Birth of a Financial Engineer: Who Creates Weapons of Financial Destruction?

While we are shaking in our boots over yet to happen attacks from foreigners, the current incarnation of weapons of financial destruction is doing real damage right now.  Factories are downsizing or shutting down.  Chain stores are seeking bankruptcy protection or going the way of the dinosaur. State governments are furloughing employees, going to four-day workweeks and many mainline banks and brokerages no longer exist. Pension plans, 401(k) plans, foundations and not-for-profit charities have lost billions.
 
Many assistance agencies are overloaded; some no longer exist because the financial crash wiped out the endowments, which funded them.
 
Everyone is scratching their heads, trying to find out what happened.  Some blame “people who bought more house than they could afford.”  Others say “sub-prime” con artists milked the system.  And, still others blame “crooked real estate agents and unscrupulous mortgage brokers.”
 
While many experts say these exotic investment “instruments” are at the center of many of our economic woes, to many of us, they may well be speaking a foreign language.  Some of these financial products are so complicated that even master investor, Warren Buffet, calls them weapons of financial destruction, based on both, their complex abstract nature and their potential to wreak havoc in the investment sector.
 
The hedge fund nightmare, fueled by arcane and exotic financial instruments, is unregulated and hosted mostly by foreign, “off shore” financial entities that are beyond the regulatory reach of what little regulation exists.  A 2006 article in LeMonde notes that
 
There are now at least 10,000 hedge funds, of which 8,000 are registered in the Cayman Islands. However, the 400 funds with $1bn or more under management do 80% of the business. They cannot be regulated. They have over $1.5 trillion in assets and the daily global derivatives turnover is almost $6 trillion (equal to half US gross domestic product). With the economic climate euphoric over the past five years, most funds have won, although some have lost. In the year ending this August, nearly 1,900 were created and 575 were liquidated. Standard & Poor would like to rank their credit-worthiness, but has yet to do so: bigger funds claim to use computer models to make trades, and three of the 10 biggest claim they make purely quantitative decisions.  Click here.
 
With some of these exotic derivatives, computer models generate the only valuation that exists.  No “real world” value exists, because, these products are valued on the fly, and some haven’t been valued, even though they are part of “credit default swaps” which have been bundled and sold worldwide.
 
Beneath the radar of the public and some government entities, the derivatives market has generated an entire academic discipline called financial engineering.
 
The last quarter century has seen the explosion of a profession, financial engineering, that has provided innumerable lucrative opportunities for otherwise indigent mathematicians - it was thus welcomed by a former mathematician like myself! Nevertheless the turbulence in the bond markets in the last couple of months, at a time when the world economy's prospects seemed set fair, have exposed a guilty secret of the financial engineering profession: its methods don't work. (Martin Hutchinson, Why financial engineering doesn't work)
 
Hutchinson says that the models work when calm markets exist, but become unstable when markets turn volatile.
 
In times of market turbulence, when doubts arise about either the mathematical models themselves or the underlying assets from which value is derived, the true value of these artificial assets becomes thoroughly unclear. Buyers assess their value at the lowest possible level, and refuse to increase their exposure to a sector that suddenly appears dangerous, while sellers attempt to get out of the business altogether.  (Ibid)
 
Not only that, but when you try to value exotic financial instruments in times of financial turmoil, the Heisenberg Uncertainty Principle rises up out of its crypt and turns volatility into a major instrument of chaos in the valuation process. Hence, in times of economic turmoil, market conditions themselves make it impossible to put a value on products whose value depends on statistical analyses.
 
Speaking of financial engineering’s dependence on statistical models, Hutchinson noted the unknowing nature of reality in a volatile system. In short, the wild fluctuations of a volatile market in crisis turn models on their heads, generating massive uncertainty and unpredictability. If, as in this case, reality had made already illiquid assets impossible to value, the mathematical model's prices could become wildly out of line with reality, which was itself unknowable. (Ibid)
 
Experimental models also fail to rise to the occasion for another reason.

The second problem with financial engineering products that the whizzes involved have failed to solve is their valuation. Simple derivatives such as interest rate swaps in currencies with liquid government bond markets and forward Treasury futures can be valued by mathematical techniques that are simple and fairly robust; thus market participants can agree on the underlying value of these assets even when markets are turbulent. (Ibid)
 
The problem with valuation becomes really extreme when the value of the product being valued is derived from a commercial paper product.  Such “derivatives” are basically pricing apples based on the price and availability of chickens. Hence, in his analysis of the difficulties of valuing one product based on the value of a completely different product, Hutchinson believes that
 
The problem becomes much more difficult when a financially engineered product involves an embedded option, or, like asset-backed commercial paper, is of markedly different liquidity from its underlying asset. (Ibid)
 
In a 2003 address, Financial Reform: Relevance and Reality in Financial Reporting, then-SEC Commissioner Cynthia A. Glassman noted that “current accounting literature, which includes many detailed bright-line tests, is also vulnerable to financial engineering, where companies engage in transactions not for the economic benefit, but to take advantage of accounting treatment so that the company appears to the market to be more successful than perhaps it really is.” (Emphasis added.)
 
Noting the cataclysmic losses on Wall Street in light of the widespread use of financial engineering models, David Hochman, current industry consultant and past Deputy Director of the New Jersey Commission on Science and Technology said:

“We are presently in the midst of a catastrophic failure of financial engineering. Financial engineering is a construct invented in academia to recognize that the term ‘finance,’ used historically for an essentially analytical discipline, practically a branch of applied economics, was no longer adequate to describe the activities of Wall Street in designing and delivering to the marketplace new financial instruments. Engineers design things. They have quantitative skills (e.g., great attention to detail, facility with simulation modeling, capacity to solve systems of differential equations, etc.) that are lacking in the general population, even those with strong business skills. Ergo, designing new financial instruments was an activity of financial engineers, who must be trained and socialized as such.”  (David Hochman, Paging Dr. Petroski to the Financial Engineering graduate lounge, stat! http://tbed.org/?page_id=38)