Revenge of the Nerd

Born in Birkenhead, a small town outside Liverpool, Wilmott studied applied math at Oxford. In his spare time, he dabbled in juggling and competitive ballroom dancing. After earning a Ph.D. in fluid mechanics from Oxford in 1985, he got his start as an applied mathematician, working on jet-engine turbines for Rolls-Royce and calculating detonation sites for an explosives company. In the late 1980s, he started applying math to finance. His first burst of fame came in 1993 when he co-wrote a textbook on derivatives. Soon he'd made a name for himself as a contrarian guru, writing more textbooks, and giving speeches around the world to rooms full of bankers. From 2001 to 2005 he ran a $170 million hedge fund that returned an average of 15 percent a year.

Back on Oxford Street, Wilmott walks by several tube stops, deep in conversation on the topic that gets him most agitated these days: structured credit, the area of finance most at fault in the crash, and where quants inflicted the most damage by applying mathematical models they swore could predict default rates. "A complete lapse of ethics and responsibility," he calls it.

A collateralized debt obligation (CDO) is the most common form of structured credit. Banks build CDOs by putting together a bunch of loans, slicing them into little pieces (tranches) and selling them off to investors. Think of it as disassembling a cow into different cuts of meat—from prime steaks to ground beef—that are priced according to their quality. The first CDO was issued in 1987 by Drexel Burnham Lambert, the same firm that went bust in 1990. After the fall of Drexel, CDOs went away for a while, until the quants came along. In 2000, the CDO market was jump-started by David X. Li, who, while working at JPMorgan, created the Gaussian copula function, a formula for determining the correlation between the default rates of different securities. In theory, the model tells you the odds that, if one CDO goes bad, others will too. The apparent genius of the Gaussian copula is its abstraction. Rather than relying on the immense amount of data used to figure the odds that a CDO might default, Li appeared to have discovered a law of correlation. That is, you didn't need the data; the correlation was just there. Armed with it, quants could price CDOs much faster, and traders could buy and sell them at record speeds. Gaussian was rocket fuel for the CDO market. The global volume of CDO deals went from $157 billion in 2004 to $520 billion in 2006. As more banks got in on the game, the once large profit margins started to shrink. In order for banks to make the same kind of returns, they had to pack more and more loans into a CDO, essentially making bigger bombs. Li was on his way to a Nobel Prize when the world blew up. Wilmott marvels at the carelessness of it all. "They built these things on false assumptions without testing them, and stuffed them full of trillions of dollars. How could anyone have thought that was a good idea?"

To Wilmott, Gaussian is an example of how dangerously abstract quant finance has become. "We need to get back to testing models rather than revering them," he says. "That's hard work, but this idea that there are these great principles governing finance and that correlations can just be plucked out of the air is totally false." Wilmott spends a lot of time with another former student trying to tackle the biggest problem facing quant finance right now: how to price all those CDOs sitting on the balance sheets of banks, the toxic assets we hear so much about. "We don't have the tools yet to truly price them," Wilmott says. "People thought we did, but they were nowhere near robust enough."

The optimist in Wilmott thinks that people realize these models don't work. But he's not really an optimist. "What I think is going to happen is that people will forget and we'll just keep going on the way we have been with nothing really changing," he says. Wilmott is encouraged by President Obama's proposals to tighten regulation of derivatives; he thinks it'll keep quants on a shorter leash. But he's also stunned by the lack of outrage over the financial mess. The violence that erupted at this year's G20 summit wasn't anywhere near what he thought it should've been. "Where the hell was everybody? If people aren't angry now, they'll never be."

Wilmott realizes he's fighting a losing battle, and that changing finance will take a lot more than a few thousand better-prepared quants. As long as banks get paid in the first year for selling a CDO that doesn't mature for 30 years, little will change. Still, he does sense a tidal shift. "I've been helped by recent events, but I don't really take solace in that. I'm not gonna say I told you so."