Is Financial Engineering Bad?

One of the constant criticisms emerging from recent credit crises is that financial engineering does not do any good to the society. To dismiss the whole work stream merely as jugglery that provides intellectual satisfaction to the brainy and a nightmare to the general public is kind of unfair. It’s like saying anything related to Nuclear reactor is bad. It depends on what you using nuclear reactor for. If it’s for power generation then it’s extremely clean and over the extended period of time costs less but if you are to build weapon then kaa-boom.

The securitization phenomenon – the root cause of the whole crises – is relatively new. It was crystallized in 1960’s and picked up the pace in late 80’s and 90’s. The concept is quite simple and intuitive at the core. If you have $100 to lend then you can loan it only to one person (considering the need is $100) or you can create a security out of it and free up the capital. Once you loan $100 at 10% per annum, the expectation is that you will receive $110 at the end of one year. Instead of waiting for one year, you can sale that loan to a third party for $102. You make $2 immediately while the third party makes $8 over the period of one year. Now you have $102 for loaning out. The cycle continues. This is the base logic. Now add thousands of loans together and then sell that product to the third party. The risk is transferred to third party at certain cost and more money is available for business. Securitization is primarily used in mortgages business, where the loans are given for non-liquid assets like buying houses or cars. The type of securitization I explained above is the simplest format and more complex products are built based on customer needs as well as market conditions. This phenomenon has potential to raise huge amount of capital. It also seamlessly matches people who have money with people who need money making debt a tradable liquid asset. The point to note here is that these assets are not as liquid as stock market or bond market. There is no centralized exchange to

So far so good!

The problem actually started when money raised through investor was single handedly diverted towards housing market. The supply of money was far more than actually needed. In short money became cheap. So, folks started building houses or buying houses in the hope the prices will keep going up and there will always be a buyer. That’s when law of gravity started working. I mean, literally! Home is an illiquid asset. You can’t flip it the way you can play with stock market. In the stock market the maximum loss is the amount of money invested. On the other hand, home keeps exhausting money in the form of maintenance cost and property taxes. So, if you failed to sale the house in time then you are pretty much screwed. Obviously default rates rose sharply. This alone shouldn’t have precipitated into a perfect storm. Both the regulators as well as banks knew that this bubble is bound to burst but they kept playing the game till the end. Bankers kept buying, structuring and servicing extremely complex, highly illiquid securitization products. Rating agencies kept their ratings for such products intact. CDS – Credit Default Swap is insurance in the finance world. As the name suggests, in case of default the seller of CDS pays you the money. AIG kept selling such CDS to practically everyone. The concentration risk became very high for most of the bank and yet the risk management departments in any of the banks failed to raise alarm. Regulators refused to even acknowledge that there is any bubble till the end. The economy, specially the size of US, is very hard to handle in short term. But if problem was identified and measures were taken to divert the flow of money into other sectors like renewable energy then that could have averted the disaster.

It is worth noting that not that all the criticism heaped on financial engineering is wrong. When huge amount of money started finding its way into housing market, size of this work stream vis-à-vis others started growing rapidly. It did not employ that many people nor did create any infrastructure. It was basically castles in the air that still created real gains to the investors rational enough to cash out in time. So when the whole thing crumbled there was nothing left and yet it created disproportionately large ripples across the whole economy. All though the whole housing market is valued in tune of couple of trillion dollars, in a typical fashion everyone wanted to get out at once. The result was that the stock market lost staggering 11 trillions worth of value. With short-term debt notes practically ceasing to exists, it all most brought down many companies to halt. New investment froze and new business floundered. The job loss that started in the banking sector soon engulfed all other sectors. People lost their retirement benefits, pension benefits and of course their investment. Wall Street for all practical purposes ceased to exist as three of the five investment banks either went bankrupt or were bought out. It was chaos for sure.

In the end lot of things went wrong at the same time for such a disaster. And I hope that the field of financial engineering is not made into a scapegoat.