Caught in the Credit Crunch? Don't blame quants.

By Nina Mehta

Every so often, the markets stumble badly and the blame game starts.

In 1987, portfolio insurance was fingered for the massive selloff on October 19—now known as Black Monday—that resulted in a 23 percent plunge in the Dow Jones Industrial Average.

In August 1998, Russia defaulted on its bonds, throwing the traditional pricing relationships between government bonds from various countries out of whack. The combination of bad assumptions and leverage—using borrowed money to jack up profit opportunities—led to the implosion of high-profile hedge fund Long-Term Capital Management and the threat of a wider collapse of financial markets. That resulted in a $3.5-billion bailout orchestrated by the New York Federal Reserve Bank. The common scapegoat, after the routs of both 1987 and 1998, was overconfident reliance on quantitative, computer-driven models—one of the fundamental applications of financial engineering.

-Illustration by David Gothard

With the recent subprime mortgage crisis, financial engineering is once again taking some heat. Financial engineering is the use of mathematical and engineering methodologies to address financial problems. In the current search for culprits, many experts and the media have pointed not only to a greedy mortgage industry, but also to the failure by institutional investors and credit-rating organizations to properly understand the risks buried in complex credit-related products. Chief among these are collateralized debt obligations or CDOs—pools of securities often backed by mortgages, including more risky subprime loans, which are sliced into products based on their riskiness and sold to investors. Given the complexity of these products, some industry watchers see the subprime meltdown as a sign of financial innovation gone awry—making it nearly impossible for individuals and companies to appropriately analyze their risks. In their view, the spreading subprime disaster is the stepchild of complex financial products and misperceived risks.

So should financial engineering take the rap? No, says Victoria Averbukh M.S./Ph.D. ’97 OR a former Deutsche Bank strategist in mortgage-backed securities who now directs the School of Operations Research and Information Engineering’s Financial Engineering program in Manhattan. “Events of the summer may suggest that more diligent understanding of securities pricing and risks is needed, but even that’s debatable,” she observes. In her view, what’s needed is greater vigilance about the risks that are bought in a financial world that has grown increasingly complex.

What’s not debatable is that financial engineering has unleashed tremendous innovation over the last few decades. This innovation encompasses the evolution of financial derivatives—contracts whose values are based on an underlying instrument like a stock or bond—into new products that enable companies and institutions to hedge risks that once made their future less certain, to complex securitizations such as CDOs. Many say that the tools of financial engineering, like any other set of tools, require an eyes-wide-open approach. “Anecdotal evidence suggests that a lot of the big subprime CDO holders did not have adequate credit models or chose to rely on third-party models without a complete understanding of the risks in those products,” Averbukh says. “Wall Street will always want better profit margins, but the industry needs to tap more deeply into financial engineering in response to growing complexities.”

Robert Jarrow, a professor of finance and economics in the Johnson School of Management who started Cornell’s official financial engineering program in 1995 with mathematician David Heath (they launched an informal program in the early 1990s), agrees that financial products and the models undergirding them aren’t to blame. Ditto financial engineering.

“They’re very complex instruments,” Jarrow says about subprime mortgages and the CDOs issued against them. “Better and more thoughtful modeling would have alleviated—and perhaps even made impossible to happen—the subprime crisis.” In his view, the meltdown shows the need for better knowledge and people in financial engineering, not a paring back of their presence. He views the subprime crisis “as a cry, a manifestation of the need for better modeling.” Not enough good quantitative modeling was done in advance of the crisis, he says.

Evolving Discipline
At Cornell, and at other schools with financial engineering or quantitative finance programs, the subprime crisis comes at an interesting moment. Unlike in 1998, financial engineering is now a full-fledged discipline. In 1998, Cornell’s financial engineering concentration—a joint program between ORIE and the Johnson School—was entering its fourth year. Carnegie Mellon, another early bird in this area, had launched its program in 1993, the same year MIT launched a financial engineering track for its MBA degree. Now there are dozens of financial engineering graduate programs globally.

In the years since the first of these programs got rolling, financial engineering has changed. Jarrow notes that in the early 1990s it was unclear how financial engineering would develop. Indeed, it wasn’t quite a field in those years, but an offshoot of operations research and applied mathematics geared toward solving problems in finance. Jack Muckstadt, director of ORIE in the early 1990s, recalls that back then the need was simply to develop a mathematically and practically oriented program for master’s students to meet Wall Street’s demand for quantitative talent. It was the “proper moment to start a program,” he says, and Cornell became the first school to launch a financial engineering program in an engineering college.

ORIE Director James Renegar -University Photo

But the path financial engineering would follow wasn’t set. And not everyone was convinced the field would even last, despite the interest of students and ongoing demand by the financial industry for physicists, mathematicians, and quantitative analysts who could build models. “We thought it might be a temporary fad that would die out, that Wall Street wouldn’t be able to absorb nearly as many quants as it has,” says ORIE Director James Renegar. That uncertainty proved misplaced. Renegar notes that Wall Street’s need for quants has only accelerated, and that it’s now apparent that even to sell many products, financial firms “need individuals with a thorough understanding of the underlying ­mathematics.”

