 'fundamentals', amorphous qualities such as the morale of its employees or the cut of its chief executives jib...Quants were agnostic on such matters, devoting themselves instead to predicting whether a company's stock would move up or down based on a dizzying array of numerical variables such as how cheap it was relative to the rest of the market, how quickly the stock had risen or declined, or a combination of the two - and much more.". But as the author foreshadowed at the beginning of the book: "Amazingly, not one of the quants, despite their chart-topping IQs, their walls of degrees, their impressive Ph.D.'s, their billions of wealth earned by anticipating every bob and weave the market threw their way, their decades studying every statistical quirk of the market under the sun, saw the train wreck coming.".

They had it made. After setting up their original trading programs which found small inefficiencies in the efficient market hypothesis, they basically sat back and raked it in. The computers did all of the work. It was all based on arbitrage and probabilities and while the market was in a generational bull market, there were no problems except for the bloodbath at Long Term Capital Management in the late 1990's which almost collapsed the market as well as the dot com meltdown on 2000. But they bounced back and even made money during the downturns. Not this time. It was too hot to handle: "As investors tried to unload their positions, the high-frequency funds weren't there to buy them - they were selling, too. The result was a black hole of no liquidity whatsoever. Prices collapsed.". They were trapped: " a self-reinforcing feedback loop. More selling caused more volatility, causing more selling, causing more volatility.".

Patterson makes a powerful argument as to why these high rollers were a huge contributing cause to the 'Panic of 2007'. He also points out there were other factors involved such as President Clinton repealing the Glass-Steagall Act in the early 1990's and former Fed Chairman Alan Greenspan keeping the interest rates too low and pumping more and more money into the system. However, Patterson does a terrific job of connecting the dots back to the beginning of the quant movement and takes you step-by-step through all of the hijinks until the market went haywire and plunged just two years ago. He points fingers, and it isn't at all of the hedge funds, only some of the more notorious ones. If you want to get the skinny on where your IRA or 401K plan went down the tubes, look no further than The Quants. It's a very good book.