"After a bit more reflection, I'm going to write a post discussing, from the viewpoint of Patterson's book, the folly of the TARP, government intervention, and implicit saving of the quant funds by the federal government."
Well, I've reflected, and arrived at some conclusions which work, at least for me.
Before I express them, let me also repost the key failings which Patterson's book revealed among the largest, apparently most market-influential quant hedge funds,
"1. They all exhibit a shallower comprehension for the human behavioral aspects of financial markets than their mentors.2. With each succeeding generation of acolytes, the belief that pure mathematical and statistical methods can apply, sans contextual understanding, to financial markets grows stronger, and the awareness of key underlying, limiting assumptions grows weaker.
3. Crucial dimensions of risk management for both the hedge funds, and the instruments they often trade, e.g., leverage, collateral, and ability to meet an instrument's, such as a credit derivative swap's obligations, are profoundly separated from the actual trading activities.
4. As such, both senior managers of the firms engaging in these activities, as well as counterparties, bear significant responsibility for having little understanding of the pragmatic aspects of risks which were undertaken by these quantitative traders.
5. Perhaps most ironically, all of the current generation of quantitative traders believed in exceptions to Eugene Fama's general EMH model, yet, in a fallacy of composition, when, together, they exploit commonly-observed inefficiencies, they become the very agents of EMH, obliterating the profitable inefficiencies they so recently observed and on which they traded."
It's my contention that, by inadvisably rescuing Citigroup and Morgan Stanley, the federal government unwisely allowed many investment firms run by flawed managements to survive what should have been their Darwinian, Schumpeterian moment of extinction.
Beginning in late 2007, the fall in values of financially-engineered, structured fixed income products, e.g., CDOs, caused large losses at firms such as Citigroup and Merrill Lynch. As equity in those firms plunged, their managements scoured the globe for new sources of equity. The downward spiral in asset values, in time, during 2008, took down Bear Stearns, Lehman Brothers Holdings, Merrill Lynch, Wachovia, Washington Mutual, while finally approaching making insolvent Goldman Sachs and Morgan Stanley.
I contend that this phenomenon, left unchecked, would have resulted in much more damage to, and possibly the end of quant hedge funds like those, and quite possibly those described in Patterson's book. Specifically, Citadel, AQR, and PDT within a failed Morgan Stanley.
Why?
Without government guarantees of major players in markets for instruments which those hedge funds traded and held, the values for those instruments would almost certainly have plummeted, as so much market-making capacity would have been liquidated. Simply put, there'd have been nobody to whom to sell the various swaps, CDOs and other fixed income assets.
Existing on large amounts of short-term financing from banks, as they do, the quant hedge funds would likely have become insolvent, as their losses on assets far exceeded their slim capital ratios.
Suppose the firms which Patterson profiled (with the apparent exception of Simons' Renaissance), and many like them, were to have lost everything and closed?
Would this have been such a bad thing? I think not. Rather, it would have been the most desirable outcome.
As I noted in the five points I restated from my prior, linked post, the managements of many of these funds was, and still is, badly flawed. Their risk management systems are flawed and too simplistic. They use too much leverage for survival during the worst market events. They fail to broadly understand the true impact of the existence of so many of their ilk, together, attempting to exploit presumed market inefficiencies, i.e., that this very act, using so much capital, leads to the return of those market niches to efficient pricing.
Such flawed management needs to be weeded out and extinguished. That's the free market way. Short term success may exist, but, longer term, those business models incapable of weathering occasional storms must perish. Otherwise, capital is inefficiently allocated.
Instead of adding to the chances of future long term stabilization of financial markets, our government's rash, incorrect actions in 2008 have only served to prolong the lives of hedge funds which are managed using flawed models, techniques and assumptions.
As hedge funds, these entities were to only take investments from 'sophisticated' investors. So their failure shouldn't bother us. And if, among those so-called, self-identified sophisticated investors, were entities holding, say, pension assets of unions or the endowments of non-profits, well, that's just too bad.
Sooner or later, those institutions need to face the consequences of dabbling in financial markets in which they do not truly have expertise. We, the rest of society, can't save these institutions from themselves forever without substantial costs to the rest of our society.
Finally, the unintended, or, perhaps more frighteningly, intended consequences of the TARP and related Fed actions of 2008, were to have saved some wealthy investors, at a cost to the rest, and definitionally poorer elements of US society. That's just wrong.
After reading Patterson's book, think about whether you really believe that families with an AGI of under $200,000 should be taxed to pay for the rescue of people like Weinstein, Asness, Griffin and Muller.
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