May 4, 2010
Most of the pseudo-mathematicians don’t really know the difference between a discrete process and a continuous process, and when it is reasonable to believe that a continuous process can be assumed for theoretical purposes because the (real-world) discrete process converges to it, and when it is not.
And they don’t know basic probability theory well enough to apply simple forms of it that don’t rest on too many assumptions, and that would be more transparent to practical analysis. Instead, they revert rapidly to the more “sophisticated”-looking, but more opaque, techniques of regression analysis or Ito’s lemma, or the like.
The field doesn’t discipline this sloppiness. Even the “best” journals publish papers with mathematics that is poorly defined and in many cases outright wrong. The checks are not good enough to winnow out the sloppiness and errors, and there’s no incentive to do it. In financial corporations quants have a fiefdom in which they can operate without a real quant ethical discipline. In fact they do things that they think professionally unethical all the time – like gaming the ratings systems, for example – because it is standard practice.
The most egregious example in recent history, among many, of quants using pseudo-mathematics to achieve a result that is impossible with real mathematics was its use to procure AAA ratings for the top tranches of “CDOs-squared.” These were nothing but repackaged BBB-rated (low quality) mezzanine tranches from the original CDOs.
The BBB-rated mezzanine tranches of the original CDOs were deemed to have a much higher probability of default than a AAA rating requires. But by bundling many of these BBB-rated mezzanine tranches together, the quants went ahead and assumed they would get the benefit of “diversification,” improving their quality because of the low correlation among the tranches being bundled.
But the trouble was, each mezzanine tranche in the package was already highly diversified, consisting of in some cases 10,000 loans. To take credit again for further diversification and low correlation was absurd – not just in practice, but mathematically absurd.
The problem is, I think, stated clearly in an article by New York Times business writer Joe Nocera about retiring hedge fund manager Neil Barsky, a former Wall Street Journal reporter:
One of the things that struck him when he first started working on Wall Street, he said, was “how compensation-oriented Wall Street is. When I was a journalist, I could get rewarded in 100 ways, including being on Page One. Wall Street is the other extreme. There is a singular focus on compensation that is simple, it is clean, but ultimately it is unhealthy.”
Why should you do things right when you’re making gobs of money anyway, and people – and books – think you are highly sophisticated and worship you with hyperbolic language?
Michael Edesess is an accomplished mathematician and economist with experience in the investment, energy, environment, and sustainable development fields. In 2007, he authored a book about the investment services industry titled The Big Investment Lie, published by Berrett-Koehler.
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