» The Deficiency of Financial Engineering
Last Updated on January 22, 2020 by John Fischer
Financial Engineering leads to greater financial risks, rather than mitigating it. In these time of ever changing economic markets, the once useful methods of financial engineering are no longer advantageous to its users. These theoretical formulas were first perceived as a positive discovery, a part of financial technology that allowed enormously complex risks to be modeled with more simplicity and precision than ever before. Financial engineering made it possible for traders to sell immense quantities of new securities, expanding financial markets to incredible heights. Because these methods were making people so much money, many of the risks and limitations of the models went largely overlooked.
It is important to explore the risks to investors that are associated with financial engineering.
- Financial engineering doesn’t account for market turbulence.
- Financial engineering isn’t an exact science.
- It doesn’t calculate all the risks associated with investments.
When you’re dealing with corporate investments, home mortgages, pension funds and other areas of the bond market, the mathematical model ultimately fails which can, and has, caused trillions of dollars to be lost. These models proved worthy to use under certain circumstances. They provided an industry-standard process to calculate the likely value of financial derivatives. The method was fine if you used it prudently and abandoned it when market conditions were no longer appropriate. However, the market began to behave erratically. If the financial market starts behaving in a way that the model didn’t predict or expect it can result in devastating loss.
The US housing market has been a perfect test case for how financial engineering can lead to fantastic gains, only to create devastating losses. Americans now owe several trillion dollars on their homes. Mortgages ultimately have no guaranteed rate of return to investors, since the amount of money homeowners mutually pay back every month is a function of how many have refinanced and how many have defaulted. There’s also no fixed maturity date because money seems to appear in irregular masses as people pay down their mortgages at erratic or impulsive times—for example, when homeowners decide to sell their house. The most challenging threat of the financial engineering model is that there’s no easy way to assign a single probability to the chance of default. Wall Street solved many of these problems through a process called tranching, dividing a pool and allowing for the creation of safe bonds with a risk-free triple-A credit ratings. Investors following the formula believed there was no way hundreds of homeowners would all default on their loans at the same time. Market losses were expected to be individual. But not all catastrophes are singular, and tranching still hadn’t solved all the problems of mortgage-pool risk. Some things, like decreasing house prices, affect a large quantity of people at once.
People who have surveyed the economic crisis will understand that the real economy of businesses and commodities is being surpassed by complicated financial devices known as derivatives. Derivatives are not money or goods. They are not something tangible or easily measured. They are investments in investments, bets about bets. Derivatives once created a flourishing global economy, but they also lead to turbulent markets, the near collapse of the banking system and the economic downfall. It was the use of financial engineering equations that opened up the realm of derivatives and caused such economic depression. Perhaps it is time to go back to the basics where an investment was valued based on market demand, current and future earnings based in reality. At times simple common sense can go a long way in ensuring that an investment actually makes sense and is worth what Wall Street says it is.