Chapter 12 – Shooting the Moon – Stupid Financial Technology Tricks



Stupid Financial Technology Tricks and Global Economic Collapse

Like many others from the stock side of greater Wall Street, I felt blindsided by the events of 2008. “Blindsided” is actually a gross understatement; I felt like the guy who comes home and finds the neighbors were running a meth lab that has exploded and flattened the block. I have tried to moderate this “mad as hell” attitude in writing this, and recognize that many participants did in fact realize that something was very wrong. One commented, “Bit by bit, we iterated toward more dangerous things, and each step seemed okay.”

It is an understatement to say the steps were okay. This was not a natural event, like Hurricane Katrina, or an external attack, like 9/11. This was a case of “Honey, I think I broke the world financial system.” To repeat the disclaimer of professional expertise on this subject: Of the billions in institutional assets I managed in the 1990s, exactly zero were invested in collateralized debt obligations ( CDOs ), credit default swaps ( CDSs ), and mortgage-backed securities ( MBSs ). I knew what they were, and particularly enjoyed the stories in Michael Lewis’s book Liar’s Poker of how the inventors of mortgage-backed securities at Salomon Brothers would shut down the market occasionally for food orgies of Roman proportions.

Our market neutral portfolios would often be equitized, putting back the market return with a simple futures position. Sometimes clients would want so-called portable alpha using futures in a market other than the one used for the stock portfolio, so we could add our return to a bond market, or an international stock market, as described in Chapter 5 ( “A Gentle Introduction to Computerized Investing” ). That was as far as we went with derivatives. There was little or no leverage due to the institutional constraints we had for pension accounts, and our strong desire not to blow up our clients’ portfolios and our income stream by turning what would be a moderate drawdown into a disaster. Lehman Brothers’ leverage was widely reported to be more than 30:1 when they turned out the lights, and other firms were equally overextended, which, while not without precedent, proved particularly toxic when applied to what proved to be nearly incomprehensible securities.

Faulty Financial Engineering and Lousy Derivative Securities Risk Management

Robert Merton, who shared the Nobel Prize for economics in 1997, was also one of the founders of Long Term Capital Management, the firm at the center of a $ 5 billion crisis in 1998. At the time there was a sense of great peril, and the size of the rescue, which now seems quaint, seemed overwhelming. Merton wrote, As we all know, there have been financial “incidents” and even crises that cause some to raise questions about the innovations and scientific soundness of the financial theories used to engineer them. There have surely been individual cases of faulty engineering designs and faulty implementations of those designs in building bridges, airplanes, and silicon chips. Indeed, learning from (sometimes even tragic) mistakes is an integral part of the process of technical progress.(1)

This is not the place and I am not the person to fully explain the morass we have fallen into. I did ask the people I knew, at Berkeley and on Wall Street, to give me a crash course so I could understand how technology contributed to the crisis, how it could help get us out of it, and how to avoid a repetition. I have real and virtual stacks of articles, papers, books, and links; it would take a book this size to cover them all. A particularly clear and incisive non-technical discussion can be found in Vanity Fair , by historian Niall Ferguson ( “Wall Street Lays Another Egg,” December 2008).

One resource stands out for an audience looking to get some traction on the global financial mess, and looking for pointers to current quality material from primary and media sources: the Baseline Scenario web site(2) started for exactly this purpose by MIT Sloan School of Management professor Simon Johnson, who returned to MIT in August 2008 after a year as director of research for the International Monetary Fund. Instead of picking up where he left off in his research and teaching, he devoted his energy to starting and maintaining the Baseline Scenario site. The place to start there is “The Financial Crisis for Beginners.” It begins:

We believe that everyone should be able to understand how the financial crisis came about, what it means for all of us, and what our options are for getting out of it. Unfortunately, the vast majority of all writing about the crisis — including this blog — assumes some familiarity with the world of mortgage-backed securities, collateralized debt obligations, credit default swaps, and so on. You’ve probably heard dozens of journalists use these terms without explaining what they mean. If you’re confused, this page is for you.(3)

At this site you’ll find links to radio programs, mostly National Public Radio ( NPR ), and video material that will bring you up to speed quickly. The main portion of the site, also used for an MIT course on the subject, is updated regularly with more in-depth material on the latest turns in the financial crisis. Having franchised out the discussion of the origins of the crisis, and the larger issues around it, we can turn to the subject of this chapter, the role of technology in this mess.

To Protect and to Serve: Market Transparency in Financial Theory and Free Markets

In financial theory, market transparency is a necessary condition for a free market to be efficient. In practice, at a micro scale it means that we can see the prices to buy and to sell securities (quotes) and the prices at which transactions actually occur (trades). A macro view of market transparency is that information about the securities being traded should be similarly reliable. Assuring that markets are transparent is a key role for regulators.

