Tuesday, February 10, 2009

On Financial Engineering

I spend a lot of time listening to what I will term as 'financial engineers'. As a practicing engineer, I find the field fascinating. But something always bothers me about what I hear. I hear so many terms that sound virtuous or impressive. Financial engineers use terms like 'invest', and 'managing risk'. They speak of disciplines they follow, like 'Fibonacci retracement', 'point and figure', 'value at risk' and other financial prediction systems. Notwithstanding the fact that these financial engineers are ofter spectacularly wrong, there is a deeper, more fundamental objection that nags at me as I hear them talk. And that objection is that financial engineers are not engineers at all. They are not building or creating anything of value to society. Simply put, their 'discipline' is of little more value to society that a 'discipline' to win at a craps or blackjack table by gaming the system to play the odds. It may make money for some, but it serves society poorly. And we, as individuals and as a society, have placed our financial welfare entirely too much in their hands. How did we get there?

Good Investment

Consider a simple financial system consisting of you and I. I could loan money to you in order to help you gain a return. I could charge you interest, or I could help you establish an enterprise and share in its profits. In each case, the investment is designed to allow growth to occur that otherwise could not absent the investment. But, in this simple system, there is no possible context for me to gain when you or your enterprise fails. I can loan you money, but I cannot 'short' you in any real world context. There is also no notion of a 'trader', who gains when my investment in you does better than I expect. This system can be scaled up. A system of organized credit and equity markets is possible by scaling this simple idea. Some financial innovations made in the past few decades were quite beneficial.

There is much to be said for the systems that allow small investors to pool their money in order to provide capital to large enterprises. This is at the core of mutual funds, for instance. Mutual funds, as originally concieved by financial engineers, gave investors the means to invest their money in the equities and bonds of several corporations. The original intent was to allow investors to participate in the growth of corporations. This was a beneficial goal, because it fostered collective economic growth, and allowed returns generated by large enterprises to be shared. Similarly, a system of credit is also beneficial, when it is used to foster growth that could not otherwise be attained, or to enable the acquisition of valuable posessions, such as homes, that cannot realistically be acquired through savings.

The Growth of Investment as a 'Discipline'

Somewhere along the way, however, the systems of investment and credit designed by financial engineers morphed. The pursuit of the best returns and the best gains on investors money trumped the original goal of investors sharing in growth. Financial engineers became traders. Even todays so called financial 'professionals', in many cases, merely follow trading disciplines. Innovations like short selling, hedging, market timing, and buying and selling disciplines grew as financial engineers began to find more and more ways to attempt to gain returns. The goal of financial engineers, which was to make the best return for their investors, crossed a line, and became blind to the interests of society. Due to blind pursuit of returns, what began as a beneficial way to pool capital became 'the market', and the ones charged with managing 'investment' in the market morphed into nothing more than casino gamblers following a system to make money. In a similar fashion, the goal of credit also morphed. Instead of being used as a beneficial tool of society, credit became a way to live beyond ones means - to circumvent hard financial choices and discipline. And the two systems (markets and credit) became intertwined, and began to feed off of one another in a blind, upward spiral.

You might object. After all, what is wrong with seeking the best returns? Or with getting what you want without waiting? What could be wrong with 'managing money' in an attempt to provide a secure retirement, or money for your kid's college? Isn't it just being a wise investor? What is wrong is that the financial system as it works today is the wrong means to these ends. For many, it may help these goals be met, but collectively, in its current form, it cannot meet the goals for everyone. There will inevitably be those for whom the system fails, or who will be left out. And the system will not serve the overall interests of society at all. Because, fundamentally, a society must be about more than just money. But our financial system is only about money. The financial system does not react to the true economy. Rather it drives the economy.


An investment system that seeks only returns will inevitably result in a misallocation of capital. This is because the best returns will by nature be found in the areas where growth is strongest. Take real estate, for instance. If real estate is on the upswing, more money will be allocated to real estate by the financial system in blind pursuit of returns. This will be true even if real estate investment is not needed. Once the needs of an economy for housing, commercial buildings, and so forth are met, excess capital will merely drive prices upwards, resulting in bubbles. Over the past 20-30 years, financial engineers and the blind pursuit of returns have blown up bubble after bubble, inventing more and more ways to make money. These bubbles have occupied overly large segments of the economy, obscuring what in reality was a deteriorating fundamental picture. This has corresponded with so called 'financial democratization' or the advent of increased ability to 'trade' rather than invest long term by most players in the financial system.

Goind hand in hand with this bubble creation by the investment system was the credit system, which was used to provide the funds needed to keep a cycle going and the bubbles blowing. Easy credit made it possible for bubbles to grow well past the point where the growth was necessary or beneficial to society. But the use of credit is a two edged sword. It cuts going up and going down. As a result of this increased leverage made possible by credit, the system must rely upon ever increasing asset valuations, or constant growth, to survive. Not only constant growth, but exponential growth is necessary, because the system as it grows favors non productive activities in many cases, including the growth of the financial industry itself. And when the system, so highly leveraged, begins a natural decline, the deleveraging of credit on the way down is as powerful as was the growth on the way up. Except far more destructive.

Collapse and Lessons for Tomorrow

Now we are observing the apparent end of this system built by financial engineers. The engineers at the top (central banks and governments worldwide, advised by economists) are attempting to manipulate the system with more and more innovation to somehow escape the inevitable conclusion - the system has failed. The system has failed because it was flawed at its core. It was based on a false assumption - that moneymaking alone could be the basis for the system. It was flawed at its core because it relied upon leverage and credit, which requires constant growth, and a constant beneficial operating environment. The system was not built to withstand adversity, or so called 'Black Swan' events that perturb it. And, as the system struggles, the financial engineers tell now tell us that 'buy and hold is dead'. And that 'active portfolio management' is now needed to enable you to 'meet your financial goals' especially in a down market. They are proposing to continue the failed sytem, and to make it even more prone to capital misallocation and eventual failure. This time, however, the game is up. There is no more capacity in the system for continuation. As the credit that enabled the blind upward spiral defaults, the downward spiral is only accelerating. Like engineers that build a faulty bridge that eventually collapses, our financial engineers have built a financial system that has now failed and is collapsing before our eyes.

The changes that will be wrought by the collapse of the system built by today's financial engineers will be great. The world of tomorrow in many ways will be fundamentally changed. The financial engineers of tomorrow must learn from the mistakes of those of today. We must go back to basics, and build a new system while avoiding the cardinal sins of the old. We must build means of capital allocation that benefit society. Somehow, we as a society must cross this threshhold. We cannot base financial engineering solely on financial gain. Somehow financial engineers must figure out how society can employ credit wisely. The lessons we will all be forced to learn in the next few years will be very expensive and painful ones. But the financial systems of tomorrow and our society will be better for it. This, at least, is a dim and distant silver lining.

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