The Fisics Of Phynance

by John Christmann

On September 10th, 300 feet below the pasture strewn border between Switzerland and France, a large group of physicists gathered to witness the inaugural run of a 17 mile circular particle accelerator known as the Large Hadron Collider. In a cavernous control room lined with monitors and banks of blinking equipment that dwarf the home theater departments at Circuit City, the physicists watched attentively as a button was pushed, hurling a beam of protons down the gently curving tube of what can best be described as the world’s largest flashlight.

The build up to the historic event was heightened by sensationalized reports that the Large Hadron Collider, which was designed to smash atomic particles together like Big Bang crash test dummies, might create a black hole that would instantly suck up the planet and much of the surrounding solar system. Knowledgeable physicists were hauled out to pooh-pooh such speculation, although they did concede that such an event was theoretically possible even if the probability was astronomically small. Way smaller than being hit twice by lightning they reassured.

A lead physicist initiated the count down and depressed the button. Three. Two. One. The room immediately exploded in exuberant applause. Not because the button was pushed; but because 90 microseconds later the beam of protons struck the intricate sensors of a large steel catcher’s mitt, disintegrating into sub-atomic road kill that decayed forward and backward in time leaving ghostly traces of their infinitesimal lives twinkling on the vast array of computer monitors. The Large Hadron Collider worked! And the earth was still spinning.

Three days latter Lehman Brothers declared bankruptcy, initiating a chain reaction of events leading to the most catastrophic financial melt down the world has ever seen. Coincidence?

A Random Walk

It turns out, the strong and weak forces that bind physics and finance are not unfounded. In 1900 a young mathematician by the name of Louis Bachelier wrote a thesis paper entitled The Theory of Speculation suggesting that stock prices could be modeled after the random movement of particles suspended in liquid, called Brownian Motion. The principle of Brownian Motion was later used by physicist Albert Einstein to prove the existence of atoms. Unfortunately Bachelier’s random walk model did not incorporate the rude intrusion of human behavior into price evaluations. This came succinctly to light in 1929 when the stock market crashed.

With the potential to lose so much money, the physicists stayed out of finance for a while, preferring to explore the wondrous world of atoms and really big explosions. For many years their attention was guided by very successful government projects to build a hydrogen bomb and put a man on the moon. Even if we couldn’t understand how it all worked, the outcomes were pretty convincing.

But in the 1970s physicists were once again drawn to parallels between finance and blossoming fields of scientific study like Chaos Theory, Cosmology, and the Grand Unified Theory of the universe. The doors of Wall Street were open to these geniuses, who armed with high powered computers, began to develop obscure “derivative” products which followed the price differences between, say, treasury bonds in Bolivia and Pork Belly Futures in Plano, Texas. Many of these derivative products were modeled on quantum physics, borrowing from the complex equations that were used to describe the relationship between elementary atomic particles.

Unfortunately these models were not quite perfect, for in October of 1987 the market crashed again, in part due to automated computer trading that valiantly tried to synchronize derivitive trades against the trades made by irrational humans. The physicists on Wall Street regrouped with better models and bigger computers, but then in 1999 more trading decisions by irrational humans in Asia and Russia brought about the collapse of the highly leveraged hedge fund, Long Term Capital Management, nearly bringing the banking system to its knees.

But in the intervening periods people made a lot of money, our retirement accounts soared, and the values of our homes steadily rose. The financial physicists continued to thrive on Wall Street. As long as we were all making money, who cared?

Horse Trading

I tried to explain the current financial crisis to my kids who have been inundated with more news reports than they can stand on the subject. This is what I told them:

“Suppose you want to buy that pony I would never let you have. You look around and came across a really fast, mottled brown Mustang, but I still won’t buy it for you. So you go to the bank and say, hey I found this really fast horse, would you help me buy it? The bank is interested because thanks to government deregulation they can now get into legalized gambling ventures like Off Track Betting, and they are starting to make deals like this with a lot of horse owners to run more races. They strike a bargain; they will take your allowance as a down payment and buy your pony for you as long as you bring it to the track and race it every month. They keep your horse on a dude ranch called the OK Collateral with many others horses. Your horse loves to run, so you don’t worry so much. You name it Sure Thing.

“It turns out Sure Thing is faster than you thought. It is always in the money, winning first, second, or third every time it races. It never loses. The bank is delighted because a lot of people want to bet on Sure Thing. A lot of people. And then a bright manager at the bank’s Derivative Desk comes up with an idea which he presents to senior management. Instead of taking bets on every single race, he tells them, the bank can collect one large investment bet and then pay out the winning over time as each race is run. That way investors don’t have to hang around the track each month with a bunch of winos, horse thieving brokers, and low life hedge guys, and the bank gets all the money up front so it can buy more horses and take more bets. Furthermore, different kinds of horseback securities can be created based on whether Sure Thing wins, places, or shows. These betting combinations can be offered as ‘tranches’. Much more sophisticated than traditional trifectas and perfectas, don’t you think? And since Sure Thing never loses, the manager concludes, the bank can sell billions of these bonds. Billions!

“Then the finance physicists jump in. Horse racing, they explain, is a lot like hurling protons at the speed of light around a circular particle accelerator. We have lots of computer models to calculate whether quarks or mesons or gluons will form when the proton hits the finish line. We can use the models to come up with lucrative prices for our tranches. They take the pencils from behind their ears and start writing long equations which they present to the bank executives. The executives nod while their eyes glaze over. Finally, one lone executive with a troubled expression on his face, says, “What if Sure Thing loses?”

