Friday, October 19, 2007

How the financial engineers known as "quants" contributed to Wall Street's summer of scary numbers.

Also from MIT's Technology Review:

Part II: The Blow-Up

Read Part I of the story.

The events of August were outliers, and they were of the quants' own making. (Some dispute that verdict: see "On Quants.") To begin with, quants were indirectly responsible for the boom in housing loans offered to shaky candidates.

Derivatives allow banks to trade their mortgages like bubble-gum cards, and the separation of the holder of a loan from the writer of a loan tended to create an overgenerous breed of loan officer.

The banks, in turn, were attracted by the enormous market for derivatives like CDOs. That market was fueled by hedge funds' appetite for products that were a little riskier and would thus produce a higher return. And the quants who specialized in risk assessment abetted the decision to buy CDOs, because they assumed that the credit market would enjoy nine or so years of relatively benign volatility....MORE