Toomre Capital Markets LLC

Real-Time Capital Markets -- Analytics, Visualization, Event Processing, and Intelligence

Scientific American

After the Crash: How Software Models Doomed the Markets

The above also is the title of a November 21st 2008 editorial by The Editors of Scientific American. The editorial's sub-title is "Overreliance on financial software crafted by physics and math PhDs helped to precipitate the Wall Street collapse". This editorial is well worth reading both today and in the months and years to come, as all parties consider the form and regulation of global financial markets after we get through the current credit crisis.

The editorial begins:

If Hollywood makes a movie about the worst financial crisis since the Great Depression, a basement room in a government building in Washington will serve as the setting for a key scene. There investment bankers from the largest institutions pleaded successfully with Securities and Exchange Commission (SEC) officials during a short meeting in 2004 to lift a rule specifying debt limits and capital reserves needed for a rainy day. This decision, a real event described in the New York Times, freed billions to invest in complex mortgage-backed securities and derivatives that helped to bring about the financial meltdown in September.

In the script, the next scene will be the one in which number-savvy specialists that Wall Street has come to know as quants consult with their superiors about implementing the regulatory change. These lapsed physicists and mathematical virtuosos were the ones who both invented these oblique securities and created software models that supposedly measured the risk a firm would incur by holding them in its portfolio. Without the formal requirement to maintain debt ceilings and capital reserves, the commission had freed these firms to police themselves using risk tools crafted by cadres of quants.

The staff at Toomre Capital Markets LLC has long admired this publication, partly since both Lars and Aldon started in technical fields before moving to Wall Street in the 1980s. Immediately before starting at Lehman Brothers, Lars Toomre was at M.I.T. and Aldon Hynes was at what then was one of the Mecca's of industry research, Bell Labs.

Where did we work in Lehman Brothers? We each started work in the mortgage department focusing on the very software that let Lehman Brothers and other investment banks slice and dice pools of assets into various classes (or tranches) of debt securities then known as Collateralized Mortgage Obligations ("CMOs") and now as Collateralized Debt Obligations ("CDOs"). We were two of the first quants hired by Lehman Brothers' fixed-income division working on some of the early software that this editorial targets!