Thursday, August 1, 2013

Financial engineering I

Moral: Wherein we take a long, deep look at what is behind the drive to financial engineering (see, an early opinion).


This re-consideration is long overdue. Notice that the opinion mentioned in the above Moral dates from 2008. At that time, there were glimmers of problems to come. Many potential causes for the problem seemed to go back to misuse of mathematics and computation, from what I read. Of course, it turns out that these mainly caused things to be worse. That is, the problems date back to age-old human issues, such as greed, sheer stupidity, behavior and thinking that bordered on sociopath'y, and more.

Turns out that we had no perp walks (the abundance of rogues, notwithstanding). Of course, we also had all sorts of side-lines. Made-off took off some of the edge. He was punished as his type of shenanigan was easy to grasp. Not so much for those who used financial engineering as an umbrella.

Then Ben coddled the market'eers. But, we'll get back to all that.


We are going to use MIT as a focal point for discussing financial engineering (see their blog). Evidently, in terms of academia, the Polytechnic Institute of New York University was the first to have a department certified by The International Association of Financial Engineers (wiki page). Notice that they got started in 1992. That's new, relatively.

However, they are affiliated with something that I'm associated with: SIAM (Society for Industrial and Applied Mathematics). Note that SIAM dates from 1951.

Aside: Comparing organizations by their time of inception can be interesting. IEEE dates to 1963, however it's predecessors dated from 1884 and 1912. SAE dates from 1905. IChemE formed in 1922. The older societies are by-products of the evolution of industry, its tools and practices. Later groups, many of them, have a heavy emphasis on computational approaches (my bailiwick, foks). So, the IAFE is new; too, what they're proposing, and doing, is very much dependent upon advanced computing.


Before talking more on motivations (both for me and the IAFErs and in general), let's look at what can be read on Wikipedia: Financial Engineering, Computational finance, ..., Criticisms, ..., Securitization, ..., Risk (say of tranching), ...


Motivations? Whatever money is we can agree that having enough is a worry for a lot of folks. Then, some folks seems to have too much. A sensible person, with a lot of dough, would want to use it for good purposes. All sorts of things come to mind: take care of the poor, help make a better future, etc. An example is this paper at the MIT site: Commercializing biomedical research through securitization techniques (see the paper).

That sounds like a good idea, right? It's far removed from some who seem to want to just make more money, in greater and greater heaps.

Recently, the WSJ had an article about Blackstone's plan (the Comments are interesting) to use financial engineering. In this case, they have bought 10s of thousands of houses (foreclosures, probably obtained on a dime). These will be rented. Okay. They want to be a landlord. That's nice (as long as they're more than the slum landlords that seem to crop up here and there). But, then, that's not enough (property management); they, Blackstone, want to package this whole thing so that they can sell bonds. Ah. Well, it's clever. Too, they might find buyers even if they cannot get ratings.

Aside: as we saw before, this type of thing was sold as cash-equivalent with ratings that were sky-high -- AAA, even. Many ate losses; some [were of] large, [staggering amounts] (some may not have unwound, yet, thanks to Ben). Can they, [this approach and these bonds], get ratings now?


The thought about tranching holds but is under review. Though there seems to be a lot of silliness involved, there actually may be something of value to these ideas. So, we'll look at that, next. [Recall, the early characterization was that it looked liked searching for something from nothing (as in, perpetual motion).]


11/24/2013 -- The ACM has a review article on algorithmic trading that everyone ought to read. Essentially, if we use a plane as an example (consider what Boeing has had to do to get the 787 out and about), we would say that the financial folks are putting passengers on experimental aircraft with little regard to their safety and comfort. The whole notion is atrocious. How does it happen? They've coached things in mathematics and computerese, plus they've bastardized Adam Smith's ideas. Where is our sandbox, and where is the stable economic system that we can build?

09/18/2013-- Pop, fizz, ... Ben had to show largess because of idiots who ran the economy to the ground (rogues all around). Ben is going. What do we have to look forward to? Businessweek has a review issue (of the past five years). Several articles are especially interesting. Too, phrasing shines: spin dross into gold (in relation to mortgage bonds). Perhaps, we'll get back to some of the more pertinent ones, at some point. If we do, it would be to bring forward what has been said here, from the beginning. To wit? Tranche and trash (WSJ has a good take on that). Securitization? This article brings on weeping (one example of the misuse of mathematics and computing that has been harped about). Adoption, and improved understanding, of lazy evaluation let loose the powers that resulted in the wild web and its little children, namely social media and more. To grasp the problem, we have to go back to computing that is in some type of responsible area. Avionics comes to mind. If what is couched as software in looser domains (financial engineering? -- looser?, yes bailouts are the norm despite all of the protestations of the ruling elite; or the whole cadre of the poorer folk can just suck it up when there are problems in order to relieve the fat cats' loss) were to used in flight controls, would we not have planes falling out of the sky? We'll get back to the simple issues that seem to not be seen by the elites chasing after the bucks that Ben has been throwing out of his helicopter.

08/23/2013 -- Another example. Jon has it right: high-frequency to blame. Of course, there are several reasons for the market being out of control.

08/12/2013 -- The President of the US is talking about changing the mortgage game. For one, Fannie and Freddie would change dramatically. The WSJ reported that these ones are making oodles of money (if so, it's due to Ben's free money). We'll have to weigh in here, at our speed, of course. For one, we'll lay out the progression that got us to use of the CDO in the mortgage context. Fancy, creative finance is what drove these things. Too, we'll consider what ought things look like (look, there have been many changes for the past 100 years or so; a look at these issues from a temporally unbiased manner is imperative.

08/08/2013 -- The comment at MIT (as in, Massachusetts Institute of Technology) was rejected. It can be found below (08/02/2014). Over the years, I've lost a lot of comments that way as I didn't record the material prior to submit. By the way, MIT, one of my academic advisers during my studies did his graduate work at, and was degree'd from, your place. Of course, there are plenty of other institutions in the Boston area (however, the Cambridge pair (disclosure: I have more than a passing interest in New England -- all aspects -- due to its historical significance in the supposed dream of mankind) make an interesting couple).

08/05/2013 -- If things continue as they are going, in finance, the markets will die. They'll become warped caricatures of themselves which cannot attain long-term viability. The contributions of Financial Engineering are pushing, in many cases, to this type of unhealthy status. Yet, what else is there? So, people are piling into the equity chimera. It is guaranteed, that most will be losers. In fact, over the long term, we can show that no height of miscreant gain can offset the depths into which the majority are being trampled. Hopefully, this time around, we will learn something. Frankly, I wasn't aware enough to know what was going on last time. It took awhile for my head to accept that the idiots had us tied up. I've been slapped silly since and expect this to go on. Doves have the power, right now. And, you know that the peace twig is only for the Wall Street types. One would hope that something like FE would bring in the proper ethical view. We'll see. In the meantime, I'm going to get more into the misuse of mathematics. You would not expect this from MIT (wait! have not engineers been behind some of the largest banes of mankind as well as providing their wonderful boons? -- we'll venture, audaciously, into reviewing the balance there - as in, which is the larger set: boon, bane?). ... Age-old issues continue to plague us (more than the royal we). One would think that, perhaps, we could learn at some point (why not now?).

08/02/2013 -- Put the following comment, here, at MIT: I appreciate that you have this blog that I could run across (“what took me so long?,” I wonder – as I first ran into FE (as in, became aware of it) in the 2008 time frame with a reaction of incredulity – more below). Perhaps, the blog can be used to lead consideration of those things that cause us to build upon “sand (financial and otherwise)” when we ought to know better.

But, such a discussion would go beyond mere emphasis on the analytic frameworks, as even with modern computational assistance, such views are incomplete. That, of course, is arguable, especially when FE has been used to pad pockets (near-zero reality spreading that gain across the multitudes as losses). One thing that we all know is that money has its power. Finance needs more than ethics (see below) as a counter-balance.

Now, FE is what? If it is “engineering” as a discipline, upon what science is the endeavor based? I have not seen a good definition. Please point me to one.

I hope that the response is not economics (which we all know is dismal). But, if it is, then one would hope that there would be an experimental basis with which to evaluate long-term consequences of decisions made within this domain’s purview. And, that basis would have well-defined ways and means to handle the inherent complexity (suggesting, of course, core issues with computing).

Now, if the basis is purely computational mathematics, then we must even more stress the need for a “scientific” mindset, abetted with liberal doses of proper consideration for quasi-empirical notions. From what I’ve been seeing (observer), the current focusing on “algos” leaves a lot to be desired (say, as compared to the discipline found with product engineering). Especially does this seem to be true with FE (again, looking in as an outsider).

This past downturn has been followed with all sorts of changes (some from the FED’s actions) that have not been tested in any reasonable sense (except, perhaps, for their ability to pull money from pockets). In fact, if FE has a strong computational finance flavor, where is your test bed and laboratory? And, before that, the necessary methods and their metrics (broad sense assumed)?

This comment is not looking for flip answers. MIT has a strong presence in FE, from what I’ve seen via search results. A good start would be to lay out something that we could agree upon as the basis for discussion.

I’m not talking FE 101 as the deep philosophical issues (well beyond ethics) would come to the fore, immediately. Such is the importance of the discipline. It is where advanced computation (with the whole gamut of connotations) and what we value and use, as money, intersect.

Everywhere I look, there is void (absence of ethics and more?) except for silly notions of game theoretic concepts as the foundation for our future. GT is no more than one of the tools that need to be applied (from whence [is] its use as an over-arching worldview?).

Is it [not] true that Finance, and its engineering, would need to build more than chimeras for us to expect (yes, uncertainty and risk cannot be avoided) a sustainable future for ourselves and our progeny?

Modified: 11/24/2013

No comments:

Post a Comment