January 2010, the beginning of a new decade, offers a good reason to look back on the economic drivers of the just closed chapter of recent history, especially while still facing consequences of the most severe market turmoil since the Great Depression. Media and market commentators have exhaustingly and rightly spotted factors like Fed policy, underregulation, shadow banking, lobby-influence and financial engineering (non-taxative list).

The last point remained somewhat underrepresented and is mainly mentioned in connection with greed, bonus hunting and leverage. But there´s a more relevant side of it. How useful is financial engineering for economic development? Quants were the kings of the kings during the last business cycle, running the hottest story in town. A PhD in Mathematics with no what-so-ever market background was paid stellar money for number crunching to achieve decimal place performance optimization.

At the latest, summer 2007 made clear that not even Quants can operate outside market gravitation. Within a few days Quant funds from ie Goldman Sachs and Bear Stearns imploded and needed to be rescued by their mother companies. After two years of muddling through, a former star of the sector strikes the sail and gives in.

Bloomberg reported: “Robert Litterman, chairman of Goldman Sachs Group Inc.’s quantitative hedge-fund group, will step down at the end of this month, a move planned before President Barack Obama’s call yesterday to limit proprietary trading at banks, according to people familiar with the situation.”

Even more important than Litterman stepping down is the fact that his baby, the Global Equities Opportunity fund, was closed in December 2009:

Litterman, a 24-year Goldman Sachs veteran, advised a unit that ran Global Equities Opportunities, a quantitative hedge fund that required a $3 billion cash infusion in 2007. The fund, which used mathematical models to trade securities, closed last month after its assets fell to $200 million from as much as $7.5 billion, according to two people familiar with the situation. “One of the lessons learned is we cannot be as big as we were,” Litterman said at the GAIM International hedge-fund conference in Monaco on June 19, 2008. “We couldn’t get out and if we had, it would have made it worse. We had to ride it out.”

A new book “The Quants – how a group of mathematicians and computer scientists nearly destroyed Wall Street” critically reflects on the borderline operations of automated trading systems and the danger of cheap liquidity. Short, this form of financial innovation temorarily reached its limits. Instead of increasing efficiency and liquidity (main arguments raised by Quants to justify their work), the technique became a difficult-to-control risk factor for market stability.  Paul Volcker is right to criticize developments like CDS, that were, under the current regulation, misused as methods of “taking bad paper and making it look like good paper”.

Not to paint a too black picture of modern financial engineering techniques, I am convinced that they can positively contribute to the economic development of a country, even the global economy. We´ve just experienced the current limits of it and need to update our regulatory regimes to avoid making the same mistakes again. The update is needed as we will always find carry-trade opportunites, if not in the Yen or USD (recently) then in another currency. The lessons learned also carry some positive aspects in the application of financial engineering techniques:

• Computer supported or -driven trading strategies became widespread utilities even in the mutual fund business.
• The fall of the Quants led to empirical insights of certain flawed financial market theories, like normal distribution kurtosis and EMH.
• The shortfall of adequate derivate products in liquidity and accuracy to implement certain strategies became highly visible.
• Hedging was established as a widespread technique across the institutional and private investor community.

Barney Frank´s discussed bill seems to understand these conclusions. Obama´s recently announced bank plan adds another protection layer on top which should help avoiding situations like mid 2007, where Investment banks needed to bail-out their own hedge funds.

My current worries are not about the failures of the past. My worries are concerning the latest ´invention´ (kicking off 2006): the passive investment market, primarily via ETFs. Having started as index-covering, delta 1 trackers, ETFs emerged to a commonly used, flexible legal entities for all kind of speculative, engineered strategies. Some of them are actively managed, fully retail-compliant vehicles that cause a massive mismatch between the knowledge base of retail investors and what´s being played behind the curtain. I assume, the fast-growing ETF market will face a severe correction of strategies accepted by the investor base. A currently widening coherence spread between the original idea of passive investments and its current misuse, will be closed. Hopefully in a soft, regulation-driven attempt and not by a market-led correction (ie caused by an ETF bail-out) in which retail investors would again be the ones paying the bill.

Let me finish with a blink.

How many quants does it take to screw a lightbulb? Matthew Greenfield of StoneWork Capital answers teh above questino thusly: