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.

Shiller on Failure to Forecast the Crisis

Robert Shiller argues that economists distaste of behavioral finance is the reason why warnings about the crisis were ignored. Shiller was one of the few economists who warned about the housing boom, so his experience is worth considering. I still think, however, as I discussed in a previous post, that it was the lack of belief in market efficiency that got us into this mess.

Behavioral Finance and the Crisis

David Brooks argues that the current financial crisis will be a coming out party for behavioral economics. His starting point is Greenspan's recent confession:

As Alan Greenspan noted in his Congressional testimony last week, he was “shocked” that markets did not work as anticipated. “I made a mistake in presuming that the self-interests of organizations, specifically banks and others, were such as that they were best capable of protecting their own shareholders and their equity in the firms.”

But this misses a key point. The major players were rational. They made money because they received bonuses based on returns that hid risk. The problem was agency not irrationality. What Greenspan apparently missed is the fact that the managers of corporations do not have interests that coincide with the shareholders. The separation of ownership and control is an old issue in economics. We know that when agency problems arise incentives are need to get the agent to act in the interests of the principal, here the shareholder. To get agents to pursue profits incentive contracts give them shares. But the downside risk is zero -- you cannot indenture as a slave a manager who loses big money. Hence, the manager has big incentives for risk taking. This is what happened.

Now one can argue that the boards of directors or very top managers should have watched risk more closely. But they were booking large profits and large bonuses. Had they believed that markets were efficient they might have wondered how they were earning such large returns -- where are the associated risks that allow this. But instead they assumed markets were inefficient and assumed they had hired wizards. Notice that this is exactly the opposite of the view that Brooks is expressing.

This is not to say that behavioral finance may not have good insights about issues related to the financial crisis (and finance in general, here is a survey), but certainly not in the way argued by Brooks and most commentators today.