As Wall Street became the destination of choice for MIT and Harvard mathematicians and physicists throughout the last decade, alarm bells should have sounded at our regulatory and policy-making institutions.
An interesting op-ed piece by Calvin Trillin appeared in the New York Times recently, here, that caps a recent trend exposing the so-called genius of Wall Street as a fraud. Other Times writers, including Joe Nocera, here, Dennis Overbye, here, and Steve Lohr, here, have tackled the subject of Wall Street’s smarts, but none as succinctly as Mr. Trillin. In the op-ed, Mr. Trillin claims to have met a man in a Manhattan bar who summarized the cause of the financial system’s near-collapse: “Because smart guys had started working on Wall Street.” This overly simplistic analysis became profoundly interesting as I continued reading, and developed into the following rubric:
- Fortune and academic standing on Wall Street are historically inversely correlated, with Wall Street’s millionaires graduating in the lower third of their class;
- The lower third, who usually made generous livings on Wall Street, became enamored of potentially huge fortunes, and began leveraging their businesses;
- Top graduates, who typically became physicists or judges (tip money on Wall Street), instead began calculating arbitrage risks for hedge funds and other investors;
- The top graduates, who were very smart, invented credit default swaps and other derivatives, enabling the lower third to become obscenely wealthy;
- Wall Street nearly collapsed largely due to derivatives and credit default swaps developed by these very-smart people.
This theory, while enticingly simple, truly exemplifies what occurred on Wall Street as a result of the oversimplification of risk into quantifiable and discrete components. Although I have written about this before, here, this discussion has largely been ignored by both the regulatory structure and policy making institutions in the United States. We continue to be highly exposed to complex financial instruments that few understand or even acknowledge. The potential domino effect of interrelated industries and institutions is just now beginning to be understood.
Smart-thinking has enabled Wall Street to develop complex and leveraged financial products that have never been tested or vetted in less than optimal conditions and whose potential downstream impacts are unknown, while leverage has magnified the institutional risks of these products ten-fold. We literally outsmarted ourselves into believing that we had created structured products that could withstand severe economic headwinds, but without any understanding of how these products behaved or how they would impact the financial institutions they serviced.
We’re no better off than we were 10 years ago, when top graduates began migrating in large numbers to Wall Street, we’ve simply transferred most of their failures to the taxpayer. Where does it stop?
