Hedge Funds, Investment Banks: When Will They Ever Learn?

Where have all the flowers gone?

Long time passing

Where have all the flowers gone?

Long time ago

Where have all the flowers gone?

Girls have picked them every one

When will they ever learn?

When will they ever learn?

(First verse from the song by Pete Seeger "Where Have All The Flowers Gone")

Reader Mayascribe alerted me to a book review in the Friday Wall Street Journal which had missed my attention. The review is by WSJ writer Scott Patterson. The book is "The Quants" by Scott Patterson. Yes the review is by the author, so it's not really a review but simply an summary of one part of the book.

Patterson describes the computer model world of the high powered mathematicians and scientists (called quants) that work on trading models for major hedge funds and Wall Street firms (including investment banks) that behave like hedge funds. The excerpt recounts what happen on a few days in August, 2007 with a group at Morgan Stanley (MS) going by the name PDT (Power Driven Trading).

In a just a few days the investment world almost spun out of control as changes were occurring in the MBS (mortgage backed securities) markets totally outside the range of the complicated models used for trading. PDT and other hedge fund like activities around the world were suddenly losing billions. They had to dump stock positions by the truck load and massive swings in stock prices were occurring.

Curiously, the stock market, although quite volatile in many stocks, was seeing indexes rise significantly, even if erratically. That resulted from many of the positions being dumped requiring buying to cover short holdings, driving prices higher. The public remained oblivious to the warning that these few days presented about the soon to start market swoon that would start from the market top just a few weeks later.

This entire story reminds one of the Long Term Capital Management hedge fund story. In 1998, LTCM suddenly lost control of a gigantic highly leveraged portfolio with models designed by a previous generation of quants, led by a couple of Nobel prize winners. The problem in that case was emerging markets, mostly emerging market debt. Changes started to occur outside of the parameters assumed by the models. The size of the LTCM meltdown was such that the entire financial system was threatened and massive intervention by central banks was necessary to prevent a financial collapse.

Just a year or so later, the remaining vestiges of Glass-Steagall, the law passed in the 1930s to keep the banks separate from the casinos, were repealed. From that point on the quants expanded into the banks. Welcome to PDT at Morgan Stanley and similar groups within all the major banks.

Where have all the flowers gone indeed. When will they ever learn?

Will the Volcker plan announced last week effectively address this problem? There is a lot of wealth, addicted to easy money with government backstops when there is failure, that say: No way. Chrystia Freeland, Gillian Tett and Tom Braithwaite just posted a Financial Times article that reports on Wall Street bank plans to use the upcoming Davos World Economic Forum to lobby against the Volcker plan.

Borrowing from another line in the song, we better be sure that in this case there is no "long time passing".

Disclosure: No positions.