I have just finished reading Gillian Tett’s book on the financial meltdown: Fool’s Gold: how unrestrained greed corrupted a dream, shattered global markets and unleashed a catastrophe. Tett is a deputy editor on the London-based Financial Times and has written a perspective on the crisis largely from the point of view of a group of bankers in J.P.Morgan whom she claims invented and promoted some of the financial instruments that eventually led to such an earthquake for all of us.
What is there to find in this account from the perspective of someone who takes an interest in complex social processes, power and paradox?
Firstly, Tett trained as a social anthropologist gaining her PhD from Cambridge. Perhaps because of this background one of the things that interested her about her subject of study, the credit market, were the beliefs and values of those who were operating in the sector and what they took for granted. She was also interested in the silences and lack of attention paid by others to what was a burgeoning shadow market in complex derivatives. Neither journalists, regulators, nor even other bank colleagues working in other departments took an interest in what traders were doing and seemed to be happy as long as they were creating ‘wealth’.
Indeed, the wealth-creation caused a problem in itself as more and more institutions wanted to climb onto the band-wagon, even those who had no history of risky trading. What would otherwise have been thought of as quite stodgy, pedestrian banks hired teams of traders to make money for the bank in the way that others seemed to be doing. Making money from complex derivatives became and unstoppable social force: it was almost impossible not to be swept up in it.
Those who developed complex financial instruments convinced themselves that they were being innovative and were helping to drive out inefficiencies in the market. They were helping to disperse risk and make money at the same time. And of course, innovation is usually considered to be a good thing, something all companies should be striving for. Unfortunately, the complex methods were taken up by traders who applied the techniques beyond the field of corporate loans where they originated, to the much more risky area of mortgages. Since there are always unintended consequences with any innovation, complex derivative trading was taken further and further away from what it was originally used for and taken up in ways that made the outcome of using it unpredictable.
In this sense Tett’s book is a tale of people blinded by their ideology, that innovation is a good thing in markets, that the market is self-correcting and that interference by the regulatory authorities is always a hindrance to trade. Some of the innovations involved finding ways to circumnavigate the regulations creating shadow banking that was actually bigger in value than visible banking. These were ways of bending the Basel Accords which oblige banks to keep a certain ratio of equity to debt. By moving the trade off the banks’ books the requirement to post capital against debt was avoided.
Another interesting factor from a complexity perspective is the way in which the quantitative models used to calculate risk were based on standard linear statistical techniques which model bell curves. Risk is thought to be evenly distributed around the mean, and the tails of data at both ends are thought to be relatively insignificant. This was faulty thinking on two fronts. Firstly financial instruments were being developed so fast that the data fed into the models were extremely poor since the instruments had no antecedents, making the predictive power of the models weak. There was very little history to analyse so basing a model of extrapolating from the past to predict the future proved a poor way of working. Additionally, the unthinkable did happen: there were uncommon combinations of common events which made what would have appeared to have been insignificant trends using abstract linear analysis run away trends in real life. For example, the models worked on the basis of the level of probability of individual house owners defaulting on their loans. However, when significant numbers of householders began to default in a neighbourhood this brought the value of everybody’s property down, which in turn increased the probability of defaulting. The amplification of a small difference soon became a tidal wave.
In the end the trading turned not on quantitative models but on more intangible human relationships based on trust and confidence. When confidence of the participants in the market eroded all the trading ceased.
Tett’s book is a gripping read, and there is a lot to chew on for anyone interested to understand better the mess we find ourselves in. There is a lot, too, for those interested in the complex interplay of intentions between people in organisations where groups become so convinced that they are acting for the good, and press on with what they are doing powerfully and so creating a social trend that proves unstoppable. To justify what they are doing they point to their robust statistical methods and claim that they have conquered risk. Because of the money to be made, there is a feeding frenzy. As a result, both the predictable and the unpredictable happens, both innovation and wealth creation as well as greed, envy and a race to the bottom.
Interestingly Tett’s prescription for the way out of all of this is for greater ‘holism’: there is nothing wrong with complex financial derivatives per se, she says, merely the use to which they are put. If only bankers could think of the bigger social picture they might behave differently. In the end, then, we are back to a kind of systems theory where if only the bankers could get the ‘whole system in the room’ they would make different decisions. I wonder, in the light of the way that many investment bankers still expected to take very large bonuses this Christmas despite the hardships facing everyone else which they had significantly contributed to, whether this would ever be possible. It seems unlikely that bankers, like anyone else, will be able to decide to leave their bad selves at the door.