Sunday, September 28, 2008

Computers Caused Wall Street's Collapse

Blame computers for the collapse of Wall Street. Yes computers! Well, more precisely, software programs in the hands of brilliant, young MBA’s, who, totally divorced from reality, and lacking experience and commonsense, have subjected the world’s economy to a tsunami of Black Thursday dimensions.

As with any great disaster, multiple causes exist, but only the computer programs made this disaster possible.

Let me explain. Jim Walsh, District Counsel of the Seattle District of the Army Corps of Engineers, hired me in 1976 as a 100 day wonder to research an Indian Law issue involving the claims of the Colvilles and Spokanes to Grand Coulee and Chief Joseph Dams. No one, especially President Roosevelt, asked them if they minded that the dams would be built on their reservations, flood out their lands, and destroy their fishery resources, but that’s a different story.

The project involved working with the Corps engineers who designed, built, and maintained dams. They educated me on infrastructure issues and the design process.

Once upon a time, not many decades ago, engineers did their computations with a slide rule. Whether it be an airplane, bridge, dam, ship, power plant, or skyscraper, the wizened engineers knew the stress points and factored in a margin of error. Even with its algorithms, the slide rule did not provide absolute certainty. The result was that engineers over engineered; they knowingly and intentionally over designed to ensure structural stability.

Technology changed and the seasoned engineers retired. The newly minted engineers are fresh out of engineering school, educated with the latest technology, and highly proficient in computer programs. Many are clueless as to what a slide rule is.

They rely upon the precise answers spit out by the computer, which provides an illusion of safety. The keystroke replaced the personal touch.

These engineers did not program the software, much less understand its assumptions or limitations. Thus, they design up to the razor thin margins of error provided by the computer.

Over engineering is often replaced, albeit unknowingly, with under engineering.

The same pattern exists on Wall Street. From our nation’s most prestigious universities and business schools come a horde of highly educated, brilliant manipulators of data, in reality undereducated numbers crunchers. Like all the youth of the world, they march fearlessly into battle ignorant of risk, just like the Charge of the Light Brigade.

John Kenneth Galbraith’s classic The Great Crash of 1929 should be required reading for everyone working on Wall Street. A dash of history is a better educator than computer programs. As Santayana said, “those who don’t learn from history are doomed to repeat it.” A little knowledge of Ayn Rand is also in order: “Check your premises!”

The programs consistently underestimate risk – especially human risk. Programmers are optimists. These programs are not based on reality, especially the foibles of humans. Fraud and bubbles are historical constants. Zero percent down, adjustable rate, interest only mortgages with balloon payments, were not factored into the high returns, minimal risks displayed on the computer screens of the wunderkinds.

They did not understand that mortgage brokers were paid for generating mortgages and that banks were also not concerned with the risks of these mortgages because they were going to sell them to others. Traditional lending standards went out the window. Both the brokers and bankers passed on the risks to the all-too trusting wiz kids.

Two decades ago a brilliant professor at Berkeley devised a “risk minimization investment scheme” called “portfolio insurance.” It looked great on paper, but failed on Black Monday in 1987 when put to the test. Similarly, “stop losses” to minimize risks don’t work in a major decline.

Not just sub-prime, or alt A mortgages were at risk, but so too were regular mortgages, underwritten in the housing bubble of the New Millennium. The underlying premise behind all these complex financial instruments was ever rising housing prices – truly an example of the greater fool theory of investing. The original mortgages were sliced and diced into complex slivers called derivatives. They were just as seductive as portfolio insurance two decades earlier.

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