The Blow-Up

This summer, as a meltdown in the subprime credit market spilled over into other markets, all eyes were on the mathematically trained financial engineers known as “quants.” Who are these guys?

By Bryant Urstadt

On Wednesday, August 8, not long after the markets closed, 200 of the smartest people on Wall Street gathered in a conference room at Four World Financial Center, the 34-story headquarters of Merrill Lynch. August is usually a slow month, but the rows of chairs were full, and highly paid financial engineers were standing by the windows at the back, which looked out over black Town Cars below and the Hudson River beyond. They were “quants”, and they had a lot to talk about, for their work was at the heart of one of the most worrisome summer markets in decades.

The conference sponsored by the International Association of Financial Engineers (IAFE), and its title asked, “is Subprime the Canary in the Mine? ‘Subprime” borrowers are home buyers whose poor credit history means they don’t qualify for market interest rates.

The panel was moderated by Leslie Rahl an MIT graduate and the founder of Capital Market Risk Advisors. Her job is to advise companies on risk and help them understand the products quants invent. But understanding was in short supply in August. Some of the quants’ financial products had collapsed in price, with unexpected consequences in another financial sector: the trading of equities.

And was subprime the canary in the mine? It was a question the panelist and the audience who showed up at Four World Financial Center last August are only beginning to answer. Leslie Rahl, for instance, cautiously told me in a follow-up e-mail that it is “looking more and more like the answer is yes.” Many signs have suggested so, from job losses to a continuing credit drought to a weakening dollar, but that history has not yet been written.

As a prelude to the panel discussion, Rahl, asked the audience to predict whether credit spreads would shrink or widen in the coming months. She was talking about the difference between the price of a treasury bond and the price of a riskier corporate bond, a standard Wall Street gauge for the health of the economy. A widening credit spread is generally seen as a sign of uncertainty, and a narrow spread as a sign of optimism.

“How many think spreads will widen?” she asked. The hands of about half of the smartest people on Wall Street shot up. “And how many think they’ll narrow?” The other half—equally smart—raised their hands. “Well,” she said. “That’s what makes a market.” If they didn’t know, nobody could.

October 15, 2007