Public participation in the stock market grew dramatically in the early part of the twentieth century, and without regulation, abuses such as fraudulent information, extravagant fees, and extreme leverage became common. The last financial crisis of the magnitude we are seeing today made the need for regulation apparent. The Securities and Exchange Commission (SEC) explains its origins on its web site ( http://sec.gov ):

When the stock market crashed in October 1929, public confidence in the markets plummeted. Investors large and small, as well as the banks who had loaned to them, lost great sums of money in the ensuing Great Depression. There was a consensus that for the economy to recover, the public’s faith in the capital markets needed to be restored. Congress held hearings to identify the problems and search for solutions.

Based on the findings in these hearings, Congress — during the peak year of the Depression — passed the Securities Act of 1933. This law, together with the Securities Exchange Act of 1934, which created the SEC, was designed to restore investor confidence in our capital markets by providing investors and the markets with more reliable information and clear rules of honest dealing.

The mission to provide investors with reliable information is what makes all of the quant-textual approaches based on SEC filings (described in Chapter 9 and elsewhere in this book) both possible and valuable. It is why the micro-scale market data — trades and quotes — are visible on the bottom of every business television station and financial web site.(4) (See Figure 12.1 .)

Figure 12.1 All levels of detail are available for stock and option markets, down to individual trades and quotes. Market transparency to the max. Nothing remotely like this exists for CDOs, CDSs, and the rest. Source: NYSE.

Figure 12.1 All levels of detail are available for stock and option markets, down to individual trades and quotes. Market transparency to the max. Nothing remotely like this exists for CDOs, CDSs, and the rest. Source: NYSE.

Simple derivative securities like futures and put or call options transfer risk in readily understood ways. Futures markets started so farmers could protect themselves from a drop in crop prices that might keep them from covering their costs and being able to keep their farms for another harvest season. Consumers of agricultural commodities (e.g., wheat) could lock in prices that would let them fill their commitments to deliver products made with those commodities (e.g., bread) at the prices they had agreed to sell them, without risk of ruin. These commodity derivatives were also used by pure speculators with no underlying business interest in the price of wheat (or silver or oil) to make large bets on the direction of prices, since the futures markets could be many times larger than the actual physical supply of the underlying commodity. Speculative misbehavior was the inevitable result, and again, the federal government stepped in to regulate the market, this time by creating the Commodity Futures Trading Commission (CFTC), as explained on its web site at http://cftc.gov: …

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All notes for this chapter about Stupid Financial Technology Tricks and the Global Economic Collapse

1. Robert C. Merton and Zvi Bodie, “The Design of Financial Systems: Toward a Synthesis of Function and Structure,” Journal of Investment Management 3, no. 1 (First Quarter 2005): http://www.people.hbs.edu/rmerton/Designpaperfinal.pdf

2. http://baselinescenario.com

3. “Financial Crisis for Beginners,” Baseline Scenario, http://baselinescenario.com/financial-crisis-for-beginners/

4. OTC markets are not inherently a bad idea; they work for corporate debt and other securities. A lack of reporting for these toxic derivative securities created a dark market on an unprecedented scale.

5. Carol Loomis, “Robert Rubin on the Job He Never Wanted,” Fortune , November 28, 2007, http://money.cnn.com/2007/11/09/news/newsmakers/merrill_rubin.fortune/index.htm

6. Marking to market is the process of evaluating a security to reflect its current market value instead of its purchase price or book value. Marking to market is generally a good idea, but there are circumstances when it can serve to amplify the effect of what might otherwise be a short-lived mini-panic. A discussion is beyond the scope of this chapter.

7. Ben Bernanke, “Reducing Systemic Risk,” Jackson Hole, Wyoming, August 22, 2008, http://federalreserve.gov/newsevents/speech/bernanke20080822a.htm

8. “PWG Announces Initiatives to Strengthen OTC Derivatives Oversight and Infrastructure,” November 14, 2008, www.ustreas.gov/press/releases/hp1272.htm . 9. Rosenblatt Securities, “Trading Talk,” October 17, 2008, http://rblt.com/newsletter_details.aspx?id=38

10. Sharon Weinberger, Imaginary Weapons: A Journey Through the Pentagon’s Scientific Underworld (New York: Nation Books, 2006).

11. The 1940 newsreel of the collapse is not to be missed; see it here: www.youtube.com/watch?v=HxTZ446tbzE , or just search YouTube for “Tacoma Narrows Newsreel.”

12. See the “Top 10 Worst Engineering Disasters” at http://listverse.com/science/top-10-worst-engineering-disasters/

13. Chairman’s Letter, 2002 Berkshire Hathaway Annual Report, pp. 13 – 15, www.berkshirehathaway.com/2002ar/2002ar.pdf

14. Charles Duhigg, “Pressured to Take More Risk, Fannie Reached a Tipping Point,” New York Times , October 4, 2008. http://www.nytimes.com/2008/10/04/business/worldbusiness/04iht-05fannie.16689176.html?_r=1&scp=10&sq=duhigg%20fannie&st=cse

15. Alan Greenspan, October 24, 2008, hearing, House Committee on Oversight and Government Reform, http://oversight.house.gov/story.asp?id=2256

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