It’s Part VII! (Remember, if you’re having trouble keeping up, check here for a complete list of all posts in the series.) Today John S looks at the magical world of hedge funds.
The Quants: How a New Breed of Math Whizzes Conquered Wall Street and Nearly Destroyed It
by Scott Patterson 2010
“Quant” is a word that pops up over and over again in descriptions of the financial crisis, but it never really gets defined. It tends to be used on Wall Street the way “sabermetrician” gets used in baseball or “Nate Silver” is used in politics: It just means someone who uses math in a slightly unconventional way while doing his job.
Nevertheless, these “quants” were blamed for much of the financial crisis, as those industry “experts” who concocted elaborate formulas showing that housing prices would never fall and homeowners would never default. I turned to Patterson’s book to find out who, exactly, these “quants” were and why their formulas—unlike Nate Silver’s and Billy Beane’s—went so awry.
Patterson’s title bills the book as a story of these “new… math whizzes,” and the cover even contains a quote from Warren Buffett: “Beware of geeks bearing formulas.”* Unfortunately, Patterson’s book focuses primarily on the world of quantitative hedge funds. In other words, instead of focusing on those within the banks themselves and how these whizzes were used to justify massive trading strategies, Patterson’s book is about some of the most successful outsiders.
*Interestingly, this may be the first book I’ve ever seen to advertise itself with a quote that’s not about the book itself, but about the book’s subject.
On that front, Patterson’s book is actually an interesting look at the theories behind quantitative trading, and how they rebelled against the efficient-market hypothesis. It also functions as an account of the hedge fund boom: “In 1990, hedge funds held $39 billion in assets. By 2000, the amount had leapt to $490 billion, and by 2007 it had exploded to $2 trillion.”
As hedge funds grew, the line between them and banks blurred. Many of Wall Street’s best traders realized they could make more money by setting up their own hedge funds—two of Patterson’s main subjects, Cliff Asness and Boaz Weinstein, left major investment banks to start hedge funds—so the banks tried innovative ways to keep them. Often this meant setting them up with their own in-house hedge funds—as Bear did with BSAM—or becoming more like hedge funds themselves. Indeed, as Patterson says, “Wall Street’s banks morphed into massive, risk-hungry hedge funds.”
As hedge funds, which started out as a small realm for particularly shrewd traders, grew in size, they sank in prestige. It was no longer the realm of the best of the best, but of anyone who could raise sizable amounts of money. As such, many of the trades hedge funds relied on became less profitable as so many investors poured in.* Patterson recounts how the growth of hedge funds hit a bump in 2007, shortly before the financial crisis reached its peak.
*One such trade, known as the correlation trade, figured prominently in the housing crash. In this trade, which became very common at hedge funds, a buyer would buy the “equity” tranche of a CDO—generally the lowest quality—and use the high returns from that investment to buy credit default swaps on the higher quality tranches—effectively shorting the high quality portions. The idea behind this trade was that the correlations between the loans that ultimately made up the CDO were very high—either all the loans were good or they were all bad. If they were all good, then you might as well buy the equity tranche, since it had the highest rate of return. If they were all bad (which was generally the case as the housing bubble grew), then you might as well short the highest-rated tranche, since its CDS were the cheapest.
Of course, as hedge funds started to pile into this trade, not everyone got the correlations right. Howard Hubler at Morgan Stanley lost over $9 billion on one trade by getting it effectively backwards. For his trouble, Hubler was paid $25 million in 2006.
But it’s not entirely clear how much hedge funds had to do with the crisis itself. Patterson at times seems to labor to make a connection, pointing out that it was quantitative hedge funds that were first to pull their money from Bear Stearns. But even he doesn’t seem convinced by that—no single hedge fund had anywhere near the resources to bankrupt a bank with over $300 billion in assets. And while it’s certainly true that many hedge funds rushed into the housing market, ultimately paying the price, many of the first to notice that bubble were from hedge funds as well: Michael Burry, John Paulson, etc.
From a purely marketing perspective, it’s understandable why Patterson would want to tie his book to the crisis, but it’s not clear that the connection really fits. Perhaps more troubling, though, is that Patterson never really arrives at a workable definition of “quant.” It seems to vary based on who he is talking about and what point he is trying to make. Patterson’s book is at times entertaining, but it’s ultimately unsuccessful in its goals.
by Sebastian Mallaby 2010
Still, Patterson’s book made me curious about the role and nature of hedge funds, so next I turned to Sebastian Mallaby’s book on their history. More Money Than God might be the best book I read during this project, but it also has the least to do with the financial crisis of 2007-08. I would absolutely recommend it to anyone with an interest in hedge funds or financial markets in general, but not to anyone trying to learn about the specific events of the last few years.
