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Financial Re-Engineering

10/01/2010 9:00 AM e14"633
Bengt Holmstrom, Paul A. Samuelson Professor of Economics; Andrew W. Lo, Harris & Harris Group Professor, Director, MIT Laboratory for Financial Engineering; Robert C. Merton, Ph.D. '70, MIT Sloan School of Management Distinguished Professor of Finance; Jiang Wang, Mizuho Financial Group Professor of Finance; William Wheaton, Director, MIT Center for Real Estate, Professor, MIT Department of Economics

Description: Like a contemporary "whodunit" with a global crime scene, the financial meltdown has left behind countless victims, and lots of pointing fingers. The reasons for the collapse are debated by this group of estimable economists, some of whom worry that without really understanding what happened, we are in for a repeat episode.

Moderator William Wheaton starts the discussion by suggesting that the interconnected global system of financial markets may be inherently unmanageable and overly risky, due to its complexity. Andrew Lo sees both peril and promise in these markets. Securitization, the bundling and trading of debt assets, "effectively allows ordinary borrowers that typically had to go through banks to tap into the power of global capital markets." But there are "unintended consequences: Technological innovations outstrip our ability to understand them." Financial transactions in a world of 8 billion people can become too complex, leading to uncontrollable systemic risk and disaster, much the way small brushfires swiftly grow and consume millions of acres.

Robert Merton does not believe the complexity of trading securities or derivatives is at issue, but rather, human management: "Get those people with antennas out of the financial system, and put in people with some common sense." Financial institution overseers need a "much higher level of skill set and training," says Merton. They don't need to be "quants," but require "intuition as to the risk characteristics of these instruments." This means understanding that risk often changes in a "complex, nonlinear way." The tools required by modern finance are there, and do work, he asserts, "and they're explainable without some off the shelf, weird theory."

Bengt Holmstrom describes how most financial systems are structured around trust that adequate collateral exists in a product, even when "you have no clue what assets lie behind it." So "opacity is the very typical characteristic of liquidity and banking has never been, and no doubt will ever be anything but opaque." Yet there must be enough, or good enough collateral "so people don't have to ask questions." Back in 2006, when people began "to feel nervous about the quality" of securitized products, in 2006 and 2007, he says, they clung to faith in the products. With trillions of dollars rolling over every morning, "if you say 'Stop, guys, I just want to see the papers,' it's over. The market stops right there." Holmstrom thinks new science is required "to understand how a collapse like this happened."

However the crisis emerged, panelists think more steps should be taken to avert another one.
Jiang Wang
believes a "critical step" would be gathering information "relevant to systemic risk," because the market does not currently provide sufficient information on that." Holmstrom's "first reaction --a Band"Aid -- is to pull back," raising collateral requirements in the markets. Lo suggests an independent federal agency along the lines of the National Transportation Safety Board to "focus on the science and engineering merits of various financial proposals, and to study and monitor the financial system to measure systemic risk in a convincing, compelling way."

Merton believes it may be possible to track systemic risk better, using new methods of economic analysis, but ultimately believes, "We'll always have crises, not because we're stupid, but because we are willing to take risks to get the benefits."

About the Speaker(s): William Wheaton holds a joint appointment in the Departments of Economics and Urban Studies and Planning. An authority on regional economics, Wheaton is a principal in a consulting firm that provides market analyses for development companies active in the market for commercial space.

A member of the MIT faculty since 1972, Wheaton helped to develop the field of urban economics by pioneering the theory of how land, location, and housing markets jointly operate. He also specializes in the problems of urban infrastructure and local government finance. He has written numerous articles in scholarly journals throughout the world, and is a co"author of Urban Economics and Real Estate Markets, the first text book to cover both real estate applications and economics.

Wheaton helped organize the MIT Center for Real Estate, and teaches the program's core course in Real Estate Economics. He was the first economist to apply econometric methods to the forecasting of real estate markets, and is a principal in Torto Wheaton Research, a globally"recognized real estate consulting firm that works with the real estate industry to analyze the fluctuations and trends of the market.

Wheaton received a B.A. in Economics from Princeton University, and a Ph.D. from the University of Pennsylvania. Over the years he has worked with many U.S. governmental agencies, as well as the World Bank and the United Nations.

Host(s): School of Architecture and Planning, MIT Center for Real Estate

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