Turbulent Times in Quant Land(ZT)

Lehman Brothers Stategist Becomes The Sage of The Subprime Contagion Theory

"Whiletraders and market watchers got a breather from last week's volatilityover the weekend and took time to figure out what had happened, atheory of what had caused the disastrous results at many quantitativehedge funds solidified into conventional wisdom. The sage of the theorywas Matthew Rothman, the global head of quantitative equity strategiesfor Lehman Brothers.

His memo on “Turbulent Times In QuantLand” (linked below) quickly became the most read primer on what causedthe damage, and he became one of the most quoted analysts on WallStreet. Both the Wall Street Journal's Kaja Whitehouse and the New YorkTimes Gretchen Morgenson relied on his report for their analysis.

Basicially,what Rothman describes is a three step process that undid the quants.First, fund managers who faced margin calls and losses from in the debtportfolios found themselves unable to sell those portfolios at whatthey considered reasonable prices. The market for these collateralizeddebt products had always been illiquid, and many were value accordingto models of their expected performance because their was no market tocompare them to. With fears of subprime and collateralized debtobligations spreading in the market, there were few buys for thesepositions. So instead the fund managers began unwinding more liquidequity positions, buying stocks they had sold short and selling theirlong positions, and this was the second step in the quant bloodbath.

Thissudden unwinding caused the prices of these stocks to “misbehave”—quantspeak for when prices stubbornly refuse to obey the models they haveworked very hard on. What was “supposed” to go up went down and viceversa.

"Wednesday is the type of day people will remember inquant-land for a very long time," Rothman told the Wall Street Journal"Events that models only predicted would happen once in 10,000 yearshappened every day for three days."

Since so many of themuch-prized and closely-guarded secret quant models are very similar,the confusing signals from the unpredicted stock price movements causeda domino effect. The third step of the unraveling came when a few largequant funds began further de-levering and otherwise reducing risk byliquidating positions. This exacerbated the problems set-off by theearlier sell-off.

The result has been a blizzard of letters fromhedge fund managers to their worried investors, emergency conferencecalls and now, from Goldman Sachs, a bailout of one of their largestquant funds. Nervous investors are now in a prisoners dilemma of sorts,fearing that large-scale redemption requests could topple the hedgefunds with an old-fashioned “run on the bank” but worried that iflosses continue and everyone else bails out, they might be leftsuffering an even worse fate of being the last man standing on asinking ship while the lifeboats head for the horizon."

Turbulent Times in Quant Land (pdf)