Don’t blame it on the mathematicians

The very group of the smart mathematicians and computer geeks, known on Wall Street as “The Quants”, who created the most clever, innovative and complex schemes in the financial history of mankind - mortgage derivatives, collateralised debt obligations (CDOs), credit default swaps (CDSs) and the likes – and received Nobel Prizes for their innovative creativity, are now being blamed for bringing the global financial market to a near complete collapse.

For example, the newly released book by the prominent business reporter Scott Patterson entitled: “The Quants: How a New Breed of Math Whizzes Conquered Wall Street and Nearly Destroyed It" blames the “Quants” for much of what happened.

Blaming the “Quants” may be convenient, but are the they really to blame?

The fact of the matter is that these “Quants” didn’t do anything wrong. They did exactly what they were hired to do – play the “game” to the best of their ability. They didn’t set the rules of the game; they played it within its existing rules and regulations. They used complex mathematical models within the constraints of the financial system to calculate probabilities and risks and played the game just as any game should be played – smartly.

They didn’t set out to scam the system deliberately and neither did they use bribery and corruption to make money for their bosses - If anything, perhaps they were used by their bosses.

The “Quants” models worked beautifully and flawlessly for as long as the financial wheel was being oiled by money flowing through it. As we learned later, the wheel was (fortunately or unfortunately) interrupted by the failure of real estate and came to a complete halt once the flow of money stopped, resulting in a near meltdown of the entire global financial system.

As smart as the “Quants” were, what went wrong? Did they take unnecessary risk, miscalculate the risk or were their models based on faulty assumptions?

Whatever the case may be, the “Quants” knew that what happened could happen but they did not expect it to happen this soon. Neither did Alan Greenspan, Ben Bernanke, the former and current Chairmen of the Federal Reserve, nor anyone else in that circle. Greenspan was quoted as saying that he didn’t expect what happened to happen in one hundred years or more. But his statement pertains only to the probability of that event and not to its consequences.

The “Quants” calculated that probability to be near zero but it is not clear if the “Quants” actually realised (or wanted to realise) that the true consequences of that event would be a potential complete collapse of the entire global financial system with grave global consequences for many years to come. Surely they must have calculated the whole risk and not only the probability.

In calculating the risk of an event, as we call it in risk analysis, one has to take into consideration both the probability and the consequences of the event. The event we’re talking about here is the default that triggered the cascade of events that caused the financial crisis, and the consequences of the event is the near collapse of the global financial system and all the current and future changes that would follow.

The “Quants” seemed to have been fixated on the near-zero probability of the event than on its consequences. The “Quants” and/or their bosses either ignored the grave consequences of the event or simply did not realize their true magnitude.

Given the small probability of the event, the exuberant amount of money they could make, the mathematical elegance, finesse and financial innovations they created, it is more likely that the “Quants” simply ignored the consequences deliberately and decided that it was a risk worth taking. Was it pure greed? Perhaps. Human nature is not innocent of such a charge.

But whatever the reason may be – pure greed, power, thrill, faulty assumptions of their models, miscalculation of the risk, or a combination thereof – for the “Quants” and their bosses it was a risk they took in a game they played. For many of us, taking a risk and playing a game with people’s lives and hard-earned money is hard to fathom. But in business, it is like a game and the “Quants” did their technical best (but perhaps their human worst) to calculate the risk.

The fact still remains, however, that what happened couldn’t have happened had the system been well regulated to protect it from being invaded by human greed or mathematical “ingenuity”.

Human greed and the constant drive for more are ugly human traits that will exist for a long time. Until these traits change, we should focus on creating financial systems that are less vulnerable to them. The “Quants” exposed the regulatory vulnerability of the current financial system that prompted President Obama last week (Thursday, February 18, 2010) to come up with regulatory measures to fix them.

The question is can the existing financial system be fixed by such measures to prevent, or at least minimise, invasions by the human greed or mathematical “ingenuity” and simultaneously promote fairness and prosperity, or is there a need for another system? That remains to be seen.

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