That financial engineering can be problematic, for several reasons, has been a theme here. The Econ/Eng focus is to look at this.
In his WSJ op-ed (In Finance, Too, Learning Entails Risk), L. Gordon Crovitz makes some valid comparisons using Merton's talk at MIT (Why The Financial Train Went Off the Rails).
However, in Engineering, we don't find live tests, like the following: a new airplane, such as the 787, being tested with a bunch of passengers aboard. No.
It's nice that Crowitz brings in the test metaphor, yet the reality is that the testing mainly is how effective the instrument is in providing opaque cover for extracting money out of the pockets of the hapless into the funnel leading to gigantic bonuses. These guys haven't begun to understand their fudiciary duties or have they?
Oh, that isn't fair, I know. Yet, what tests do we see in finance other than that which rates the instruments power in generating leverage and the accompanying fees? Oh, yes, we have those who provide ratings. Ah, what science do we find there?
Such a test does not exist now, except, perhaps, in some academic framework.
But, having said that, truth engineering will continue to be making an effort to deal with just this requirement.
08/31/2009 -- We're going to look at this, again, from the finance view as we expand theoretics and technicals via an econoblog.
04/24/2009 -- More on Merton's stance.
From the rest of the Merton talk at MIT, he claims that financial engineering is here to stay. MIT claims some influence there. No doing these types of structures is like saying that we don't need cars. But, we need people who understand, at all levels. Too, these things progress, like any artifact. We need a NTSB type of oversight. Also, perhaps, a SWF to be the ultimate liquidator to manage the 'realness' of assets. Interesting thoughts.
On risk, yes, it can be passed around. Merton thinks that collateralizing is better than rating (well, yes, realness versus some hyped review). We also need to have clearing of these things (like swaps, via OTC) when financial firms are involved.
At some point, things come to roost. And, it's not just badboys, like those doing the Ninja loans, etc., who are to blame.
Merton says that the alpha that looks good for all (or about all) hedge funds don't consider liquidity shocks.
04/21/2009 -- On the Merton talk at MIT, and after stopping at the 53:14 point, some comments about his message:
Sounds like Merton is proposing an extension to the Modigliani theorem to lessen some of the stench from innovations like the CDS which, like other derivatives, were supposed to not needing any oversight. These issues are still open. Yes, only 1 or 2 of many innovations may work; yet, those who are proposing these things take big payouts while the rest pay up.
As many have said (see the comments), using 'science' (well, it is a social science that is involved) does not make the 'engineering' any more sound than gaming.
Merton is right to talk down complexity in one sense, yet the innovative thrust seemed to optimize opaqness thereby allowing payouts that were not justifiable or sustainable.