The third book I recently read that has some math or physics content is Wall Street Journal reporter Scott Patterson’s The Quants: How a New Breed of Math Whizzes Conquered Wall Street and Nearly Destroyed It. It’s a very lively and entertaining telling of a story which features quite a few mathematicians who have gone on to make (and then sometimes lose) absurd amounts of money using mathematical models to try and exploit market inefficiencies. Jim Simons and his large group of mathematicians and other Ph.D.s at Renaissance play a significant role, and among other mathematicians who make an appearance is Neil Chriss, co-author of Representation Theory and Complex Geometry, one of the most well-known books on geometric representation theory (now available as a “Birkhauser Classic”).
Patterson’s story emphasizes heavily the relationship to gambling. He writes extensively about Ed Thorp, who developed the theory of card-counting, did well with this at casinos, then moved on to the hedge fund business. Just about everyone profiled in Patterson’s book is described as having read and been inspired by Thorp’s 1962 book on card-counting (Beat the Dealer). Many of them are serious poker players, and the book opens by describing the scene at the one of the recent Wall Street Poker Night Tournaments. These are yearly events (Chriss and Simons are among the organizers) that bring together quants and professional poker players to play high-stakes poker, with proceeds donated to Math for America.
The subtitle of the book puts the blame for the financial crisis on this kind of activity, but there’s not much evidence given to justify this. Most of the book is about various hedge funds, and the stories of failure are pretty much the same old story of Long Term Capital Management’s failure back in 1998. Finding some sort of market inefficiency and exploiting it tends to work for a while, but sooner or later either others start doing the same thing or patterns change, sometimes very quickly. If one has gotten greedy and started using too high levels of leverage, one can get in trouble fast. The best-run hedge funds (for instance, Renaissance) managed to stay out of trouble, others didn’t. How much of a public problem all this is remains unclear. To a large extent the failures just lead to some rich people (and universities like Harvard) becoming less rich, while some hedge-fund owners and employees see their income go down but get to keep the fees earned while they were taking too much risk. It’s very clear why a lot of mathematicians and physicists go into this.
None of this though seems to have had a determining part in the disastrous financial crisis of recent years and its ongoing effects. The book has little to say about a more significant failure that involved a different group of quants, those responsible for the bad mathematical models used to justify the mortage securitization business. From what I can tell, there the story is that if there’s a lot of money to be made creating a financial instrument carrying large risks obscured by complexity, it’s not hard to find people willing to help you sell it by creating bad mathematical models of its behavior.
The story of The Quants is a remarkable one, whether or not the people described have some responsibility for the current state of the financial industry and the dangers still embedded in it. While reading the book I couldn’t help thinking that it would be a good idea if the best of them would play a little less poker and take on another pro bono task, that of coming up with a good understanding of the current pathologies of the financial system, and models useful in the task of figuring out how to change it to something more socially desirable.