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2 THE BEAR'S
LAIR Why financial engineering doesn't
work By Martin Hutchinson
The last quarter century has seen the
explosion of a profession, financial engineering,
that has provided innumerable lucrative
opportunities for otherwise indigent
mathematicians - it was thus welcomed by a former
mathematician like myself! Nevertheless the
turbulence in the bond markets in the last couple
of months, at a time when the world economy's
prospects seemed set fair, have exposed a guilty
secret of the financial engineering
profession: its methods don't
work.
The first exposure of financial
engineering's failings came oddly enough in the
area that had seemed most solid, that of
liquidity. Theoretically, if financial engineers
design ever fancier artificial securities and
derivatives, but everybody uses the same
mathematical models to value them, there is no
reason why an active market should not operate in
the securities, at whatever price the models
direct.
In practice this only works in
calm markets. In times of market turbulence, when
doubts arise about either the mathematical models
themselves or the underlying assets from which
value is derived, the true value of these
artificial assets becomes thoroughly unclear.
Buyers assess their value at the lowest possible
level, and refuse to increase their exposure to a
sector that suddenly appears dangerous, while
sellers attempt to get out of the business
altogether.
That explains the sudden
drying up in support for asset-backed commercial
paper in August. It also explains the precipitate
drop in the prices of ABX (index of subprime
mortgage loans) credit default swaps on subprime
mortgage-backed securities in October. Overall the
market in such swaps declined by no less than 25%,
while AA-rated credit default swaps, supposedly
among the finest credits available, were trading
at less than 50% of principal amount by the end of
the month. Either the rating agencies had gone
horribly wrong in assessing the default risk of
those AA credit default swaps, or the underlying
pool of subprime mortgages was so rotten that more
than half of a $1.5 trillion asset class would
vaporize. The real problem for the market was:
nobody knew which.
The problem was further
compounded by Wall Street's accounting
methodology, which allowed assets to be valued
based on the theoretical prices produced by the
mathematical model. If as in this case reality had
made already illiquid assets impossible to value,
the mathematical model's prices could become
wildly out of line with reality, which was itself
unknowable. Naturally, Wall Street institutions
did not wish to take writedowns on the assets, so
were unwilling to undertake transactions at prices
which might call into question the valuation
methodology of their portfolio. The effective
market for the assets thus settled to something
like 20 bid, 90 offered, killing the price
discovery process and turning them into toxic
waste on their owners' balance sheets.
Banks and investment banks have adopted a
number of approaches to the problem of their
balance sheets' subprime mortgage-related assets.
Merrill Lynch wrote the assets down by $4.9
billion at the end of September, but then found
itself obliged to write them down by a further
$3.5 billion when publishing their third quarter
figures in late October, thus bringing the
departure of chief executive Stanley O'Neal. Given
the ABX price drop in October, a further writedown
may now be needed. Goldman Sachs maintained a
posture of insouciance, claiming that the
brilliance of their hedging had prevented any
significant losses at all (but were the hedges
adequately liquid, or was their increased value
simply the result of aggressive revaluation
through mathematical models?). Sachsen LB of
Germany threw up its hands at the impossibility of
funding its subprime mortgage portfolio and
subsided into the arms of a larger bank,
Landesbank Baden-Wurttemburg.
Only Nomura
Securities took a properly decisive approach,
selling its entire $2.4 billion portfolio of
mortgage-based assets (thus worsening the problem
for everybody else) firing the people involved and
taking a $700 million write-off, about 28% of its
mortgage assets, and slightly more than 100% of
its subprime portfolio. Writing off 105% of one's
holdings of a financial engineering product may be
regarded as aggressive, but its cold realism is
probably healthy in the long run.
The
second problem with financial engineering products
that the whizzes involved have failed to solve is
their valuation. Simple derivatives such as
interest rate swaps in currencies with liquid
government bond markets and forward Treasury
futures can be valued by mathematical techniques
that are simple and fairly robust; thus market
participants can agree on the underlying value of
these assets even when markets are turbulent.
The problem becomes much more difficult
when a financially engineered product involves an
embedded option, or, like asset-backed commercial
paper, is of markedly different liquidity from its
underlying asset. In the case of liquidity
differential there is no generally agreed way to
value liquidity, hence no means of ensuring that
mathematical models account properly for the
difference in liquidity between short term and
long term securities. Creating artificial
liquidity through use of structured investment
vehicles may produce an apparent stream of income
to the arranger from the differential between
short term and long term yields, at the risk of a
huge liquidity crisis in the event that short term
paper can no longer be sold at a reasonable price.
The standard option valuation models do
not work at all well for out-of-the-money options,
because they assume the randomness of future
events that are in reality not random but unknown.
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