“Dream Team” Discusses Financial Engineering

Nobel laureate Robert C. Merton ’66 (above, third from left) joined the director of the School’s financial engineering program, Professor Emanuel Derman (second from left), and Goldman Sachs director and University Trustee Armen A. Avanessians ’83 (above, left) in an informal and lively discussion about the future of financial engineering.

An audience of nearly 400 students and alumni listened intently as the trio, introduced by Interim Dean Gerald A. Navratil as the “dream team” of quants—quantitative analysts who apply numerical or quantitative technique to finance—discussed financial engineering and its future. Sanjay Verma ’90 (above, right), co-head of US Fixed Income Asset Management at Morgan Stanley, moderated the discussion.

While the current market condition is not a result of a failure of financial engineering principles, the panelists agreed that financial engineers can help repair the system.

“Financial innovation has been a driver for hundreds of years,” said Merton. “We should not let recent events sidetrack financial engineering.” Merton, who won the Nobel Prize in economics in 1997, is currently the John and Natty McArthur University Professor at the Harvard Business School. He was one of the School’s first students in the engineering mathematics program, now known as applied mathematics.

Derman talked about the public cynicism surrounding the current financial system and a need for “financial leaders with brains and principles.” “We keep waiting for a Churchill but they keep throwing us Chamberlains,” he said. Derman is a former managing director at Goldman Sachs and head of quantitative risk strategies in firm-wide risk prior to coming to SEAS as a professor in the Department of Industrial Engineering and Operations Research. He is the inaugural director of SEAS’s financial engineering program, and is well known for his work on the Black-Derman-Toy interest-rate model and as the author of My Life As A Quant.

Avanessians suggested that “financial engineering academia should take a broader role in public policy debates in the days ahead.” Reflecting that “there is no shame in being quantitative,” he offered a vision of a university curriculum that included courses like Accounting for Physicists. “We can’t solve the problems we’re facing with talk alone. We need engineers who can apply their quantitative and analytical skills to a variety of issues.”

Avanessians is director of Fixed Income, Currency and Commodities Strategies, Equity Strategies, Investment Banking and Financing Group Strategies, and GSAM Strategies at Goldman Sachs. He holds an MS in electrical engineering from SEAS, where he is chair of The Columbia Campaign for Engineering, chair emeritus of the SEAS Board of Visitors, and chair of the Financial Engineering Steering Committee for the financial engineering program.

In discussing the subprime mortgage crisis, Merton said that the credit rating agencies were using models that were not expected to perform the function they were performing as a substitute for posting collateral in financial institutions with large derivatives portfolios. They were created in a simpler time, he said, and were to rate firms with mostly tangible assets like manufacturing plants and equipment. “The model was not complex enough,” he said, “and so the reality was not what the rating indicated.”

Derman said the School’s financial engineering program has responded to recent events by offering two new courses, Foundations of Financial Engineering and A Guide to Financial Industry for Quantitative Professionals. In addition, courses also can  be taken in the School of International and Public Affairs and in the Business School. Students normally in the 12-month sequence for the MS degree now have the flexibility to take a summer internship and complete the course work in the fall term, graduating in December 2009.  “We are aware of the changing environment and job market,” said Derman, “and we are making accommodations by offering more courses on asset management to prepare students for jobs on the buy-side. We try hard to prepare the students for the professional world, with courses by adjunct professors who work in the financial industry. We help the students with resume writing and have frequent Town Hall meetings to address their concerns.”

The panelists made additional suggestions for changes in the economic system, including recommendations for:

  • data transparency;
  • fair-value accounting;
  • regulatory due diligence, including regulation of the shadow banking system; 
  • a National Capital Markets Safety Board, like the National Transportation Safety Board, that sends a team of experts to evaluate every major financial failure and to give a report that will help ensure it doesn’t happen again;
  • an increase in financial engineering expertise on corporate Boards of Directors; and
  • creating a sovereign wealth fund for U.S. companies so that assets do not go into the Federal Reserve or Treasury Department but are managed by professionals to maximize the return for risk instead of simply being a liquidator of those assets.