Top critical review
Useful history, unconvincing narrative
Reviewed in the United States on November 6, 2017
The enjoyable portions of the book were those detailing objective history in the finance field. The author summarizes the quant side of finance well, explaining both sides of the efficient market hypothesis debate, its implications, and the players involved.
He starts with the development of the 'random walk' or Brownian motion. He notes that this concept is based originally on the findings of Robert Brown, a botanist in the early 19th century. His initial discovery was the seemingly random movement of pollen particles in water under a microscope. Oddly enough, it was actually Einstein in the early 20th century who later realized that the random motion was due to individual water particles interacting with the pollen particles. This concept was eventually adopted in the finance field to describe movement in market prices of securities. Ed Thorpe, an early user of the concept, developed a volatility-based model as a means to value options contracts...a precursor to the Black-Scholes-Merton option pricing model.
He goes over the LTCM strategy in detail. At a high level, the fund bet on return spreads for particular securities reverting to historical levels. One version of this involves on- and off-the-run treasury securities. Since on-the-run securities generally enjoy a higher demand, they tend to trade at a premium and have greater liquidity. So LTCM would buy off-the-run treasuries at the relatively lower value and short on-the-run securities. Their overall risk seemed mitigated since they had small net positions within any single market. However, following the Russian default in 1998, the 'flight to quality' caused a large spike in on-the-run treasury securities, causing sizable early losses to LTCM and all the copycat funds mimicking their strategy. Margin calls required the sale of long positions, but in the less liquid off-the-run market, these sales had a material impact on prices, exacerbating losses and causing more margin calls. This vicious cycle resulted in the failure of LTCM's heavily leveraged portfolio, ending in a bailout from other financial institutions.
The author describes the liar's poker game, which sounds fun, where players have to successively guess how many of a certain number shows up on a collection of dollar bills. The successive player can either call the previous player's bet or raise the number of predicted occurrences. It's kind of like the game 'bullshit' with playing cards.
The author also covers carry trade, wherein traders borrow lend-able assets in one market with low interest rates and lend them in another with higher interest rates. The strategy requires failure of interest rate parity on exchange rates to hold over the investment horizon, which is more likely in emerging markets than in others. Japan's monetary policy has historically made them a primary market in which investors applied this strategy.
He gets some into collateralized debt obligations, explaining the tranche structure and how cash flows through. He notes that many investors under-estimated the correlation between tranches when investing, resulting in a serious miscalculation of risk-adjusted cash flows and a mismatch between risk rating and actual risk.
The above is all part of a narrative wherein individuals attempt to treat finance and economics as a field similar to the hard sciences, where the subjects (people) follow predictable patterns that can be modeled. He challenges this assumption and states that mathematical predictability is not reliable in these fields, which is a reasonable position held by several schools of thought. He points to behavioral finance developments as alternatives, including the adaptive market hypothesis. In this model, as opposed to the EMH, market inefficiencies can exist and be bid away, but may fail to rematerialize systematically. In other words, markets adapt to inefficiencies and prevent them from reoccurring. It also paints investment markets as far more chaotic, with institutional investors trying to squeeze every last penny out of every possible inefficiency imaginable.
He covers high frequency trading and dark pools, glossing over the often faux liquidity HFT offers, and explaining that dark pools are basically just exchanges that can't be seen by the general public (and to a similar extent regulators).
The moral of his story is that quants were the cause of the crisis. Unfortunately, his own story made me feel that the quants were just as much victims of the crisis as anyone else. There's no step-by-step causal relationship developed to explain how they caused the crisis, just this vague idea that their incorrect models may have caused asset price bubbles, and that the irrationality of the masses (not captured in models) resulted in the bubble bursting. But the link between quant funds and housing prices is nonexistent, even if the link with housing derivatives is apparent. As with most books about the crisis, the author stops short of sources and focuses on symptoms. I would not recommend as a wealth of crisis knowledge, however I would recommend as a brief history of finance and financial markets.