What makes Mallaby’s book so impressive is that it succeeds both as a work of journalism and analysis. Almost every other book falls too far on one side or the other of that spectrum.
Mallaby proceeds with a general history of hedge funds, beginning with their early days when Alfred Winslow Jones started his in 1949. Initially, hedge funds relied mainly on stock picking, but Mallaby traces how each new hedge fund pioneer brought his own innovation to the market—and how each innovation then became mainstream.
Mallaby is helped by the fact that hedge funds tend to attract colorful personalities, like Julian Robertson, George Soros, and Jim Simons. His profiles of these people don’t read like staid financial journalism. Even more important, though, is how introspective many of these figures are. Instead of the typical Wall Street bluster and bravado, someone like Soros, who is worth $20 billion and gets two chapters devoted to his financial analysis, admits that, “the outstanding feature of my predictions is that I keep on expecting developments that do not materialize.”
The figures are even introspective about the value of what they do. One of Mallaby’s subjects, Michael Steinhardt, offers the revealing quote: “I don’t feel what I do is profoundly virtuous… The idea of making wealthy people wealthier is not something that strikes the inner parts of my soul.” This kind of honesty is almost completely absent form most Wall Street bankers, who are forever reminding people of the irreplaceable role they have in the economy. But Mallaby’s book actually dares to question the role of hedge funds and, in a more general sense, Wall Street itself.
Certainly, though, Mallaby is sympathetic to hedge funds, and he ultimately comes down decidedly in their favor. He highlights that it was largely hedge funds that uncovered the accounting problems at Lehman Brothers, poor policies of various central banks, and the housing bubble itself. And he points out that, though hedge fund investors are exclusively the very wealthy, sometimes this helps everyone.
In response to Fred Schwed’s famous query about the usefulness of Wall Street—“Where are the customers’ yachts?”—Mallaby insists, “Ask Harvard! Ask Yale! …Hedge funds are a major reason why universities can afford more science facilities and merit scholarships, and why philanthropists from the Open Society Institute to Robin Hood have more money to give out.”
This may not be as convincing as Mallaby thinks. The idea that hedge funds are good because they allow rich people to give more money to charity is hardly inspiring—the vast majority of hedge funds’ gains, after all, do not go to these causes. And the work hedge funds did exposing fraud and bubbles is less impressive when you dig deeper and see how they obtained these deals and at whose expense they came: Soros’ famous bet against the British pound, for example, made him over $1 billion, but cost British taxpayers over $4 billion.
Mallaby is much more persuasive, though, in his argument that, though hedge funds may not exactly be noble, they are not particularly harmful. Hedge funds didn’t cause the housing bubble, though they may have profited from it; Soros didn’t implement the Bank of England’s policies, he just recognized their flaws.
More importantly, hedge funds mind their own business. They manage their own risk and, since they don’t have deposits to fall back on, they keep their leverage within reason. Though nearly 1,500 hedge funds failed during the crisis, none were bailed out by the government. Even Long Term Capital Management, which famously went under in the 1990s, was bailed out by private funds from other Wall Street banks.
At the end of his book, Mallaby contrasts the investment banks that failed with Citadel, one of the biggest and most successful hedge funds (run by Ken Griffin, one of Patterson’s main subjects). Citadel, thanks mainly to its exposure to the big banks, came close to collapsing during the crisis. In fact, it lost $9 billion in 2008, nearly twice what LTCM lost when it had failed. But Citadel survived, largely by doing things the banks failed to do: it raised capital proactively, secured long-term funding, accounted for its risk, never overleveraged, etc.
As Mallaby puts it, “Citadel’s humiliation was a model of how the financial sector should work. Investors who had risked their capital with Griffin, and been rewarded for years, were forced to take extraordinary losses—exactly as it should happen. But the financial system was not destabilized, and taxpayers were not called upon to throw Citadel a lifeline.”
This is true… for now. It’s easy to see a time, of course, when the government starts to intervene on behalf of hedge funds, perhaps noting their “systemic importance.” But for now, at least, they are not the problem.