Skip to main content

Quant Bloodbath Revisited, A PrimerLehman Brothers Stategist Becomes The Sage of The Subprime Contagion Theory

  • Author:
  • Updated:

While traders and market watchers got a breather from last week’s volatility over the weekend and took time to figure out what had happened, a theory of what had caused the disastrous results at many quantitative hedge funds solidified into conventional wisdom. The sage of the theory was Matthew Rothman, the global head of quantitative equity strategies for Lehman Brothers. His memo on “Turbulent Times In Quant Land” (linked here) quickly became the most read primer on what caused the damage, and he became one of the most quoted analysts on Wall Street. Both the Wall Street Journal’s Kaja Whitehouse and the New York Times 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 debt portfolios found themselves unable to sell those portfolios at what they considered reasonable prices. The market for these collateralized debt products had always been illiquid, and many were value according to models of their expected performance because their was no market to compare them to. With fears of subprime and collateralized debt obligations spreading in the market, there were few buys for these positions. So instead the fund managers began unwinding more liquid equity positions, buying stocks they had sold short and selling their long positions, and this was the second step in the quant bloodbath.
This sudden unwinding caused the prices of these stocks to “misbehave”—quant speak for when prices stubbornly refuse to obey the models they have worked very hard on. What was “supposed” to go up went down and vice versa.
"Wednesday is the type of day people will remember in quant-land for a very long time," Rothman told the Wall Street Journal "Events that models only predicted would happen once in 10,000 years happened every day for three days."
Since so many of the much-prized and closely-guarded secret quant models are very similar, the confusing signals from the unpredicted stock price movements caused a domino effect. The third step of the unraveling came when a few large quant funds began further de-levering and otherwise reducing risk by liquidating positions. This exacerbated the problems set-off by the earlier sell-off.
The result has been a blizzard of letters from hedge fund managers to their worried investors, emergency conference calls and now, from Goldman Sachs, a bailout of one of their largest quant funds. Nervous investors are now in a prisoners dilemma of sorts, fearing that large-scale redemption requests could topple the hedge funds with an old-fashioned “run on the bank” but worried that if losses continue and everyone else bails out, they might be left suffering an even worse fate of being the last man standing on a sinking ship while the lifeboats head for the horizon.