The Wall Street meltdown might have a silver lining.

    No I’m not talking about the schadenfreude that many are experiencing now that the investment bankers are falling from their lofty heights. That might be fun, but it’s not a silver lining. No, I’m talking about the large amount of highly talented people who became “quants” aka mathematical modelers in the finance sector now having to seek employment elsewhere.

    Now don’t get me wrong, there’s a place for finance, but we as a society over-invested in it. One of the really sad things was that the greed led a lot of people to put deep and abiding faith in the models. Those of us involved in mathematical models for any length of time know from bitter personal experience: The last thing you should do is believe a model, especially if it’s your model. Models are useful, not true, and should be viewed with a great deal of skepticism, always. While I suspect that the “quants” knew this, the greedy, myopic twenty five year olds doing the trading—the ones with the right hair and a nice liberal arts degree from an Ivy or Duke—didn’t (they’re certainly not trained to evaluate such things), and given the almighty dollar coming their way I suspect a good number of the quants started believing too.

    If you want a case in point, I offer up Doctors Merton and Scholes, Nobel laureates in economics, 1997, and principals of Long Term Capital Management. LTCM was a hedge fund founded by the smartest guys in the room. Unfortunately, their model was predicated on some assumptions that turned out not to be true, most importantly one about lack of correlation in various investments. This assumed other people weren’t copycats on what LTCM were doing. Whoops, funny how when the smartest cats in the room seem to have found a burrow of endless mice every other cat starts copying.

    One of the giant market distortions engendered by the rise of Wall Street has been the shortage of scientists, broadly defined: Fewer Americans going to engineering, chemistry, math, statistics, economics (besides finance, that is), etc. Instead, far too many of the best and brightest young people go into finance and investment banking. Something like 20% of the graduating class of Harvard in recent years goes directly to investment banking. That’s right, a 22 year old is managing your money, hoping to retire by 35 or 40 to a house in the Hamptons, another house in Bermuda, and a third one in Tahoe, with a nice trophy wife on his arm, and the surplus of young ladies living in finance capitals are there hoping to be said trophy wife. One of the reasons to chase the Ivy degree so hard was the hope—not unreasonable—that an in would be available for Junior into a hedge fund, Lehman, etc. So this massively distorted the college admissions market, too, making otherwise solid schools seem like poor buys and encouraging many families to run up piles of debt on undergraduate educations, mostly in the hope that Junior would get the right contacts in Duke that he wouldn’t get at, say, Illinois.

    I recall taking real analysis back in the mid ’90s. Hands down the smartest guy in the class was a Cal Tech educated engineer getting a PhD in Finance. Now this was just before the big model finance mania. He’d worked for a big aerospace company but with the defense budgets going down, he realized that his future lay elsewhere. This is, of course, why so many physicists ended up on Wall Street, too. I’m sure he did well but you know, finance doesn’t actually produce anything, whereas airplanes are something. It was getting so bad near the end of my tenure in grad school that I’d see students trying to “stealth” their way into finance by applying to programs in one area but taking finance classes. Getting into an actual PhD finance program was tricky and often costly but most schools will let you take a few courses in another department….

    So if there is a silver lining, I hope it is this: Smart kids with math skilz considering careers in finance, please come back. The rest of the world needs you to help deal with things like, oh, climate change, looming mass extinctions, energy shortages, world hunger, transit and infrastructure, finding productive things to do now that we won’t make piles of dough on houses nobody wants, to say nothing of good old “basic science.”

    As for the Ivy league liberal arts major turned investment banker who ran my admittedly modest portfolio into the ground with $200K in student loans breathing down his neck… thanks but I don’t want aioli, arugula, sprouts, grape tomatoes or olive tapenade, I’ll enjoy my schadenfreude plain and unadulterated.

    For further reading:

    • Niall Ferguson, The Ascent of Money. Excellent and very lucid writing. I read this on a plane to Vegas (for business!), which seemed appropriate.
    • Nassim Nicholas Taleb, The Black Swan. Rather more personal pique than is really necessary and some excessively broad statements, but generally he’s right on, particularly about the excessive faith in the Gaussian error distribution when modeling extreme events, the so-called “tail risk” being too low. We’ve seen this in other areas as well.
    • Any others?