"The computer made me do it."‏

[pdmunro]

I'm trying to put the parts of the credit crisis together for myself, so I wrote the following piece.

 

The computer made me do it

Anatomy of the credit crisis

 

Question: What’s the cause of the financial crisis?

Answer: Actually, you’re looking at it - your computer.

 

Having had to create a couple of computer models of complex biochemical systems, I love reading about the shenanigans of the backroom computer boys. As the financial crisis lengthens, stories of its beginnings are starting to emerge.

 

The sources below, strongly suggest that the genesis of the credit crisis lies with boys and their principle toy, “the computer” – that wonder toy that can take in a few data inputs and bounce back a simple number that says “yes/no” to a loan query. Complicit in the process, have been mathematicians, programmers and their bosses. Mathematicians for designing kooky, unstable models. Computer programmers for writing easy-to-use graphical interfaces that hide all the messy mathematics. Bosses who are delighted to have a loan decision reduced to the click of a button.

 

The beginning of the chain of misuse is the mathematical formula that says there is a simple way of deciding, if a person will default on their loan. No need for a time-consuming comparison with others in similar financial circumstances. Far simpler is to see what odds the “betting agencies” have on such a person defaulting.

 

The “betting agencies” are investment banks issuing credit default swaps (CDS). CDS’s are insurance policies taken out against loan defaults. Apparently, it mattered little that the CDS rates were plucked out of thin air, and operated on the “bigger fool” methodolgy, with each (re-)insurer committed to finding an even “bigger fool”.

 

Well, perhaps, they weren’t so much foolish as greedy: re-insuring a CDS allowed a financier to say that “The next 5 years of profits are ‘locked-in’, so I want the next 5 years of bonuses now!”, while quietly thinking to themselves, “before it all goes ‘belly-up’”.

 

Back to the mathematical models. Having “reliable” equations and parameters, computer programmers could write algorithms (computer code) that linked it all together. They designed simple graphical interfaces for the financiers to input a few pertinent (fictitious?) details from the client, while simultaneously accessing the latest CDS (fairy-land?) rates, in order to generate an “accurate” decision-number at the click of a button.

 

Hold on. The boss really wants to grow the business. So he doesn’t want just a simple yes/no answer. He wants a yes - “but at this rate of interest” - answer. Let’s up the complexity and use all the (fictitious) info to calculate that for him, so that no client “is left behind”. There will be no failures in this somewhat-brave new world.

 

The scent of all this easy money attracted the financial sharks. Adding the detailed story of the “slicing and dicing” of subprime assets to this story is fit only for an adults-only forum. Rest assured though that “slicing and dicing” is a truly wonderful snake-oil product, guaranteed to turn the most illiquid of property markets into a greasy slope.

 

Finally, to make the rivers of money really flow, another computer jock is needed.

 

Cue the quant boys who make overnight settlements of trades. Without them, the system is “constipated”. These are the guys with no fear: every night in the “repo” market, they roll over billions of one-day loans at the touch of a button.

 

At last, everyone was happy: they all had either their loans or their bonuses.

 

But when interest rates rose from the initial "teaser" rates, defaults increased and the first crazy circle of CDS’s became due. Then questions were asked. Who owes me money and can he pay it? To whom do I owe money and can I afford it? Fear set in. Buttons weren’t pushed. The result: financial paralysis, no-one would lend to no-one.

 

Questions of “Who is to blame?” arise following the use of weapons of mass destruction. Is it the one who designed the weapon's components? Or the one who put it all together? Or the one who ordered it used and who clearly benefits the most?

 

Or is it the system? And crucially: Can the system be fixed?

 

While the financial markets have started to jerkily move again of late, I remain nervous.

 

Computers are here to stay and will continue to be used as instruments to both enlighten and bedevil us. It is just so easy to conceal illusions and falsehoods in the computer’s inner workings. Who has the time, energy, or capability to unravel the deceit?

 

I am sure that, even as I write this, someone is coding the seeds of yet another financial disaster.

 

Sources

 

1. Michael Osinski “My Manhattan Project: How I helped build the bomb that blew up Wall Street” http://nymag.com/news/business/55687/

Comment: very readable

 

2. Felix Salmon “The formula that killed Wall Street”

http://www.wired.com/techbiz/it/magazine/1...currentPage=all

Comment: scary

 

3. Thomas Tan, “Why Wall St. Needed Credit Default Swaps”

http://seekingalpha.com/article/73060-why-...t-default-swaps

Comment: CDS = bonus-fueled greed

 

4. Excerpt from William D. Cohan’s book 'House Of Cards'

http://www.npr.org/templates/story/story.p...oryId=101681538

Comment: The overnight “repo” market

[kenberg]

I thank you greatly for these references, i will read them. Browsing in number2, speaking of Li's approach, we find:

 

"His method was adopted by everybody from bond investors and Wall Street banks to ratings agencies and regulators. And it became so deeply entrenched—and was making people so much money—that warnings about its limitations were largely ignored."

 

This needs to be burned into everyone's mind. Mathematical theories are, at their most basic, of the form If A is true then B will follow. Forgetting about the fact that when A is not true then B may not follow is a really bad idea. In something as complicated as finance, I imagine A is apt to be quite a long list of conditions.

 

Many many years ago I had a summer job getting computers to calculate things. I had some success so they put me on a more sophisticated job exploring some military model. I regarded the model as hopelessly unrealistic. Not our problem was basically the answer.

 

GIGO (garbage in, garbage out) continues to rule. We all know this, but when everyoone is making a lot of moeny, it is easy to forget it.