Are the Financial Engineers Responsible for the Crisis?

Something happened a decade or two ago that changed the world forever. People who were really good at math suddenly realized they could make a lot more money working on Wall Street than they could crunching numbers in the basement office of a university's math department, smashing subatomic particles together, or even designing electrical circuits. So mathematicians, physicists, engineers, and other math-inclined people started going into finance. Now that lots of the complex securities that these guys created blew up and helped trigger a financial crisis, fingers are pointing in their direction. Do they deserve the blame?

Although this is not a new assertion, former Federal Reserve Chief Paul Volcker appears to have renewed the attack in an off-the-cuff speech this week at the Federal Reserve Bank of Chicago. According to Real Time Economics, he said:

"We had all our best business schools in the United States pouring out financial engineers, every smart young mathematician and physicist said 'I don't want to be a civil engineer, a mechanical engineer. I'm a smart guy, I want to go to Wall Street.' And then you know all the risks were going to be sliced and diced and [people thought] the market would be resilient and not face any crises. We took care of all that stuff, and I think that was the general philosophy that markets are efficient and self correcting and we don't have to worry about them too much.

So what went wrong? Well, the math actually worked just fine -- it was the assumptions that were off. For example, if real estate had continued to appreciate indefinitely at the rate that these quant guys had assumed, then new home sales wouldn't be struggling to crawl back to the 300,000 per year rate this month -- they'd probably be above 2 million.Of course, that's not at all what happened.

There are a few questions here:

Who Was Responsible for the Assumptions?

As mentioned, the problem wasn't the complex financial models -- it was the poor assumptions. Now, it could be argued here that this problem wasn't caused by the quant guys; they just created the models. They were supplied the assumptions by others. Maybe it was the rating agencies, lenders, or investors. Using one common example, whoever said to assume an unrealistically low loss rate for mortgages that did not require income documentation made a huge mistake. It may have been the quant guys creating these assumptions sometimes, but they didn't do so in a vacuum. The raters, investors, and ultimately the rest of the market, had to nod along. If they hadn't, the securities they created wouldn't have been sold.

Should They Have Challenged It?

But if these brilliant mathematical minds had created these assumptions or even went along with them mindlessly, should they have questioned them? After all, these are pretty smart people, and in the retrospect, it sure sounds pretty stupid, for example, to assume that a loan pool consisting of subprime mortgages that would reset to a much higher payment amount wouldn't incur huge losses. Even if the rating agencies and investors went along with it, should whoever created these securities have questioned the validity of these bad assumptions?

It's unclear -- and that's part of the problem. Everyone wants to blame someone else. The investment banks will point to the rating agencies, who blessed the securities. The agencies will point to investors, who they say should have done their own analysis and not relied so heavily on theirs. The investors will point to the lenders, who they will likely say claimed that their loans' quality would stand up to the assumptions. And the lenders then probably point back to the investment banks and rating agencies, or maybe to the borrowers who they may blame for taking on loans they couldn't actually afford.

Although it's hard to pinpoint precisely which party there should have acted differently, the obvious solution would have been for all parties to be more responsible. Everyone should have questioned the validity of the assumptions, and almost no one appears to have done so. When I worked in finance, I was once stunned at the assumptions that a now defunct mortgage company was making about new wacky loan products it was offering. But ultimately, managers who called the shots always shrugged and said that real estate always appreciates.

And that's the problem. Markets don't work when only a few people question an assumption that doesn't pass the sniff test, because that will never stand up to the irrationally exuberant consensus. Instead, all market participants should exercise greater prudence to prevent such dangerous corrections from occurring. So are the financial engineers to blame? Yes, but so is everyone else.