Tuesday, November 4, 2008

Financial Engineering

What role did financial engineering -- complex quantitative financial models -- play in the financial crisis? This article in the New York Times discusses this issue. The article notes:

“Complexity, transparency, liquidity and leverage have all played a huge role in this crisis,” said Leslie Rahl, president of Capital Market Risk Advisors, a risk-management consulting firm. “And these are things that are not generally modeled as a quantifiable risk.”

Math, statistics and computer modeling, it seems, also fell short in calibrating the lending risk on individual mortgage loans. In recent years, the securitization of the mortgage market, with loans sold off and mixed into large pools of mortgage securities, has prompted lenders to move increasingly to automated underwriting systems, relying mainly on computerized credit-scoring models instead of human judgment.
An important point, noted by Andrew Lo is that while academic economists were receptive to his warnings of the risks associated with financial innovation Wall Street was not. The reason is that Wall Street had little incentive to listen as long as profits were high. He points out that we have fire safety regulations even though buildings have little risk of burning down, and financial regulation is needed for the same reason.

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