Thursday, October 16, 2008

Complexity a Common Culprit

From the Wall Street Journal:
Borders' Mr. D'Agostini said there are five titles that appear to most interest consumers. These include: Charles Morris's "The Trillion Dollar Meltdown," which Mr. D'Agostini says predicted market turmoil caused by subprime mortgages and Wall Street greed; David Smick's "The World is Curved," which cited the mortgage crisis as a early indicator of further problems ahead; George Soros's "The New Paradigm for Financial Markets," which looks at past crises and their significance for future events; Kevin Phillips's "Bad Money," which examines the state of the dollar, credit issues, and the world market, and Peter Schiff's "Crash Proof," which warned of a coming crisis and suggested how consumers could protect themselves.

In a crisis, everyone wants answers, now. So we have the following books and their explanation of America's ills:


Trillion Dollar Meltdown: Greenspan, deregulation, greed, over-the-counter derivatives, securitization, lack of public healthcare
World is Curved: globalization, financial complexity, reckless volatility
New Paradigm for Financial Markets: globalization, credit expansion, market fundamentalist beliefs, and deregulation
Bad Money: financial complexity, power in finance, market triumphalism, weak dollar, hubris
Crash Proof: weak dollar, inflation, US trade deficit


They all contain an obligatory mention of greed/hubris by those who got rich (funny from Soros), but also the focus on finance, as opposed to real causes (eg, productivity growth). There is a great distrust in the complexity in finance, in that the connection of a mortgage, to a derivative, is often not very transparent. But is anything these days? Computers, cars, my thermostat, all have evolved greater and greater complexity, so that 'fixing them' is now beyond the average user's ability. In the 'good old days', things were simpler, perforce, because they were just starting. Complexity happens to all fields, and it would be nice if everyone could fix their cars like the old '57 Chevy, or fix their computer by going in and adjusting the autoexec.bat file, but the greater functionality of these products requires greater complexity to their parts, and so only full-time professionals can fix things that your average proficient user could fix decades ago.

It is common to long for the old times when fields were completely understood, but forcing a field back to be transparent to the masses is not a solution, it is a stifling of productivity. Wouldn't it be great if we went back to a mathematics prior to non-Euclidean geometry, and calculus? Well, if your objective is to restrain all fields so that they be understood by your average man, I guess that would work. But when any field, industry, or product evolves it generally adds functionality, adding layers, and layers add complexity.

The problem in mortgages was not derivatives, or complexity. Lowering underwriting standards (no downpayment, lower credit score) is pretty straightforward, and affected bank-owned mortgages just as much as credit default swaps. That academics, community activists, Clinton, Bush, Congress, regulators, Wall Street, and investors, did not foresee the problems in lowering credit standards for new home buyers, was hardly caused by derivatives up the food chain. These mortgages were going to blow up eventually because a vast array of special interests under the banner of 'increasing home ownership' was going to put more and more people into houses until they proved they could not afford it, by which time the seeds were sown. Complexity of the derivatives that referred to these instruments were second order in this story.

9 comments:

Anonymous said...

???????
Things are complex yet there is one simple explanation for the sub-prime mess???? yea, that makes a lot of sense. It wasn't lower interest rates, it wasn't financial innovation it was the government. There is absolutely no convincing evidence of this. What percentage of the sub-prime loans were forced on by the CRA? Did they have lower standards than loans that were not forced, did they have higher default rates? Is this mess contained to sub-prime? Why was there a house bubble in Europe, did they force banks to give crappy loans as well? Is there any evidence or do people seek explanations that fit their ideology? I don't understand how a person can criticise other established people and yet do the same within the same paragraph. I guess consistency is not always a virtue.

Anonymous said...

hey, soros is my dawg. he justified his greed by being a 'participant' in the system if i recall correctly. i think now he lays the blame on greed unchecked by regulators, same view as CM, the tatane of them all, which is all i need to know.
everyone was acting rationally and not refusing free money, as far as i could tell.

Anonymous said...

People shouldn't borrow money they can't pay back. But still, 4% of home loans in foreclosure and 6-7% are late: Our financial system should be able to withstand that without collapsing. Something else was also VERY VERY wrong. Some of these things seem to be (a) undercapitalized banks, (b) opaque bond isntruments that are difficult to value, and (c) derivatives that were supposed to reduce risk, but had no capital behind them (making the bond prices even more suspect).

reTired said...

Maybe some of the crappy underwriting was politically motivated, but you really can't blame the reds under the bed for all the problems.
Here's an old story: back in the late 80s the Lloyd's insurance market had a prototype mess which we called the spiral. All the same stuff happened - risk was parcelled up and sold on and there was a saying at the time "he takes in a bucket of shit thinking it's a bucket of apples and passes it on as a bucket of oranges." At the front end underwriting standards went to hell because the underwriters thought they were not running any risk. And nobody further back in the mix had any clue how to price the business, for the simple reason that they didn't know what it was they were pricing. With risk being wrongly equated to premium (=revenue) people were taking on multiples of their stated risk appetite without realising it. The whole thing blew and nearly took our 300 year old institution down.
So when it all started happening in identical fashion in the banking sector we just had to laugh, until it got beyond a laughing matter.

Anonymous said...

Eric, this is a unique perspective, thank you.

Also you brought back fine memories of autoexec.bat, how quickly I'd forgotten it...

Anonymous said...

We don't have to understand the instruments. S&P and Moody's do, so they can rate them. And they couldn't.
Are complex financial instruments more like a car or a PC? I hope it's a car. I don't want to fix my car. But I want my mechanic to be able to, and they usually can.
New cars work reliably; new computers don't. I wish you could just adjust your autoexec.bat file to fix your computer: nobody can fix Windows problems. That's why they give you a bootable restore DVD, that scrubs your hard drives and your data. And every once and a while, for no reason at all, you've got to unplug your computer to reboot -- because the thing is so screwed up the on/off button won't even work.

Anonymous said...

We don't have to understand the instruments. S&P and Moody's do, so they can rate them. And they couldn't.
Are complex financial instruments more like a car or a PC? I hope it's a car. I don't want to fix my car. But I want my mechanic to be able to, and they usually can.
New cars work reliably; new computers don't. I wish you could just adjust your autoexec.bat file to fix your computer: nobody can fix Windows problems. That's why they give you a bootable restore DVD, that scrubs your hard drives and your data. And every once and a while, for no reason at all, you've got to unplug your computer to reboot -- because the thing is so screwed up the on/off button won't even work.

NU grad with CFA in MN said...

Erik, I think it was Prof. Mokyr at Northwestern that drove home the difference between the history of *physical* science and *social* science. Your car and computer analogies are flawed in that they are physical sciences, where experiments (and mistakes) can be repeated ad infinitum in a "sandbox" to create risk controls.

In a social science like economics or investing (and I hesitate to call it a science, maybe an art), we don't have the benefit of trying out multiple theories and actions multiple times with the same initial conditions. And we have a dynamic opponent altering his strategy. Heisenberg uncertainty and chaos theory aside, the physical sciences generally don't change their laws of nature in mid-experiment.

reTired said...

Anonymous sums up the negligence and dependency culture that permeated the system. Why would anybody bet their career on Moody's being able to understand an instrument? That's the trader's job, and if he or she abdicates that responsibility by relying on rating agencies then unemployment is a just reward.