Robert Shiller in The New York Times:
The subprime mortgage is an example of a recent invention that offered benefits and risks. These mortgages permitted people with bad credit histories to buy homes, without relying on guaranties from government agencies like the Federal Housing Administration. Compared with conventional mortgages, the subprime variety typically involved higher interest rates and stiff prepayment penalties.
To many critics, these features were proof of evil intent among lenders. But the higher rates compensated lenders for higher default rates. And the prepayment penalties made sure that people whose credit improved couldn’t just refinance somewhere else at a lower rate, thus leaving the lenders stuck with the rest, including those whose credit had worsened.
This made basic sense as financial engineering — an unsentimental effort to work around risks, selection biases, moral hazards and human foibles that could lead to disaster.
This is a terrible argument. Taking desperate people and giving them high-interest loans and then jacking them hard for fees is not financial engineering. Your payday loan center is not a Risk Arb desk at a hedge fund. Even if we are at a particularly cynical moment where we think it is all part of the same hustle (and trust me, I feel the cynicism) the techniques and methods are distinct.
Engineering is taking laws of physics or math and applying them to real-world problems. Mechanical Engineering is taking physics laws of force and building bridges with them. Electrical Engineering is taking physics laws of electromagnetism and applying them. Financial Engineering is taking mid-20th century breakthroughs in probability theory, notably Itō’s lemma and stochastic calculus, and applying them to financial instruments to get a sense of returns and risks.
Jacking people for fees is as old as the books. Taking a subprime loan and trying to model the various return profiles, and how to slice them up to try and make them investment grade, is in the back end – it isn’t in how the subprime loan itself was modeled. Indeed financial engineering should allow us to get rid of prepayment penalties. FE allows us to hedge out convexity risks of the prepayments in the interest rate swap market. Advance statistical techniques should allow us to get a better handle on how the prepayments evolve over time. Both of these should allow mortgage lenders to hedge out this risk, and hedge it easily. Financial engineering, when done right, should be about smoothing risks, not concentrating them.
Financial innovation should actually be able to build on that, jumping off from the edge of financial engineering. Taking something old and calling it innovative doesn’t do anyone any good.