Financial Engineers Thrive Despite the Subprime Mess

International Herald Tribune

By Sharon Reier
Friday, August 1, 2008

As the first anniversary of the August 2007 subprime mortgage meltdown approaches, and world markets still reel, you would think that the people who have received much of the blame - the math wizards, computer geeks and other quantitative analysts collectively known as financial engineers - would be in disgrace.

After all, they were the ones who created the complex, mortgage-backed instruments that got us into this mess.

Yet by all evidence, the field of financial engineering is thriving - and, in fact, growing. Far from disowning financial engineers, or quants as they are also known, financial institutions - and their regulators - are embracing them as partners in an increasingly complicated game that, it seems, only the very brainy can understand well enough to play safely.

Quant strategies, or stock trades based on mathematical formulas rather than on qualitative factors like new product lines or cost-cutting programs, accounted for about 48 percent of U.S. equities trading in 2007, up from 34 percent in 2003, according to Celent, a consultant to financial institutions.

Business schools and mathematics departments are opening new financial engineering programs around the world. In the United States there are now about 60 programs, up from a single one in 1993. There are another 20 or so in Europe. The École Polytechnique Fédérale, an elite school in Lausanne, Switzerland, is starting a master's program this September. The University of Chicago has announced a satellite program in the field in Singapore. The Baruch College of the City of New York's financial engineering program accepted only 11 percent of 514 applicants for this autumn.

Job prospects for newly minted financial engineers are good. Despite the convulsions on Wall Street, a Baruch professor, Dan Stefanica, reports that every member of the 2008 graduating class got a job in financial engineering, albeit at an average 10 percent lower salary than the previous year. And according to John O'Brien, a professor of financial innovation at the Haas School of Business at the University of California, Berkeley, hiring of this year's class of financial engineering graduates has been brisk by investment firms, insurers, accounting firms and even the U.S. Federal Reserve.

As Andrew Weisman, head of research at WR Capital Management and former managing director at Merrill Lynch Blackstone alternative investments, described it in the 2007 book "How I Became a Quant": "Wall Street Management Has Finally Come to Understand That Investing Is an Intellectual Arms Race."

If demand remains strong for the mathematical skills that quants bring to the table, the profession is also going through a period of self-examination.

"Are we going to cause systemwide blowups every 10 years?" demanded one financial engineer recently at an investing conference in New York. She was referring to the 1987 portfolio insurance fiasco that led to a one-day 23 percent Dow Jones fall now known as Black Monday, and the August 1998 bailout of the Long Term Capital Management hedge fund.

With the subprime fiasco in 2007, many observers thought Wall Street's "rocket scientists" would finally be put out to pasture. But they have been proved wrong. Over the past 20 years, quants have reconfigured the face and the vocabulary of finance and the intellectual requirements for creating new, highly profitable products.

It is today's conventional wisdom that most money managers cannot make investment decisions that justify the high fees they charge clients, so they need someone who is smarter and will develop some sophisticated strategy before anyone else knows it. That someone, usually, is a quant.

Quants essentially see themselves as intellectuals, whose backgrounds in physics, biophysics, math and logic may mystify and dazzle others, but who rarely get a chance to be in the driver's seat.

"Quants are producers," said Thomas Au, a principal at R.W. Wentworth, an investment advisory firm, and author of "A Modern Approach to Graham and Dodd Investing."

"The quants' task is to produce models," said O'Brien of UC Berkeley, who was one of the three men responsible for developing and marketing the idea of portfolio insurance.

The problem arises when the models are so complicated that senior management - whose job it is to approve use of the models and the products and strategies based on them - essentially operates on blind trust.

"It is senior management's job to distinguish between the market and the model," O'Brien said. But when people trust the models, he said, they get a false sense of security about how they work. "When they don't get it right, it is like a doctor picking up the chart and thinking that the chart is the patient," he said. "But nobody is looking at the patient."

In other words, when Wall Street finds a quant model that expands its capacity to earn money, there is no "designated adult" to warn when things are going out of control.

Part of the problem stems from the difficulty of assessing all the risks of such complicated products. Rating agencies, which evaluated the mortgage-based debt obligations behind the subprime fiasco, have been accused of trading high ratings for good fees. But according to one study, the errors may also have been the result of incomplete analysis.

