As many of you know, my original post on the sorry state of Financial Engineering [FE] education in America attracted sharp criticism from all quarters, most of which aimed at putting a good face on an obviously dismal state of affairs. In passing, that article had lain dormant on my hard drive for five years, just waiting for the inevitable to happen. At the time, I thought it would have a catalytic impact on people who would not have given me the time of day just two years ago. Not surprisingly, I was wrong.
Yes, perhaps it was an unfair attack on the brave soldiers of academic finance, toiling under battlefield conditions to improve the lot of ordinary Americans, and asking for a mere pittance in return. The only other possibility is that I had accidentally touched a deep and festering wound within a professional body intent on covering up for large financial concerns who fund most of its activities, and whose main task is to give a veneer of respectability to something that is anything but respectable.
Since all the negative criticism leveled at the article was made anonymously, we will never know. People who wish to remain nameless usually have nothing worthwhile to contribute towards a possible resolution. They also don’t have the time, mind you, busy as they are bowing before the men of Wall Street with exaggerated obsequiousness, no doubt hoping to receive their fair share of some large, manhood-validating and undeserved bonus. As a result, this post is intended more as a sober sequel to the first piece rather than an apology for some purported, unwarranted viciousness. It is addressed to the professionals among us, whatever that means, and to those wishing to become professionals in finance, whatever is left of it.
The first thing to clarify would appear to be the definition of a professional. People who blow with the prevailing wind are not professionals, but politicians.
So then, what is a professional?
Three obviously related attributes characterize all professionals:
- Uniqueness of method
- Performance under stress
- Speed of execution
A bona fide financial professional does not have “his own way of doing deals”, the same way a pilot would somehow have “his own way of flying airplanes”. On the contrary, professionals can understand each other solely because they share a common framework. However, it is only after being trained academically, i.e. within situations whereby no cash changes hands, that one can have any hope at all to develop the ability to steadfastly apply consistent and uniform financial standards under pressure. Given enough time, any moron can do a deal, and of course many have. While the heat is on, out there in the topsy-turvy world of finance, is not the time to think things over quietly, longing to discover some newfangled, harebrained scheme because you don’t have a clue how your deal is supposed to happen. Those who do this, i.e. more than 99% of Wall Street deal-makers, are quintessential amateurs, not professionals, and are headed for disaster, not success. In American finance, desperation and dilettantism are too often mistaken for creativity.
Likewise, laid back professors sipping lattes and working 9-5 M-F in some ivory-tower University are not exactly the type of creatures who can credibly talk about performance under stress. In addition, confessing one’s ignorance via some communist-style manifesto is frankly too little, too late. Someone who has never done a deal himself cannot be reasonably expected to teach others how to do deals. In fact, such people would quickly realize the futility of their classroom endeavors were they ever placed under actual deal conditions, having to get things done while attending to the countless details that form the essence of true financial analysis. Instead of engaging in the usual denunciations of greed, they would quickly develop a healthy level of humility and respect for the authentic challenges of American finance. Saying there is too much greed on Wall Street is like saying there is too much sex in a brothel.
Why bother with Saturday Night Live when the average IAFE seminar will do just as well? I’ll bet you can even earn CPE credits for listening to such self-congratulatory rhetorical rubbish. Surely, Fischer Black’s departed soul must be tickled pink at having some meaningless memorial prize named after its former bodily residence. I would bet, however, that Black would have been far happier to receive what was rightfully his, i.e. the Nobel Memorial Prize, during his lifetime. As most people don’t know, the Economics profession patiently waited until he died of cancer in mid-1995, thereby clearing the way for the awarding of the 1997 Nobel in Economics to second-rate intellects that never made a single contribution to finance, let alone mankind. As most people do know, the Nobel Prize may not be awarded posthumously.
As expected, the FE profession is still in denial, or at least experiencing severe withdrawal symptoms. A paradigm case in point: the Chicago School of Economics recently held a well-attended conference with the stated objective of investigating whether its thinking bore either blame or responsibility for the occurrence of the sub-prime crisis, and if so how much. As expected, the usual suspects reached the foregone conclusion that Chicago School thinking was totally blameless and that, in point of fact, the fault lay entirely with those who had “misunderstood” its groundless theories. The truth, rather, is that the Chicago School was actually understood, not misunderstood. On the other hand, none other than Fred Nietzsche himself, a well-known paragon of modesty, was quite fond of saying he was much more afraid of being understood than misunderstood.
It is regrettable that Chicago academics still don’t understand finance, for it is clear that a fiasco of this magnitude has its root causes in the inadequacy of the current financial paradigm. The most glaring example of such mammoth incompetence is “Man of the Year” Ben Bernanke himself, the Chance Gardener of American finance. As Samuel Johnson said, “a horse that can count up to ten is a remarkable horse, not a remarkable mathematician.” Other than Jay Leno and David Letterman, please tell me who else is happy with the Federal Reserve’s handling, or perhaps mishandling, of the credit crisis.
