the GFC through a quant’s eyes

I can’t remember which of the 3 Todd Simkin interviews on my blog I summarized where he mentions it but Todd was asked if SIG’s secretiveness has been an advantage. He said in trading, it’s been good, but when it comes to recruiting technologists or researchers, it’s been a hindrance. The FAANG companies are household names and since trading firms compete for some of the same talent, you’d want more people to know what SIG is.

I figure this recognition is behind their increased public outreach. Like this awesome video that recently dropped from the lecture series where Professor Costa teaches their trainees about the GFC.

It starts assuming you don’t even know what a bond is and proceeds to cover an unbelievable amount of distance in one hour. The narrative and history going back to the 80s is fantastic and I even learned (or reviewed) a lot of basic market knowledge.

#teaching_goals

While this video is loaded, here’s 5 bits that stood out for me. There’s also a very SIG-esque lesson in there about anchoring bias.

1. Diversification has literal monetary value – Great demonstration of how portfolio theory translates directly into pricing and risk management
2. Reflexivity in credit markets – Default rates weren’t actuarial constants but depended on loan originators’ incentives. Once originators became divorced from risk while retaining pricing/underwriting control, the system became unstable. A systems thinker would have spotted this disconnect.
3. Misaligned incentives drove market distortion – Traders focused narrowly on derivatives markets where the CDS market dwarfed the underlying bond market. Unlike bond issuance (limited by actual capital formation needs), derivative trading appetite was essentially unlimited.
4. Good ideas taken too far become dangerous – Diversification through low correlation assets is sound in principle, but this conceptual acceptance prevented people from asking the critical follow-up: “To what degree is this still safe?” (The opposite is hormesis – sometimes a little of a bad thing is actually beneficial. As the old saying goes “the posion is in the dose”.)
5. “This would turn out to be a fateful decision” – The final section on implied correlation reveals how trading desks completely inverted their hedge ratios between tranches, fundamentally misunderstanding how correlation affects different credits.