“The physicists quickly pooh-pooh such a notion. They reassure the executive that while there is a theoretical possibility of such an outcome, it is as remote as creating a black hole in a Large Hadron Collider. And here is the best news, they say. The bank can sell insurance to those skittish investors that are worried about their bets. It is kind of like horse trading; we call it Race Default Swaps. If our horse loses we pay up, but since Sure Thing never loses we can make trillions just selling insurance to people who don’t need it. Trillions!

“The bank executives, who don’t understand the complex equations, look at each other and shrug. Who are they to argue with the laws of physics when there is so much money to be made?
“OK” they say, “Let’s bet the tranche.”

“For a while everyone is happy. You own a pony and get to watch it race every month. Sure Thing keeps winning. The manager at the Derivatives Desk has earned a huge bonus. The bank executives are making millions of dollars. Investors are making prudent bets. Money is flowing. It is a good time to be a horse trader on Wall Street.

“But then one day Sure Thing starts limping. The bank is mad and threatens to take your pony away if it doesn’t run. The vet comes to examine Sure Thing at the OK Collateral. I have some good news and some bad news he tells you. The bad news is that Sure Thing has a split hoof and can’t run anymore; he must be sent to pasture. Hearing this, a lone dude trancher from the bank shakes his head sadly and forecloses the gate to the OK Collateral, taking Sure Thing away. What’s the good news you ask, crying.
“I own a lot of Race Default Swaps,” he says.

“The physicists from the Derivative Desk are called into the manager’s office. They have some explaining to do. We have some good news and bad news they say. The bad news is that horses don’t behave exactly like protons and we owe our investors trillions of dollars which we don’t have. The manager opens a window and steps out on the ledge. The physicists stop him, smiling. The good news is we covered ourselves by reverse trading trillions worth of Race Default Swaps with all the other banks. We pay them the money we don't have and they pay us right back! The manager hears this and jumps. The good news is that his office is on the first floor. The bad news is that he must now take the elevator up twenty six floors to the executive suite which does not have open windows.

“Pulling at his tie and mopping his brow, the manager of the Derivative Desk puts his best face on things. I have good news and bad news he says. The bad news is that we are about to go bankrupt and the world financial markets are about to collapse. There is complete silence in the board room. What’s the good news the bank executives ask ashen-faced.
“We have guaranteed bonuses and we own a plow horse.” he says.

“And that,” I tell my kids, “is the financial crisis.”
My son is shaking his head in disbelief. “Wow, those bankers are pretty dumb,” he says.
His older brother smirks, “It just goes to show you; there is no such thing as a free tranche.”
My daughter is crying. “I want my horse back,” she sobs.

The New Manhattan Projects

I think about this kind of stuff at night, usually in a cold sweat, as a way to put myself to sleep after worrying endlessly about my IRA and College Funds. And it occurs to me that the physicists are partly to blame for the catastrophic mess we are now in. These incredible geniuses, who predict devastating hurricanes based on the beat of butterfly wings and who collide particles together at energy levels approaching the big bang, need a little supervision; not because they are irresponsible, but because the outcomes of their work are just a little too dangerous for mankind. Our physicists have clearly demonstrated what they can do when given specific objectives. Therefore, it seems to me that our best and brightest should be set to work immediately on Government projects strategic to the vital interests of this country. Here are some ideas:

Physicists with advanced degrees in Chaos Theory should put their expertise back where it belongs. I suggest healthcare and Congress. This will be called the Washington Project.
A team of physicists headed by noted scientist, Dr. Emmett ‘Doc’ Brown, can be convened to develop time traveling DeLoreans that run on beer cans, plastic water bottles, and Styrofoam in an effort to bring our beleaguered auto industry back to the future. This will be called the Detroit Project.
Particle physicists and cosmologists could be set to work at MIT labs to develop a Mini Hadron Collider capable of creating small black holes that swallow everything in close proximity. Such machines can be sold many times over to terrorist nations seeking nuclear technology. Three. Two. One. Poof! This will be called the Tehran Project.
The creative physicists who gave us names like quarks and gluons might be joined with Pixar project leaders to create computer generated movies and TV shows using the dormant back office super computers on Wall Street. I personally would like to see revivals of Jimmy Neutron and Star Trek: The Next Generation. Such a venture could ultimately transform Wall Street into the entertainment capital of the world and reduce our dependence on annoying reality shows. This will be called the Wallywood Project.
Finally, the remaining mathematical minds on Wall Street that for years generated green matter should be teamed with the physicists exploring dark matter to develop our children’s gray matter. These teaching scientists can explain to our children why the sky is blue, why calculators don’t obviate the need to memorize multiplication tables, and why Pluto is no longer a planet. I propose the immediate development of the No Physicist Left Behind education program to restore our children’s competitiveness in math and science in the world.

As we redeploy our miscreant rocket scientists from Wall Street to Main Street, we can begin to fix our ailing banking system. The solution is actually rather simple: eliminate all complex mathematical equations from the financial industry. Specifically, institutions should be barred from trading any financial instrument formulated using long strings of Greek letters, nested parenthesis, or squiggly lines. Derivatives must be returned to calculus where they belong. I propose the development of a Formula Exchange Commission—the FEC—which will monitor the orderly replacement of large scale computer models with spread sheets manned by humorless accountants.

I recognize this transition will not be easy. But it is time to set priorities for this country. It is irresponsible to study the beginning of the universe when it feels the end of the universe is already upon us. Let’s put our rocket scientists to work. With encouragement and guidance, I believe our physicists can pull us from this crisis and restore America’s position as the global leader in everything.

And maybe then we can all get a good night's sleep.