When does financial engineering become social engineering? Ironically, the housing bubble wasn't just caused by market forces, but by an overt attempt to use complex financial instruments to socially engineer prosperity to the masses. Considering how well that turned out, should we now use the same methods to try and cure cancer or solve global warming? Andrew Lo seems to think so.
In celebration of MIT’s 150th anniversary, Andrew Lo moderated a panel discussion including “five of the founding fathers of modern finance”—Stewart C. Myers, Myron Scholes, Robert C. Merton, John Cox, and Stephen Ross. Although these names may not be familiar to everyone, their ideas, theories, and quantitative methods form the backbone of almost any financial economics textbook. Thus, it is curious that Lo—director of MIT's Laboratory for Financial Engineering—would put his reputation on the line by stating in front of such a highly esteemed group that financial engineers, so-called "quants", could use their tools to cure cancer, solve the energy crisis, or even address global warming (see The Evolution of Financial Technology video below at 16:35).
Now, in all honesty, this isn’t that crazy of a statement. Remember, our government already tried to financially engineer the “American dream” of home ownership to millions of unqualified buyers (see Bush speech May 17, 2002) through the complex securitization of subprime loans into AAA rated investments. Arguably, the housing bubble would've never been able to get off the ground—or, at least, not nearly to the magnitude it did—were it not for the pervasive spread of these investments modeled on inadequate risk assumptions that put into question the solvency of almost every major U.S. and global bank.
Then again, maybe we just need to give financial engineering another chance.
Some say that mathematical models and computer simulations can't really be blamed for the current mess we're in—that it was essentially an error of human judgement. As Stewart C. Myers says in the video:
My guess is we’d all say it wasn’t the models that caused the crisis. It was misuse or overconfidence in the models, or lack of comprehension of downstream effects of what various people were doing, or the dangers they were unwittingly running. It’s true that modern finance is a powerful tool and can be misused, but that’s not a reason to discard the tool. That’s a reason to use it better.
It seems so obvious this is true that one might immediately agree and move on. Of course we can't blame the models themselves right? Not so. It's easy to point at inanimate things and say they can't be held responsible for their effects...until we examine the thinking that went into them. In the case of collateralized debt obligations—the main instruments used to distribute and layer subprime mortgages into high grade investments—their unquestioned safety was based on the simulation of hundreds or thousands of possible outcomes distributed by a minor change in certain variables, like housing prices, rates of default, or interest rates. The fatal flaw inherent to the financial engineering of these products, however, was an assumption shared by academia, government, ratings agencies and even the chairman of the Federal Reserve, Ben Bernanke (see video), that a worst-case scenario of housing prices falling on a nationwide basis would never happen. Thus, such a scenario wasn't factored in to the models since this would nearly eliminate their value.
Andrew Lo, a leading financial engineer himself, rightfully admits that his field had a huge role to play in bringing about our current credit crisis; however, to him it is a sign of the untapped potential of financial engineering as a powerful force for good, rather than the evil it mistakenly wrought in the housing and subsequent credit crisis.
I, for one, am not such an optimist. Though I do think Andrew is correct on one point—financial engineering is an extremely powerful tool (HFT comes to mind)—let’s hope that its use by politicians, bankers, and hedge fund managers to socially engineer prosperity or solve the world’s greatest problems doesn’t turn another “American dream” into the world’s next nightmare.
