Computer Models and the Global Economic Crash

Anti-Globalism passes along a review in Ars of some recent speculation on the role of interconnected computer models in the global economic crash. "If Ritholtz, Taleb, Mandelbrot, and the rest of the computer modeling and financial engineering naysayers are correct about the big picture, then we really are arguably in the midst a bona fide computer crash. Not an individual computer crash, of course, but a computer crash in the sense of Sun Microsystems' erstwhile marketing slogan, 'the network is the computer.' That is, we have all of these machines in different sectors of the economy, and we've networked all of them together either directly (via an actual network) or indirectly (by using the collective 'output' of machines in one sector as input for the machines in another sector), and like any other computer system the whole thing hums along nicely... up until the point when it doesn't."

Comments

Can somebody 'splain this?

[seanadams.com]

I am not an economist but I have owned a couple businesses and consider myself a reasonably practical person.

I have always believed that the vast majority of today's financial instruments have been invented out of thin air for no reason other than to ultimately ensure the employment of bankers and brokers.

For example, lots of people have a checking account, savings account, credit card, poersonal line of credit, HELOC, brokerage account, and more. I see absolutely no reason why a single account could not offer all those features. The only reason you "need" all that is because the banks created all these funny rules so that they could introduce more and more products and services. This is done so they can charge you more for each of those things, and also to differentiate them from their competitors.

Besides consumer banking, can somebody explain to me why we NEED "commercial paper"? Yes, I've read the wikipedia page and I know how it's used, but I don't understand why it's needed. If you can't make payroll then you're pulling from your credit one way or another - why do we need separate instruments for a 2 week loan versus a longer term loan, or a credit card, or whatever?

And don't even get me started on real estate lending...

It's like freaking starbucks - you can get your banking services just as special as an upside-down triple no foam half calf non fat 160 degree two splenda mocha. But it's one thing for a coffee company to cater to every individual snowflake's desire, and quite another IMHO for something as important as our financial system to become as absurdly complex and fragile as it is.

As for the people who are really benefitting from all this complexity - well, it's only during recession that we all collectively take a good hard look at who's making a contribution to society and who isn't. Unfortunately the powers that be think they can beat a recession by tweaking some rates, stealing from taxpayers, or shuffling money from one hand to the other. That's just going to hurt us more in the long term. We need to clean this shit up now - get rid of unnecessary products and overhead, and let the unproductive companies go bankrupt. Let the UAW strangle themselves to death. Just get it done.

Re:Can somebody 'splain this?

[cbiltcliffe]

It's easily explained by the Golden Rule:

He who has the gold makes the rules.

There. Explained.

Re:Can somebody 'splain this?

[flajann]

Not that we "need" it, but that the overall system dynamics evolved it that way.

Re:Can somebody 'splain this?

[Anonymous Coward]

It all goes back to the "invisible fist" of the free market...

Re:Can somebody 'splain this?

[Z34107]

I am also not a financial expert, but I can see a bunch of reasons why financial paper exists.

Maybe they're like payday loans for corporations. You have a long-term contract due, but not 'till the end of the month, and you want to keep your employees in the meantime. (I'm guessing this isn't as likely; only corporations with outstanding credit ratings can actually have any success in issuing corporate paper.)

Maybe it's a way of getting a loan without going through a bank or issuing stock. Say you want to build a new factory with payroll rather than actually pay your employees; maybe you're assuming the factory will pay off the interest on the corporate paper and then some.

The biggest thing at the end of the Wikipedia article you read is that, whatever the reason the money is needed, it's cheaper than getting it from a bank. If a corporation is big enough and has good enough credit, they can issue corporate paper, at a lower interest rate, instead of paying interest to a bank.

So, that one, at least, wasn't invented by bankers just to secure their own employment. Maybe somebody who actually knows something about this (a banker, maybe?) could enlighten me.

Re:Can somebody 'splain this?

[2nd Post!]

I am not an economist but I have owned a couple businesses and consider myself a reasonably practical person.

I have always believed that the vast majority of today's financial instruments have been invented out of thin air for no reason other than to ultimately ensure the employment of bankers and brokers.

Actually, probably not. I suspect (I'm a programmer by nature, so my experience with code may apply here) it's more of each institution and "network" offering redundant services until multiple institutions mature to the point where these services collide and become confusing.

For example, lots of people have a checking account, savings account, credit card, personal line of credit, HELOC, brokerage account, and more.

That wasn't true one generation ago. My parents had only a checking acount, savings account, and credit card.

I see absolutely no reason why a single account could not offer all those features.

With the advent of computers and networks, now it is possible. But 20 years ago? Not possible.

How would a bank know how much equity you had in your house? How would your credit card company know how much you had in the bank? How would your mortgage company know what your investment amount was?

Today, you actually have one company that handles all of it (and in cases where they don't, they can still trade information). So now I can have a HELOC, personal line of credit, credit card, savings account, etc, all tied together, in that credit from one reduces the amount of credit available on another, and all paid from the same account.

The only reason you "need" all that is because the banks created all these funny rules so that they could introduce more and more products and services.

In this case I actually disagree. Different people have different had different "collateral", so different kinds of credit were available to them. That explains why different products exist. Someone with a house vs someone with a strong credit rating vs someone who had lots of money all had access to different products. Now a single person has access to all of them.

This is done so they can charge you more for each of those things, and also to differentiate them from their competitors.

Besides consumer banking, can somebody explain to me why we NEED "commercial paper"? Yes, I've read the wikipedia page and I know how it's used, but I don't understand why it's needed. If you can't make payroll then you're pulling from your credit one way or another - why do we need separate instruments for a 2 week loan versus a longer term loan, or a credit card, or whatever?

