Did the physicists on Wall Street cause the most recent stock market crash?

The short answer is, it couldn't have happened without them.

In August, large amounts of value simply evaporated from some of the biggest hedge funds in the universe -- $1.5 billion from a single Goldman Sachs fund alone.

As everyone knows by now, the sell-off was prompted by large numbers of defaults on mortgages that banks should have known better than to issue in the first place -- so called Adjustable Rate Mortgages.

The thing is, the reason so much easy credit (e.g. adjustable-rate mortgages) was available in the first place was that clever pure-math types on Wall Street -- they're called Quants, and they typically come from academic backgrounds, including mathematics and physics -- had figured out how to turn mortgage debt into financial instruments that could be sold to hedge funds, pension funds, and even individual investors.

Then, to top it all off, as soon as the sub-prime mortgage market began to collapse (those loan defaults that everyone except, apparently, the Masters of the Universe saw coming) the computerized trading strategies Wall Street employs -- the ones those clever quants had constructed -- began to go haywire.

That's because many of the trading strategies these quant-authored algorithms use were buying stocks using with a special kind of collateral -- derivatives based on those (doomed) mortgages.

It's as if Wall Street was taking out loans to buy stocks, except the "hard assets" they were putting up as collateral were actually phantasms -- imaginative fictions based on the housing bubble and the mass psychosis epitomized by the profusion of shows on cable television devoted to buying real estate and then rapidly flipping it in a hot market.

As soon as the value of these mortgage-based derivatives began to fall, traders had to pour more money into the accounts where collateral is held, because the rules say the amount you put up as collateral must remain constant. That money came from the sell-off of blue-chip stocks.

The result was a negative feedback loop -- blue chip stocks, which normally do well in uncertain markets, began to fall in value, while the stocks of companies with uncertain futures began to rise. Because so many trading houses on Wall Street are employing nearly the same strategies in their trading algorithms, the contagion spread through the system, in the same way that populations of animals or plants that are not sufficiently genetically diverse can be susceptible to plagues that exploit features they all have in common.

Not everyone agrees that this is how the events of last August played out. Some argue that the daytrading-on-steroids computerized trades carried out thousands of times a day by a single fund, in the case of some investment strategies, are merely a way to make markets more efficient; to smooth out the highs and lows inherent in any chaotic system.

But it seems obvious that no matter how clever the algorithms employed by the quants on Wall Street, they are ultimately based on myriad assumptions, and that unlike human traders, computers are ill-equipped to re-examine their assumptions in light of fundamental shifts in markets brought about by larger trends in the vast and impossibly complex system of commerce carried out by the planet's six and a half billion inhabitants -- at least not yet.

[Technology Review]