A bad workman......

'Blaming' computers isn't very sensible, but the uncritical use of
computers may have contributed to the current banking
crisis...........


Dominic Lawson: I blame computers for this crisis

Electronic calculation is not the same as wisdom. Confusing them is
dangerous

Tuesday, 20 January 2009

So we taxpayers are called upon to provide another £100bn or so (no
one quite knows, least of all us) – and the cry goes up once again:
who is to blame for the banking crisis?

The most obvious answer is: the bankers themselves. On the day that
the Government injects yet more cash into Royal Bank of Scotland's
smouldering hulk of a balance ***, perhaps there is some weird
patriotic pride to be had in the fact that Newsweek has ignored all
the notable American candidates to name Sir Fred Goodwin, chief
executive of RBS from 2000 to October 2008 as "The World's Worst
Banker".

There are many other candidates for blame, however. The economists'
own favourite villain is the former Federal Reserve Chairman, Alan
Greenspan. Actually it's "Sir" Alan Greenspan: Gordon Brown made sure
that he got a KBE too, before it dawned that the owlish American was
not, after all, the world's wisest life-form.

Then there is the nexus between the property business and politicians
– the former having speculated colossally on the latter's belief that
there were votes to be had in keeping that market inflating into
infinity. These are also good people to kick as you contemplate your
ever-diminishing pension.

Yet with all these human targets, there is one often overlooked
candidate for blame which is not constructed of carbon (and which will
not feel any pain when you kick it). This is the silicon microchip.
The astonishing growth in the calculating power of computers is a
wonderful thing, enabling us to do things we would never have dreamed
of even a decade ago. Electronic calculation, however, is not the same
thing as wisdom; and there are great dangers in confusing the one with
the other.

Two early books on the financial crisis have made this point well. The
first, an American's account, is the Trillion Dollar Meltdown by
Charles Morris; the second, written by a British investment analyst
called George Cooper, is The Origin of Financial Crises.

Morris points out that we had already had notice of the havoc that
could be wrought by computerised trading programs; first, on 19
October 1987, when Wall Street fell by 23 per cent in one day, as
earlier movements in share prices triggered massive selling by
computers, quite independently of any decisions by humans. It caused
all-too-human panic across the globe.

The second warning sign was the collapse of the hedge fund Long Term
Capital Management in 1998. LTCM's partners included two Nobel prize-
winners, Myron Scholes and Robert Merton, celebrated for their
mathematical models for the pricing of financial derivatives. LTCM
scoured the market looking for price relationships deemed anomalous by
the Nobel Prize winners' algorithms. These quantitative anomalies were
tiny, observable in real-time only by computers, so LCTM needed to
back its bets with vast sums (which, of course, were borrowed). Yet
their models had not factored in the possibility that the Russian
government of Boris Yeltsin would default on sovereign debt. They were
left with billions in unsaleable futures contracts, and were dead in
the water.

Perhaps, if LTCM had been allowed to go under, this would have caused
later so-called "quant" investors and "algo-traders" to exercise more
caution; but the Fed instantly decided that the financial markets
would have become too destabilised, and twisted the arms of the
investment banks to take over LTCM's positions. This prepared the way
for a much bigger destabilising financial crunch a decade later – only
this time there were no investment banks left to lean on, leaving only
the taxpayer to do the mucking out.

George Cooper's account of the crisis makes a further point about the
problems caused by basing investment decisions on computer programmes;
the computer will always come up with a price which even a very
damaged derivative should rationally fetch, based on the possibility
of some remaining value in a debt gone sour. Yet because humans react
emotionally and in a herd-like fashion, they will refuse to assign any
value to such "toxic" paper: hence a bank might think there would be a
reasonable limit to the downside of risky investments, while, in the
real world, when fear takes over from greed, there is no such limit.

There is also the simple fact that computers enabled the bankers to
contemplate, with just a mere push of a button, trillions of dollars
worth of derivative contracts. Figures which might cause a nervous
collapse, when analysed within the human brain, seem soothingly
manageable when generated by the click of a mouse: and, of course,
there is the usual tendency to think that because it is generated by a
computer, it is in some sense "right"– even if the assumptions on
which the computer based its calculations were originally fed in by a
human who had never spoken to, still less met, the end user of the
financial instrument.

This was especially true of the market in so-called "Collaterised
Mortgage Obligations" (CMOs). As the former banker Charles Morris
notes: "In 1983, modelling the payout scenarios on a comparatively
simple three-tranche CMO took a mainframe computer a whole weekend.
But by the 1990s, when Sun workstations were standard furniture, CMO
shops gleefully turned out phantasmagorical 125-tranche instruments
that no one could possibly understand." Least of all, one might add,
the pre-computer age senior non-executive directors of the banks, who
were the official guardians of shareholders' interests; but which of
them were clever enough to say "I don't understand"?

Actually, one old boy was that clever. Six years ago, Warren Buffett,
the world's richest private investor, warned that the computer-
generated derivatives markets, already "worth" over $85tn (£60tn),
harboured "financial weapons of mass destruction".

Buffett's analogy was peculiarly apt. For the mathematical geniuses
working on these computer programmes were called "rocket scientists"
by their employers. During the Cold War years of the nuclear arms and
space races, such "geeks" would more likely have been working at Nasa
or the Pentagon, than on the floors of investment banks.

Perhaps it would have been better for all concerned if they had
remained happily involved in designing bigger and better weapons
systems. That way, no one would have got hurt.

d.lawson@xxxxxxxxxxxxxxxxx

http://www.independent.co.uk/opinion/commentators/dominic-lawson/dominic-lawson-i-blame-computers-for-this-crisis-1451417.html











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