Wednesday, October 21, 2009

Blinded By Technology

Last night, the Frontline series on PBS featured a new program entitled The Warning. It was a revealing look at the long-percolating financial crisis and the role that one woman, Brooksley Born, played in trying to sound the alarm. This was not a story about the meltdown of 2007 - 2008. The program focused on the long-ago era of the Clinton Administration, which carried forward the previous Republican administration's posture on financial deregulation. In a nutshell (if there is such a thing when it comes to these complex events), a crisis was caused by the refusal of the Fed or the Treasury to consider regulating Over-the-Counter Derivative trading. Born, then the head of a minor federal agency called the Commodities Futures Trading Commission, tried to put forth regulations because she alone, it seems, saw that a meltdown in OTC Derivatives could cause a cataclysmic failure in the banking system. Her seniors in the administration, Alan Greenspan, Robert Rubin, and Larry Summers successfully crushed her efforts and neutered her agency. Within six weeks of the showdown in Washington between Born and Greenspan, Long Term Capital Management (LTCM) went into free fall on their derivatives business.

For those who don't know that much about economics, and I include myself in that group, LTCM was founded by the technology wunder kids of economics. They had developed highly sophisticated mathematical trading models that supposedly allowed them to make enormous bets with minimal risks. Some of their senior people were Nobel Prize winners in economics. For a while, it seemed to work and LTCM made terrific returns. Everyone wanted in on the action including over a dozen of the largest Wall Street investment banking houses. There was just one catch: the LTCM money machine was a Black Box and no one outside LTCM was allowed to see how they were making their money. It was a "Trust me or don't play" model. Worse yet, each of the banks was told that they had an exclusive deal with LTCM. When the walls came tumbling down because of a financial crisis in Russia in 1998, LTCM fortunes went south big time. Everyone wanted out and that is when the banks found out they had been snookered. In the end, the Fed and the Treasury called all the bankers together and told them they each had to pony up $300 million to buy-out LTCM and save the financial markets from imploding. The banks did what they were told and the crisis passed, but not without extreme anxiety both in Washington and on Wall Street.

The Frontline program focused on the need to regulate OTC derivatives - which remain unregulated to this day. There are now over $500 trillion in derivatives in the market. At the time of the LTCM fiasco, there were $17 trillion at risk. The stakes are obviously much higher today. Derivatives, of course, are only part of the problem that we are currently facing. Securitized mortgages and lax lending standards have caused an even bigger mess than we faced in 1998. But for me there is a technology story in all this and that is one of hubris. It is the folly to think that someone has figured out how to model the financial markets so perfectly that they can ignore unforeseen and unplanned events that can make the model so much worthless software code. No system as complex as world markets can be modeled today with that kind of accuracy. The arrogance of LTCM and the ignorance of the bankers who bought LTCM's Black Box is appalling. Yet, it shows the faith we are willing to place in "the best and the brightest" who seem to have all the answers...without any caveats.

Don't get me wrong. I am not saying we shouldn't try to build models to understand complexity, whether it is in financial markets or global climate models. My belief is that we should expose any model upon which very significant decisions are being made to outside review. As we now have the tools to tackle evermore complex problems, we need to remain aware that every model starts with assumptions. And you know the old saw about the word "assume" makes an Ass of You and Me.

If you missed the Frontline program, you can see it streamed on the web.

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