Alice In Wall Street

Financial engineers, despite their pronouncements of math/stat/coding wizardry, are really just some truffle pigs and cockroaches. The truffle pigs snuffle in the ground, generally around trees in deep parts of the forest, for the scent of the black truffle. A valuable fungus, that black truffle. Finding one, the handler has to quickly extract it from the maw of the pig. Turns out, unlike retrieving dogs, pigs like to eat their catch. Cockroaches insinuate themselves in the darkest parts of dwellings, seeking water and the occasional crumb. Few of the mainstream pundits have taken this bull by the horns. Today, Floyd Norris, reliably more aggressive then 99.44% of his brethren, lays out the story. Again, and with some rather wonderful quotes.

Not to mention: I've referenced Lewis Carroll more than once, generally repeating the phrase "... words mean what I say they mean...". Which isn't exactly the text.

Part of the regulatory challenge was laid out in 1871 by Lewis Carroll's "Through the Looking-Glass":

"When I use a word," Humpty Dumpty said in rather a scornful tone, "it means just what I choose it to mean -- neither more nor less."

"The question is," said Alice, "whether you can make words mean so many different things."

"The question is," said Humpty Dumpty, "which is to be master -- that's all."

Norris spends most of the column with the history of Lehman, and Repo 105.

Lehman taught us that there were plenty of tricks around to make balance sheets look better for one day and then revert to an undisclosed reality that was much worse.

One of the tricks was to adjust the weights of assets; as in weighted average. Of course, analogous to a Bayesian prior, the banker gets to make up the weights. And that's what Lehman (and the rest as well, of course) did.

It turned out Lehman was valuing some securities at 85 percent of face value while competitors thought they were worth 20 percent or less.

In general, the bankers do have a point: some assets are riskier than others. Home mortgages, for example, won't go rotten all at once all over the country. Will they? So the banker puts a lower risk weight when figuring the backing capital.

That made sense in theory -- some assets are clearly riskier than others and more likely to produce losses. So less capital was needed for low-risk assets, like loans to high-quality borrowers. Trusting regulators let the banks use their internal risk models to determine the weightings.

But, quoting Stanley Fischer, Fed vice chairman

"... any set of risk weights involves judgments, and human nature would rarely result in choices that made for higher risk weights."

But, here's the pig/cockroach bit:

Financial engineers invented securities that would count as equity for bank regulatory rules and balance sheets but looked like debt to the Internal Revenue Service. Unfortunately, when the pinch came, they turned out to be more like debt. Big banks are being forced to stop using such things.

Not satisfied with just putting a heavy thumb on the scales, they dispensed with the scale entirely and made up the numbers.

So, are financial engineers good for the commonweal, or only for themselves and their handlers?

As the song says, "Mama don't let your kids grow up to be banksters".