For Renegar, the changing needs of financial engineering also altered the emerging discipline. Early financial engineers tended to be mathematicians—“probabilists who got interested in the field as an application of the theories they really loved,” Renegar says. No longer. Over the last 10 years, he notes, Cornell’s new faculty members have become financial engineers first, rather than mathematicians. “They switched from being specialists in probability theory, applying their theories to financial instruments, to being financial engineers who are open to using any mathematics whatsoever,” Renegar says.

According to Jarrow, as the financial industry’s dependence on financial engineering increased, the discipline became more quantitative in orientation. “The skills and sets of knowledge students need have grown and specialized, partly because people in the industry know what they need now,” he says. “The field has evolved to the point where it’s really applied math.” Jarrow adds that when the Cornell program launched, only a couple of academic journals were devoted to mathematical finance. Now, there are at least a dozen. In his view, that’s another indication of how quickly financial engineering knowledge has grown.

Ian Domowitz, a managing director at brokerage and technology firm Investment Technology Group and a former academic, agrees that the “character” of financial engineering has shifted away from pure mathematics over the last decade. “Instead of companies retooling Ph.D.s in higher mathematics to Wall Street applications, which is what occurred a decade ago, schools now teach them how to apply mathematical concepts creatively in the marketplace,” he says. In his view, this is a necessity. “Financial engineering graduates and the programs that produce them need to demonstrate value to the market,” Domowitz adds. “Their target market is becoming broader, which means that the educational needs are also becoming broader.”

Shifting Priorities
In this new environment, ORIE has bolstered its financial engineering program to reflect changing industry priorities. ORIE in Ithaca now has four financial engineering professors: Philip Protter, Xin Guo, Stefan Weber, and Alexander Schied. Faculty from other disciplines such as mathematics or the Johnson School teach courses for financial engineering students. Jarrow, for instance, teaches an annual master’s-level course on the pricing of interest-rate derivatives, which are contracts based on underlying Treasury or government bonds. Financial engineering at Cornell also includes Ph.D. and post-doctoral students, many of whom straddle departments, focusing on mathematical finance or financial engineering.

As the field has become more quantitative, so has the master’s program, which now includes 40 to 45 students. ORIE expanded it to three semesters, included a summer internship, and made the course scheduling more rigorous. Renegar credits some of the new professors, such as Stefan Weber, for pushing for this expansion as well as the requirement that students take courses in sophisticated mathematics.

In addition to these changes, ORIE has redoubled efforts to provide students with practical financial tools and experience. To facilitate greater interaction among Cornell’s students, faculty members, and Wall Street professionals, ORIE acquired offices previously used by the Cornell Theory Center, just down the block from the New York Stock Exchange, in 2004, and are turning it into what Muckstadt calls “an outpost for financial engineering.”

FE Manhattan Director Victoria Averbukh -Mark Eisner

To further strengthen ties with Wall Street, ORIE recently turned to Averbukh to run the New York financial engineering facility. After 10 years at Salomon Brothers and Deutsche Bank, Averbukh plans to build up FE-Manhattan’s financial engineering center as a “liaison between Wall Street and ORIE.”

From Averbukh’s perspective, this is a good time to expand Cornell’s financial engineering presence on Wall Street. She notes that the subprime crisis has only clarified the need for financial engineers in the industry. FE-Manhattan is taking a two-pronged approach to fueling closer interaction with the financial industry. Starting in the fall of 2008, financial engineering students in the ORIE masters program can spend their third semester in New York. The important team project students did with financial institutions in their second semester will be moved to the final semester in New York, so their ties with the firms sponsoring those projects can intensify. “You can have someone who can build a term-structure model and not know what to do with it,” adds Averbukh. “That’s not what we want.”

Weber stresses that students will get a more hands-on, practical education in their final semester in New York. In his view, the focus will be on theory in Ithaca and practical insights and skills in Manhattan. To aid that, there will be more seminars and talks by Cornell alumni and practitioners in financial engineering in the final semester.

Iva Vukina ’04 ORE, an associate in the global rates group at Wachovia Bank in New York, expects the additional industry experience to be valuable. She says the theoretical background at ORIE provided a foundation for understanding pricing models, but that the team project she did offered a preview of the work environment. “Working in a group and having a deliverable and a due date, and learning to find the most reasonable solution to a problem—instead of the single right answer, which is typical of a classroom setting—was very important,” she notes.

The other focus of the FE-Manhattan center is to strengthen the school’s ties with Wall Street through seminars, lectures, and executive learning courses. These will take place every spring semester, starting in 2009. Averbukh, who has put together an advisory board to help sketch out plans for the future, adds that FE-Manhattan plans to add several post-doc or faculty members in the New York office during the coming year. As FE-Manhattan’s ambitious plans gradually take shape, the goal is for banks and Wall Street investment firms to gain access to the range of the Cornell faculty’s deep knowledge. Averbukh adds that FE-Manhattan will also facilitate research projects for Ph.D. students, post-docs, and faculty members that can be integrated with broader research initiatives planned with industry.