Feeling financial pain? First, blame all the scientists

A European super-duper atom-smasher blowing up the world? That's so last month. Now, physicists and mathematicians are taking the rap for blowing up the financial world, not unleashing microscopic black holes. Their crime? Creating rare "black-swan" credit panics to incinerate our retirement accounts.

Check out CBS' Oct. 5 edition of 60 Minutes, in which "mortgage science projects devised by these Nobel-tracked physicists" get the blame for the worldwide financial crisis, roughly $60 trillion worth of dubious debts now choking credits markets from Hong Kong to New York. Or take New York University risk engineering professor Nassim Nicholas Taleb, author of The Black Swan: The Impact of the Highly Improbable— the " hottest thinker in the world," according to The London Times— who says "use of probabilistic methods for the estimation of risks did just blow up the banking system."

So what do mathematicians and physicists have to say for themselves?

"Yeah, we did it," jokes Temple University's John Allen Paulos, author of A Mathematician Plays the Stock Market. "I'm secretly a billionaire. I just keep teaching so I won't blow my cover."

"The idea of blaming any of this stuff on physicists strikes me as entirely daft. It's true that some people trained in physics went into the trade of financial calculations. At that point they were no longer physicists, just smart people," says science historian Spencer Weart of the American Institute of Physics. "Any sensible person would place the main blame upon any fool who took such calculations as a guide to real-world actions."

"My first reaction is this is totally silly," Paulos says. Financiers have managed to create banking crises before, from the Great Depression to the dotcom bust of 2000, without help from mathematicians, he notes. Shoddy lenders, stinky loans and bogus promises to back up those two things are behind the current credit bust, he says, not guys in lab coats.

Fancy math only came into the financial picture after bankers slapped AAA ratings on crummy loans and fed them into their sales pitches, says Paulos. "What does a bad craftsman do? He blames his tools."

Perhaps the blame should go to economists, not physicists or mathematicians. Much of the ire is aimed at the "Black-Scholes" formula, for which Harvard's Robert Merton and Myron Scholes won the 1997 Nobel Prize in economics. The Royal Swedish Academy of Sciences said they "laid the foundation for the rapid growth of markets for derivatives in the last 10 years." Derivatives are contracts that bet on the future prices of assets, such as stocks, bonds or commodities. They're the tools behind the financial mess now exploding before our eyes.

If you really want to worry, take a gander at the Nobel diploma awarded to 2003's economics prize winner Robert Engle, whose "models have become indispensable tools not only for researchers, but also for analysts on financial markets, who use them in asset pricing and in evaluating portfolio risk," according to academy. His Nobel diploma is one of academe's most truly weird art pieces, depicting a phrenology-tattooed Kilroy peering over a tattered banner. No wonder people call economics the dismal science.

Taleb argues that "quants," the quantitative, or number-crunching, analysts on Wall Street took such models to places of extreme risk, where they no longer applied. Further he argues that many of the models failed to incorporate into the models the risk of real-world catastrophe, which he calls Black Swans for their rarity, ensuring they would lead to disaster.

"To some extent, to talk about Black Swans is just branding, to give something a name that we already know," says mathematician Marco Avellaneda of New York University's Financial Mathematics division. "I think it is pure scapegoating to blame the models and mathematicians. It's like blaming World War II on the German language."

Still, he acknowledges that many financiers only wanted the simplest models. "Time and again, they would say they just need to put a risk number to back something, so they can turn it around to the market," Avellaneda says. "But to blame that on scientists is a mistake." Statistics and mathematical models undergird the entire financial system of the world, he adds, beyond the world of mortgages and into every aspect of business. "We can't walk away from that."

"The central problem with the current use of models has been that the rating agencies, which play a crucial role in the markets, were using models that did not reflect reality. Modelers at the major banks were able to design products that took advantage of the flaws in the rating agency models," says corporate finance professor Frank Partnoy of the University of California, San Diego law school. "Essentially, they gamed the system by leveraging the flaws in the rating agency models to create overrated' securities, instruments that received a AAA rating, but in reality were nothing close to AAA. We need to stop relying so much on the rating agencies."

"Garbage in, garbage out," says Anant Sundaram of Dartmouth's Tuck School of Business in Hanover, N.H. Any models, no matter how resilient, which relied on bogus credit ratings, he says, were in trouble.

At any rate, we'll have to hope that mathematical grounding helps somehow in the finance mess, as Neel Kashkari, the inexplicably-young (only 35), interim head of the Office of Financial Stability was an aerospace engineer prior to heading off to business school and on to the Treasury Department. Oh well. At least he didn't ditch engineering for journalism school, like at least one poor fool did, so we can hope that Kashkari restores the sullied honor of quantitative folks everywhere.