HOW QUANTS CAUSED THE 2008 ECONOMIC MELTDOWN.
Article by Glenn Omondi, Third year student at Kenyatta University
Who is a quant? It is sad that most people, especially in the developing world, do not even know that such a job exists. Oblivious to the fact that in the next 10 – 15 years, quants will be at the very centerpiece of investment banking.
A quant (quantitative analyst) by definition, is someone who tries to model human behavior in financial markets so as to try and offset the risk of default, i.e. failing to pay a loan– in layman’s language. They also try to model how markets may perform in the future so as to predict the necessity of engaging in derivative contracts. Derivative contracts are financial instruments such as options, swaps and forwards. But that is a whole new topic which I may delve deeper into in future articles, upon your request. But if you are studying Finance, Economics or Actuarial science; among other courses that may be related to economics, you may have a hint of what I am talking about.
Now, derivative contracts may be a dangerous or good financial instrument, depending on how they are used. Let me use an example so that I can put you into perspective. It is common knowledge that our local airlines Kenya Airways has been languishing for a long period now. This is mainly due to mismanagement by a string of its recent CEOs. I will refrain from quoting their names so as to avoid defamation charges. However, you can carry out your research and find out more for yourself.
Jet Fuel is not a cheap commodity. So many airlines hedge (in other words, enter into derivative contracts) against the price of Jet fuel so as to offset the risk of an increase in prices. This is the very basic edifice of a derivative contract. Let say the price of Jet fuel now is 1000 dollars. You enter into a derivative contract that basically stipulates; in case the price of Jet fuel rises, let’s say by 500 dollars thereby taking it to 1500 dollars. You will still purchase it for 1000 dollars. The hedge fund will assume the additional cost of 500 dollars. So by doing that, you have mitigated against the risk of price rise. The downside is that, if the price falls, maybe to 700. You will still be forced to pay 1000, as per the contract. The additional amount (300) will go to the hedge fund, and that is how the hedge fund makes it profitable. This is what exactly happened to KQ. The CEO was clearly advised that the projections show that the prices would fall. However, he still went over the heads of his advisers and hedged against price rise.
As predicted, the prices fell. You can only imagine. Prices of fuel are retailing at maybe 500 dollars per liter but you are still forced to pay 1000 for a long period because these contracts can last up to even a year. KQ assumed huge losses. Its share price went on a downward spiral. The CEO then bought its shares at a very low price. Knowing that KQ is a government-owned corporation hence the government must intervene, and it did. After the government pumped millions into the company to cover up for his own mess, he sold the shares at an inflated price thereby making millions, if not billions. If this is not insider trading, I don’t know what is. Corporate espionage at its very best?!
That is just but a mere example of the harm of derivative contracts. Now think of what happened to KQ, on a much wider scale. On a nationwide scale. I am sure most of you in one way or another have heard even fragmentation of the story of the 2008 Economic Crisis. Jobs were lost, bank loans defaulted and billions of revenue lost. That is simply why I admire Former President Barrack Obama. I can’t think of any other worse time to be president. Yet somehow he managed to pull the country through the rubble.
It was late 2007 when it happened. A busy day at Goldman Sachs, along the famous wall street. Many stockbrokers haggling to close deals at the top of their lungs through the telephone in the trading halls. Just another busy day at the New York Stock Exchange. Many oblivious to what was to come. This is where the Quants come in. Wall Street now is but a shell of what it used to be. Why? What you so in the famous movie, Wolf of Wall Street is just but a facade! Nowadays there is no need for a trading company to have hundreds of stockbrokers. For what?! At the dawn of trading algorithms and High-frequency trading. One trading algorithm can easily do the job of 100 brokers at a much faster speed. Trading at the speed of light, they call it. A trading algorithm is basically a computer program designed to place trades at a much higher frequency and speed than a human being. One simple trade can happen in a fraction of a second. Now you can see where the appeal is.
A Quant is basically someone with a good grasp of mathematics and maybe a substantial knowledge of economics and programming. I remember when actuaries were thought of as mathematics wizards. However, what most people don’t know is, the level of knowledge that an actuary is required to know to get a job as an actuary, is the level of knowledge that a quant needs to even get a call up for an interview. Move aside actuaries, there is a new sheriff in town. Most quants have a firm background in mathematics, topped by masters and a Ph.D. So if a quant tells you something is right, then it’s only normal that you have to agree. I mean, this guy has enough education to last you two lifetimes, and that was the major problem.
They kept on complicating their models. They got cocky, and finally, the bubble burst! A phrase was once put forward.
This takes me to my final subtopic: