The economic turmoil that our country is going through is partly the result of the arcane field of financial engineering ‘ a blend of mathematics, statistics and computing. These financial engineers, as they are known, are the creators of mortgage-backed securities and the mathematical models of risk that so wrongly suggested these securities were safe.

Though the models failed to keep pace with the explosive growth in complex mortgage-backed securities, the larger failure was human. These financial engineers originally intended to spread risk through the use of financial instruments called derivatives or credit-default swaps. These instruments were originally created to insure blue-chip bond investors against the risk of default. However, financial engineers shifted their focus and used these instruments as a means to bundle and sell mortgages, a practice that is largely to blame for the crisis that Wall Street is facing today.

Bundling mortgages and marketing them as safe investments seemed safe in principle, but the math, statistics, and computer modeling fell short in calibrating the lending risk on individual mortgage loans. This was exaggerated by the fact that the securitization of the mortgage market prompted lenders to move increasingly to automated underwriting systems, relying mainly on computerized credit-scoring models instead of human judgment. Essentially, the creation of this new “safe” investment vehicle created a demand for more mortgages, which in turn caused lenders to write more and more risky loans.

It has also become apparent that Wall Street analysts figured that since housing prices in the United States had not declined in decades, they’d continue to hold steady going forward. Obviously, the Wall Street models included a lot of wishful thinking about house prices. We now know that wishful thinking can do little to stop a housing bubble from bursting. And that’s what happened in the mortgage-backed securities and credit derivatives markets.

Better computer modeling would have helped but so would have common sense among Wall Street investors. It was no secret that lenders were furiously writing loans while spending little time scrutinizing the creditworthiness of individual borrowers. But even with lenders exercising sensible restraint, and Wall Street using better risk models, much needed federal regulation was missing. Over the last several years regulation has been stripped from our financial markets and it must be reinstated.

Financial regulation should be seen as being similar to fire safety rules in building codes. The chances of any building burning down are slight, but ceiling sprinklers, fire extinguishers and fire escapes are mandated by law. If you need additional information on any of the above, contact Clay Barnett with our firm at 800-898-2034.

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