Goldman Sachs: of Quants and Quacks

April 20, 2010 (LPAC)—With the new economy, which essentially took off with Alan Greenspan's ascension to Fed Chair in 1987, two processes were unleashed in tandem: 1) the "wall of money," i.e., repeatedly lowering interest rates, which allowed for constantly increasing levels of leverage; 2) deregulation, introduced step-by-step, which allowed for Wall Street firms to increase the exotic nature of financial paper which they could offer to the suckers, while allowing for a huge jump in proprietary trading. This process was furthered by the expansion of the carry trade, which provided another source of liquidity, and easy, short-term profits.

This facilitated the takeover of investment banks by quants, those, like Black and Scholes of LTCM fame, to bring in models derived from mathematical physics, to direct firms' investment policies. For the major firms (Goldman, Morgan Stanley, Lehman, Merrill, Bear in particular), this meant they could join forces with hedge funds, to move huge quantities of money into targets provided by the quants' computer models.

The method they use, which they claim is rocket science, utilizing methods of mathematical physics, is really probability theory — derived, in some cases by methods developed in poker and blackjack — but the game they played was rigged. As long as there was easy money, the quants, using the world's largest and fastest computers, could always find a margin between the price of anything, somewhere, to place a bet (arbitrage), and make money, by the sheer volume of money they would place, i.e., a small marginal gain, times a large amount of funds.

They moved it mostly into the new world of derivatives, and, by 1999, into insurance on derivatives, i.e., credit default swaps (CDS). The principle behind the CDS, which were originally pushed hard by Morgan Stanley and Deutschebank, as well as by AIG, is that you are betting on whether a particular instrument will default, or not. It is, essentially, a short position. By its nature, it increases the amount of funds on both sides of the bet.

This is what Goldman Sachs was cited for by the SEC, but it is a common practice, inherent in the very nature of what a CDS is!