A 2006 paper entitled "The Promise and Perils of Credit Derivatives" showed the complications at work. The authors - Frank Partnoy, a securities lawyer and former derivatives trader, and David Skeel, a law professor at the University of Pennsylvania - theorized that a rating agency charged with evaluating the creditworthiness of a CDO, or collateralized debt obligation, might run 100,000 computer simulations to determine how many times defaults on the underlying debts, such as mortgages, might cause default of the top-rated piece of the instrument. The authors determined that the agency might establish a confidence interval of 0.284, meaning that default would occur 284 times out of 100,000 - a seemingly small percentage.

However, the authors pointed out, the rating agencies treated default risk as if it were isolated from anything else in the world: They did not test their assumptions against what would happen in a generalized recession or if a significant number of different CDOs involving the same kinds of instruments went under.

The authors expressed skepticism about a methodology that allowed rating agencies to give CDOs a value greater than their underlying assets.

"Mathematical sophistication leads to the creation of new, high-value instruments," the authors wrote, "since the CDO value would have to cover high fees the various participants charged for structuring and arranging the CDO and managing the underlying assets."

In fact, their analysis was prescient: Subsequently the CDO market froze, and last week Merrill Lynch sold billions of its CDO holdings at 22 cents on the dollar.

Small wonder, then, that investors have grown suspicious of complex products. A July survey published by the global accounting firm KPMG called "Beyond the Credit Crisis" concluded that "investors do not have the same enthusiasm for complex instruments as fund managers, with 70 percent of investors who answered this survey saying that the credit crisis has reduced their appetite for complex products."

However, the negative climate notwithstanding, KPMG does not expect the quant genie to be put back into the bottle any time soon. Instead, it sees a growing need for more financial engineers to maintain a balance of power in the financial markets.

"We think there is a skills gap," said Tom Brown, European head of investment management at KPMG. Brown called the credit crisis "a wake-up call to say in this new, complex, sophisticated world, investment management companies have to spend more money to upgrade skills around risk management and the whole operation."

KPMG itself has hired financial engineering staff to play a role in its advisory assurance service, checking whether the assumptions underlying models are credible and verifiable.

Intensifying the demand for in-house quant expertise, Brown said, is a decade-long trend for investment management companies to shift from plain-vanilla investment strategies to using derivative products designed by financial engineers.

In part this is happening because after the bust, traditional stock and bond funds did not keep up with the actuarial returns that pension funds and insurers require. The response was to put larger and larger amounts of money into hedge funds and other alternative investments - many of them engineered by quants.

Andrew Lo, director of the Financial Engineering Lab at the Massachusetts Institute of Technology and a consultant to hedge funds, believes the trend toward alternative investments will continue, although poor hedge fund performance in 2008 may result in some redemptions in the near term. Nonetheless, he believes that sovereign wealth funds, particularly from Asia and the Middle East, will bolster hedge funds' asset growth.

And like many in the field, Lo also sees a positive side to financial engineering. The huge flood of algorithmic trading has meant more liquidity in the markets, enabling large blocks of stock to be traded at lower costs. Quants have also developed desirable products like low-cost index funds and exchange-traded funds.

But the dark side is that "markets are now globally connected and there are correlations that quants take advantage of that cause greater dislocations," Lo said. He predicted that as quants look for new niches and frontiers to beat the market, the half-life of their strategies will decline, possibly leading to more systemic dislocations.

Paradoxically, preventing or diminishing those systemic dislocations may require exactly the element that quant strategies try to eliminate: the human factor. Quants say their mathematics-based trading models prevent portfolio managers from getting charmed by management or falling for Enron-like fakery.

Richard Bookstaber, a former risk manager at several hedge funds and the author of the 2007 book "A Demon of Our Own Design," was a risk manager at several hedge funds and at Morgan Stanley. He has been questioning whether financial innovation has run amok, with technology and complexity creating increasingly grave problems in managing risk.

Testifying to a Senate banking committee on June 19 about the credit crisis and how another one can be prevented, Bookstaber, who now works at the institutional money manager Bridgewater Associates, speculated that risk managers could not have failed to see the building up of securities inventories that eventually destabilized their institutions and the financial markets. But either they "didn't have the courage of their convictions to insist on the reduction of this inventory, or senior management was not willing to heed their demand."

The problem, he added, can only be dealt with by "having those with true market insight and experience to apply commonsense rules."

The City University of New York