• Ian Ayres • Daniel Bouton • Robert Engle • Nassim Nicholas Taleb • Anthony Scaramucci
Moderated by • Suzanne Nora Johnson
Friday 30 January
Financial engineering – that blend of mathematics, statistics and computing which has spawned a myriad of exotic derivatives – is today blamed for much of the turmoil on Wall Street. Warren Buffet described the products of financial engineering as “financial weapons of mass destruction”.
What happened? Were the risk models built by quantitative finance analysts, or “quants” as they are commonly called, flawed, or was it a case of human failure to apply the models correctly and to understand their limitations?
How has the crisis changed the perception of complex structured products, and what can governments and banks do to manage this vast pool of toxic assets?
Highlights
• The original mission of financial engineering was risk sharing. Hedging products created by quants have enabled banks and companies to spread their risks, thereby facilitating business expansion and economic growth.
• Technology and deregulation helped fuel innovation on Wall Street and, before long, quants were creating CDOs (collateralized debt obligations), CDS (credit default swaps) and multiple incarnations of these instruments, most of which have little economic value except to line the coffers of Wall Street firms.
• These complex structures lack transparency and went largely unsupervised since they are traded over the counter and not on an official exchange. An era of low interest rates and a surplus of liquidity – which has, in the last three decades, shifted from banks to independent asset managers and hedge funds – produced the ill-fated boom in derivatives trading.
• Panellists said the problem is not with the risk models but with the risk measurements. There were obvious deficiencies in the way risks were measured.
• Rating agencies were as culpable as the quants in the use of outmoded tools and unreliable data to measure risks. The problem, explained a participant, is that rating agencies used the same scale to measure very different risks. Giving a AAA rating to a country and the same rating to a structured product is as bad as Robert Parker using the same rating system for red and white wines, he chaffed.
• Intense competition among Wall Street firms and its asymmetric compensation structure encouraged a culture of excessive risk taking and added to the pressure to engineer more and more innovative products.
• Participants recommended a number of measures to clean up the mess. Among them, outlaw over the counter trading of derivatives, revamp compensation structures to take into account long-term outcomes, increase transparency of the products and their associated risks and, finally, improve investor education.
• Less complexity should be the name of the game going forward.
