The problem is that finance is not really an engineering problem. Issues arise because the techniques used to distribute risk change the market value of the underlying assets. This was a major cause of the MBS issue. Financial engineering allowed risk from MBS's to be more easily distributed. This increased the demand for these securities, which increased their value. The price of the assets increased, even though the underlying value of the assets was exactly the same. Much of the value created by financial engineering is an illusion.
"Financial Engineering" is discredited and should more discredited.
I'm sure some physics geeks really enjoyed fitting heat equations to financial processes. This exercise ran a foul of the problem that the processes were subject to the normal distribution, were not uncorrelated and had "long tails", etc, etc.. But all these errors were just results of selecting those models which provided actionable data - the markets found those geeks who willing to endorse a dive into reckless asset inflation. This kind of thing has been around since John Law.
The emperor was just as naked five years ago as today. What has changed is what people are willing to see.
Read Nassim Nicholas Taleb. If you're a real geek for this stuff, read Benoit Mandlebrot's financial stuff. HN had a link to Mandlebrot's prediction of the present mess - written in 1998 (when it had almost happened, as opposed to now, when it has happen).
Well, fortunately "financial engineering" hasn't discredited engineering. It is merely an inappropriate and discredited application of the engineering methodology.
A good analogy is Linux. The Linux camp can't understand why people don't switch. Haven't they done everything they were supposed to do, easy installers, graphical desktops, etc? Well no, like those bankers, they're just going through the motions without understanding that at the end of the day, it all boils down to human factors. You can't solve that with equations. You have to grasp it intuitively.
