I recently read The Quants, a book by Wall St. Journal reporter Scott Patterson. The book talks about the rise, and perhaps fall, of a group of mathematicians and computer scientists turned investment bankers and hedge fund managers.
Their specialty was using quantitative statistical analysis and game theory to create sophisticated derivative investments, which relied on leverage, or borrowed money, to make huge bets on the market.
It wasn’t long before these derivatives were delivering enormous profits for their firms and their clients. It’s estimated that Wall Street firms make billions off these investments every year.
So it was ironic for me to learn of the SEC filing against Goldman Sachs (GS) for creating a product for a hedge fund, Paulson & Co., who was looking for leverage in a massive short bed on the housing market.
Singling out Goldman Sachs is interesting because they certainly were not the only bank engaged in these products. In fact, they’re akin to the tip of an iceberg. The Bank of International Settlements (BIS) just reported that, even after dropping 13.6% from the third quarter, banks’ overall derivatives exposure was $3.996 trillion at the end of 2009.
It would seem that if Congress and the Obama administration is looking for a villain, there are many candidates, not just Goldman Sachs. J.P. Morgan Chase (JPM), Bank of America (BAC), Wells Fargo (WFC) and Citigroup, Inc. (C) are all on the list as are many, many others.
Which leads me to believe that there could be more suits to come, or that Goldman Sachs is being used as leverage to get financial reform passed. I’ll leave the politics for someone else to decide.
The quants on Wall Street were, at their core, trying to answer questions to discover Alpha, or the truth: Does the market behave rationally? Is the market about money or how the people feel about money?
And that’s where The Quants becomes a tale as old as time. Once there is money to be made, it’s not hard to find people willing to create their own version of the truth. And rather than bringing them closer to the truth, the lure of the game leads them further away.
So if you’re angry with Goldman Sachs today, that’s OK. But remember they’re not alone. What you should know, and what Wall Street and Congress know all too well is that derivatives are still on banks’ balance sheets. And it may be years, if ever, before they’re gone. We can only hope that the same minds that invented these products may find a way to steer us in a different direction before the next ship arrives.
