Robert Merton's Academic View of Risk & Financial Innovation

Last week, in the April 20th Wall Street Journal, columnist L. Gordon Crovitz wrote a piece focusing on Nobel Laureate and failed hedge fund co-founder Robert Merton, entitled "In Finance, Too, Learning Entails Risk."

After beginning his editorial by describing early trials and errors in elevator development, Crovitz then wrote,

"Our era may be losing the tolerance for the trial and error needed to make innovations successful. Consider the financial engineers whose mistakes led to today's financially led recession. They thought they were creating a more stable economy by applying mathematical models to markets, using new technologies of computing power and global trading. Even having lost fortunes, today they and their financial institutions are pariahs, subject to media frenzy and government regulation.

The innovators who thought up the elevator, the cotton gin and space travel didn't intend to kill or injure people as they perfected the technologies. Likewise, today's financial engineers never imagined their miscalculations could result in a global recession.

Perhaps the best person to illustrate this point is Robert Merton, the Harvard economist who won the Nobel Prize for his work that led to the options and futures markets of the 1970s that revolutionized financial markets. He was also a founder of Long-Term Capital Management, the hedge fund that became the poster child for mistakes in financial engineering in the 1990s."

Crovitz usually writes a pretty good column. This one, however, is way off base. He mistakenly compares and equates modern financial instrument innovation with physical product innovation. Years ago, financial innovation may have been closer to the invention of physical products, but not anymore. If for no other reason, any developments post-dating the early 1970s, when financial service firms, including investment banks, began to go public, were rewarded in a radically new way. Rather than becoming a partner, or enjoying increased value as part of the partnership, many investment banking 'innovations' resulted in cash or other near-term, non-partnership compensation.

Thus, longer term considerations of how the innovations actually benefited customers was, frankly, second to how it profited the investment banks.

John Whitehead, one of the last of the old-school heads of the privately-held Goldman Sachs, publicly decried the firm's move into proprietary trading on the other side of its clients. He believed that an investment firm either served clients, or its own interests, but not both directly and simultaneously.

I believe Merton and, by his choice of topic, Crovitz, mistakenly believe that today's financial products innovators have some sort of systemic good as their goal, rather than their own short-term wealth.

Crovitz later quotes Merton as saying,

"In his lecture, Mr. Merton said this crisis was not a failure like the space shuttle Challenger disaster that could be blamed on the single factor of a faulty O-ring. Instead, many factors we're just beginning to understand, sparked by the housing bubble, led to the collapse. Risk grew across interconnected financial institutions as they bundled together assets such as mortgage-backed securities that collapsed together when volatility exceeded what the history-based models considered remotely possible. Government guarantees of deposits held by these banks, he noted, means "the government is writing a put option on a put option," making the plunge deeper.

Our fundamental problem is what Mr. Merton called the structural tension "between financial innovation and crisis." We know a lot about risk, information and probabilities, but not enough. "We've created instruments for manipulating financial risk without a thorough understanding of the underlying engineering." He compared innovations in finance to a new fast train running along tracks not yet redesigned for the speed. The value of the innovation, once perfected, outweighs the problems in the meantime."

If you think, like Merton apparently does, that some financial innovators are now going 'back to the lab' to perfect their instruments, think again. There's little percentage in that. Especially now. This is clearly an ivory-tower academic's view of the rough-and-tumble reality of today's financial markets.

Crovitz ends his editorial by observing,

"In a paper for the scientific journal of the Royal Society back in 1994, Mr. Merton warned that "any virtue can become a vice if taken to extreme, and just so with the application of mathematical models in finance practice." We know even better now that some risks can be calculated and thus reduced, while some unknowns cannot be turned into probabilities. "The mathematics of the models are precise, but the models are not, being only approximations to the complex, real world."

The measure of innovators is not in the mistakes they make, but in the lessons they learn. We now know that our complex markets need better models, which should include more humility, acknowledging that some risks are still too uncertain to measure and should be avoided. Instead of vilifying modern-day elevator engineers, we should challenge financial engineers to find fixes for what's broken."

It doesn't take a Nobel Laureate to realize that financially-engineered structured financial instruments, risk modeling, etc., are imprecise. Nor that some risks should simply be avoided.

Case in point. Years ago, circa 1995-6, when I was Oliver, Wyman & Co.'s (now the financial consulting component of Mercer Management Consulting) first Director of Research, consumer credit risk management was all the rage. The small team of managers working at Advanta, near Philadelphia, was hauling in large fees for equipping the standalone credit-card issuer with the most advanced tools for measuring and managing credit risk.

Eventually, the team was bought by Advanta. It was well-publicized, after the messy departure by several senior managers on the Advanta team, that they promptly went out and bought Dodge Vipers, a very expensive muscle car.

About a year after the team formally joined Advanta, the firm imploded from credit losses.

Oops!

My point is that some of the premier risk measurers and managers, over a decade ago, managed to destroy one of the then-premier US credit card issuers with what they didn't understand. This is a recurring theme in the post-1970 US financial services world.

Publicly-held financial service firms lay off risk to unknowing shareholders, pay themselves large, near-term bonuses, in cash or options, assuming the various sophisticated investors in the markets know what they are buying. There's no assumption by anyone of some sort of systemic 'good.' About as good as it gets is to strive for counterparty non-failure. But without losers, there can't be winners in the business of trading financial instruments.

Merton is, unfortunately, rather naive. Apparently the fate of the hedge fund he co-founded, LTCM, taught him little. And I guess Crovitz, too, has drunk the Kool-Aid, and believes that, somewhere, there is a financial instruments innovator with a heart of gold, in quest of the perfect, value-adding product for financial markets.