Given such concerted efforts at self-exculpation and blame-shifting, it should surprise no one to hear that FE institutions have not made a single meaningful change in their curricula over the past three years, or even gone through the slightest amount of serious soul-searching. In fact, except for the occasional cocktail party-bound remark to some wide-eyed debutante to the effect that the current situation is “regrettable” and that financial professionals are now “much more careful” than before, it’s business as usual on Wall Street and in financial academia. Schools are still happily teaching how to “predict” interest rates, despite having failed 100 years in a row. One would think they’d get the message. Thank God, interest rates are unpredictable else none of us would have a job! It is not the failure, but the attempt, to predict interest rates, which proves you don’t understand finance.
Since everyone concerned believes it was not their fault, it’s not their problem either. In fact, according to prevailing wisdom, all is well in financial education. Sadly, more than ever before financial professionals have become juvenile rebels without a cause, hollow men within a world they now command without authority. When you conquer without fear, you can only triumph without glory. Worse yet, the younger generation has already become utterly cynical, and rightly so, as a result of such transparent disgrace, adolescent excuses and unacknowledged shame. Our students do not need prompting from thoroughly discredited teachers to draw their own conclusions. Finance is being radicalized as I write, and the question is really when, not whether, the ultimate reckoning will come back to bite us in the proverbial behind.
Of course, a few of the more reckless hedge funds are out of business, which means that a few of the more expensive mansions are on the block in Greenwich and Calabasas. Most of us breathed a huge sigh of relief when two senior managers from the twin infamously collapsed Bear Stearns hedge funds were found innocent of any wrongdoing. It feels real good to know there was neither conspiracy nor scienter, just plain ignorance and stupidity. This is one of those rare instances where, thanks to their own incompetence, garden-variety traders neatly avoided a well-deserved, extended vacation in Danbury. Inspector Clousot would be green with envy, so to speak. A Panther has nine lives; how many does a Bear have?
Viagra sales are up (no pun intended) in the nation’s financial centers and shrinks are now happily making a bundle explaining to erstwhile Masters of the Universe, financial Don Giovanni’s turned limp losers essentially overnight, that the capital markets inexplicably “moved against them” and that a rogue Al Qaeda faction is most likely responsible. Of course, it is still possible that all this could have been nothing but a horrible nightmare, some sort of napalm-spewing Black Swan on steroids. However, in that case it must have been a gigantic one, because the fiendish beast was easily discernible years ago.
What ought to be done? For what they’re worth, the following are my suggestions:
- The first step is obviously the admission that something needs to be done in the first place. Given the evidence thus far, this is unlikely to happen any time soon. Once it takes place though, we are fairly close to a workable resolution. Financial engineering is not intended to guarantee that no deal ever loses money, no more than medical school guarantees than no patient ever dies on the operating table. But it does guarantee that consistent standards have been employed in the hope of achieving uniform and reproducible results in the sense of a statistical measure. Within a well-organized and properly functioning financial system, by definition as small portion of the deal universe needs to under-perform, or else the capital structure has not been optimized. The fact that no deal ever loses principal is not a sign of superior financial knowledge and intellectual prowess. On the contrary, it is explicit evidence for the fact that risk has been eliminated instead of managed, and always at the expense of efficiency. Contrary to what most Wall Street money managers believe, a single-name CDS contract with some AAA DPC is not a risk-management tool; it is a risk-elimination tool. As usual, those who believe risk can be eliminated usually end up bearing all of it.
- The second step would be the wholesale revamping of FE curricula around deal-making and its mandatory skill set, instead of remaining the current morbid obsession with the Black-Scholes PDE. Given that most FE academics keep as far away from deal-making as they possibly can, this is also unlikely to occur in my lifetime. Perhaps this fear of the gauntlet happens because most of them would fare even worse than those they are now accusing of misunderstanding finance, although it is true that, to misunderstand something, you first have to understand it.
- Finally, since the vast majority of FE educators are out of touch with the adrenaline-laden atmosphere along the yellow-brick road, they would have to, somehow, become cognizant of actual financial practice instead of remaining ensconced in a secluded environment telling the rest of us how life really is on Wall Street. This means that practice and theory need to slowly and monotonically merge into one another, eventually to become identical. It also means that, instead of being the butt of every financial joke that they are today, financial engineers would acquire the same epistemological status that all other engineers have always enjoyed, i.e. they would be able to make a meaningful contribution to their employers right off the bat instead of having to be retrained from scratch because they are effectively children, unable to figure out how deals come together without major handholding. In most cases, unsupervised financial engineers are highly toxic to an institution’s well-being, not to mention their own.
Admittedly, structured finance is in total disarray right now. It needs to make a serious comeback simply because it’s a good idea. Only a good idea can be maligned to such an extent. Corporate finance belongs to the 19th Century and should remain available to those still stuck in that imperialistic mindset, which unfortunately includes quite a few people. Luckily, the sun has already largely set on this clubby, exclusive, anachronistic and parochial form of finance. Only structured finance can respond positively to the looming challenges of the 21st Century, and become understandable to the many, rather than remain the preserve of the few. It is silly to blame deals for being too complex, as if they were somehow thrown onto the markets via a process over which we have no control. Deals are not too complex, for they are just what they are. They don’t need to change, we do.