Behind the Recession: MBA Follies #3

Many fingers are pointed at the collapse of the subprime market as the reason for the world global recession. Question: why was so much faith put on the subprime mortgage market when by very definition the word "subprime" denotes shaky, high risk. The answer is that subprimes were combined with other investment assets in hopes to lessen the risk, Hedges. So were created a new type of esoteric investment that no one really understood or could predict about where they would lead.

A smart mathematician, not necessarily a businessman, developed an equation that at first seemed to make it possible to simplify the economics of packaging and selling subprimes. Of course it turns out that the initial enthusiasm for the equation was unfortunately premature, i.e. empty.

The reason why the equation does not work is a very human weakness for letting the promise of great riches overshadow common sense. In the case of subprimes, the very esoteric mathematics assumed that housing prices would increase FOREVER!. Hmmmm.

Worse, it did not occur to anyone at first that just for the giggles, why not see what the mathematics would predict if housing prices did not increase forever. The answer would have been easily obtained and quite clear - everything would collapse along with the housing prices, ergo the recession. ["Recipe for Disaster: The Formula That Killed Wall Street", Wired online, 17:03].

One of the interesting new business science concepts is a whole new study field, "financial engineering" (aka computational finance), which is an attempt to package for our comprehension the new world of exotic (read incomprehensible to ordinary folk) financial devices such as derivatives, e.g. hedge funds. These new wrinkles in high finance are almost impossible to understand even for professional auditors. However, it should be noted that the most famous (or infamous) example of this new field is the subprime equation mentioned above. Will all this lead nowhere? Depends on whether really smart people can hold on to their common sense...which could be diificult when one is functioning in the rarified air of higher learning.