Nerds on Wall Street: Math, Machines, and Wired Markets

12.3. Stupid Financial Engineering Tricks

Alas, the same kind of careless design flaws found in engineered physical objects are also evident in engineered financial structures, plus a few special design flaws of their own. Foremost on that list are what seem to many observers to be a taste for excessive and seemingly pointless complexity.

Shortly after I moved from financial technology into investment management in 1993, I was glad to be able to attend a weeklong boot camp for financial executives that Andre Perold, head of finance at the Harvard Business School, organized for the Association for Investment Management and Research (AIMR) (now the CFA Institute). Coming from the stock world, I was stunned to see some of the Frankenstein derivatives that were being sold even then. Some depended on ridiculous factors, like the cube of the difference of two interest rates. Andre's harsh critique pointed out there was no imaginable economic justification for these freakish creations; they were Byzantine casino games, sold by fast-talking Wall Streeters to less sophisticated investors. The small-town managers in places like Orange County took the bait—in its case, in sufficient quantities to drive the county into bankruptcy in 1994.

Over the years, I remained somewhat mystified by much of what was going on in derivatives, and not particularly thrilled with the "what a rube" attitude I got from some of my colleagues when I expressed these doubts. I tended to keep quiet on the subject, ...