From the July 01, 2009 issue of Futures Magazine • Subscribe!

Model behavior

Many moons ago when I was in college, I needed to take some requisite science courses. Science has never been my forte, so the thought of fulfilling these requirements was somewhat daunting. I almost passed by physics classes, remembering with shivers my high school physics teacher who was brilliant (and actually worked at Argonne National Laboratories), but not much of a teacher. But one course caught my eye: Physics for Poets. That sounded up my alley, so I went for it. You’ll be proud to know I got an A on my paper, “On Building a Rainbow,” and actually learned how physics applied to everyday life and was not just a series of theoretical formulas.

I recalled this when reading in Newsweek about Paul Wilmott, a math geek and quant guru based in London. What makes him so special, aside from being brilliant, is he is a quant who is training other quants to break out of their theoretical approach to financial engineering and apply it to actual skills (infused with ethics) that can be used on Wall Street. An example provided in the article illustrates why this is important due to what happened to the markets: take an aeronautical engineer trying to design a jumbo jet, but instead of tweaking the design to follow the laws of physics, he tweaks the equation to follow the design. This appears to be what happened on Wall Street — too many quants were following too many models that didn’t fit the products and it crashed.

Now Wall Street has had plenty of warnings about (not-so) model behavior. One in particular stands out: Long-Term Capital Management, which practically brought down the financial system. The guys running the firm were Wall Street masters and Nobel Prize winners. That combo should have been unstoppable, but then something happened: unforeseen events that didn’t fit their model, and the rest is history.

Unfortunately “history” has repeated itself and has roiled the markets over the past year to the point that like a bridge that begins to buckle and gyrate (bringing to mind that classic film shown in physics classes), chances are it will break apart eventually. Government stimulus has been a blessing and a curse. It has provided a bridge for troubled banks, but it could end up setting off hyperinflation. All this because the smartest guys in the room were too smart for their own good. In our cover story, “Economic recovery: Running on empty,” Associate Editor Christine Birkner gets some expert insights on where interest rates are headed (up) and it’s not pretty.

Ironically another piece by Henry Jarecki and Jason Ungar, “Doing your due diligence” looks at how the management industry as a whole didn’t use common rules or follow specific models in the Bernard Madoff affair, and they reveal how this reckless disregard for searching for the truth hurt investors.

Hopefully these recent events have humbled Wall Street, but with the banks’ drive to pay back TARP funds, no doubt for many reasons, but largely so the government monkey is off their backs, I’m doubtful. Have they learned anything? Wilmot isn’t sure. In the Newsweek article he still doesn’t believe we have the right tools to price these exotic products. Further, there doesn’t seem to be much change in the compensation mentality. Traders still get paid short term for products that may not pay off (or may explode) until later. Also, the greed factor always will be there, and that’s what pumps up the madness of crowds and boom and bust cycle. But if he can infuse some ethical behavior into traders and highlight the weaknesses of some financial models, there is hope of breaking this cycle of ruin.

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