As before, commercial paper was "invented" before credit cards (or business lines of credit or whatever) existed. It satisfied a market need that probably doesn't exist today.

And don't even get me started on real estate lending...

It's like freaking starbucks - you can get your banking services just as special as an upside-down triple no foam half calf non fat 160 degree two splenda mocha. But it's one thing for a coffee company to cater to every individual snowflake's desire, and quite another IMHO for something as important as our financial system to become as absurdly complex and fragile as it is.

It's this statement that brought me to this answer. Software is flexible (soft), so it can be molded quite easily to different needs according to different usages. The problem is that after four versions needs have evolved, but the original code has not, so now you have something complex and fragile that was originally quite simple and straightforward.

As for the people who are really benefitting from all this complexity - well, it's only during recession that we all collectively take a good hard look at who's making a contribution to society and who isn't.

So like software, it's only

Re:Can somebody 'splain this?

[NotQuiteReal]

...banks created all these funny rules...

I think you meant to say "banks created all kinds of workarounds to funny rules that politicians created"

Re:Can somebody 'splain this?

[uncreativeslashnick]

Most of it is the way it is because it evolved that way, and because of the laws/rules under which it all evolved. You paint with too broad a brush when you say that the vast majority of today's financial instruments have been created out of thin air. That's nonsense spoken out of ignorance, the same way a non-geek might say, "why can't software designers create programs without bugs?"

Commercial paper is a very broad term and encompasses everything from promissory notes to normal consumer checks. Just about any transaction not involving cash or electronic transfer is done with commercial paper. A huge portion of financial transactions are still done with commercial paper. So in the general sense of the term, it is still very, very necessary.

Now if you want to start examining specific financial instruments, like the derivatives backed by (partially) crap mortgages, we can have a conversation. I think the idea behind those instruments was basically sound, but the things ended up being a lot more complicated than people thought. It makes sense that if you lump a bunch of mortgages together, only a small percentage of those will default, thereby distributing your risk. But in a climate where fraud was rampant and the people signing people up for mortgages had no incentive to make sure people could actually pay those mortgages back, your lump of mortgages has a much higher chance of containing too many bad mortgages to make the resulting instrument profitable.

The derivatives market had the perverse effect of creating and encouraging that climate, because the mortgage buyers would buy without enough questions because they knew there were buyers who would buy the derivatives without too many questions. The fundamental problem with the whole concept, it seems to me, is that the derivative buyers and sellers forgot to insist on and question the credentials of the individual mortgagees they were investing in. Had they done a little bit of verification there, we might not be in this place right now.

Re:Can somebody 'splain this?

[Lumpy]

Ohhh I have an idea.

Instead of doing Shady and immoral accounting practices why not do what honest small business do.

YOU HAVE THE CASH ON HAND TO PAY YOUR BILLS.

Accounting has turned into VooDoo and it's what causes these messes.

I dont run out and buy a shitload of gear on credit for my video and photography business. I do what sane people do.. when I can afford it I buy it. when the hard times hit, I ride it out easily while my competition scrambles to try and pay off the 60 some loans and their credit lines.

What if I need a new piece of gear for a job?? That's what the 50% down for the job is for. I need $8500 in gear for a corperate shoot? I get the $9500.00 downpayment at contract signing and buy the gear, do the shoot, collect the rest at delivery, and call it done. really simple.

Re:Can somebody 'splain this?

[AdamInParadise]

My parents had only a checking acount, savings account, and credit card.

In many developed countries (Europe, Japan, ...), many people have a single account which supports both checks and debit cards. Mine is also used as a brokerage account, but I'm probably not a typical client.

Re:Can somebody 'splain this?

[DNS-and-BIND]

Cash in the bank is money sitting idle. You want your money out there, earning for you. If you choose an overly conservative strategy where you don't borrow money, then your business isn't running efficiently. I assume you're an owner...in a corporation, you would be subject to lawsuits and removal if you are not getting the shareholders the maximum benefits available. Remember, a CEO's goal (lawful duty, actually) isn't to make a profit, it's to maximize profit.

Re:Can somebody 'splain this?

[HisMother]

This bullshit is exactly what's wrong with our entire capitalist system.

Re:Can somebody 'splain this?

[Anonymous Coward]

We don't need it. But the system made people borrow more than they could.

First it was "minorities" (or rather ACORN's definition of a minority "someone who votes for us") that got suspended rules on borrowing, thanks to the CRA, introduced by one disaster president without teeth, Carter, also known for being the cause of the human rights situation in Iran, and activated by the next disaster president, Clinton.

But the damage that this inevitably caused was seen by many opportunists that were just about everyone. So just about everyone, not just Americans, but Europeans, Arabs, Japanese, Chinese, ... the whole nine yards, was given relaxed loaning standards. Since that money ended up in banks, it could be paid to their investors as intrest.

So why did this system work ? Well mostly the money paid for houses was put in bank deposits. So let's depict the money flow :

bank -> lender -> seller -> bank

This is however not how it looks in the administration. Let's check how the accountants enter this scheme :

bank -> lender
bank : + $loan_amount in future income
              - $loan_amount in money
lender : + $loan_amount in money

lender -> seller
lender : - $loan_amount in money
seller : + $loan_amount in money

seller -> bank
seller : - $loan_amount in money, + (100+x)% * $loan_amount in future income
bank : + $loan_amount in money

So now let's look at the total balance of the banks, in the short term :

+ $loan_amount in future income (slightly more)
- $loan_amount in future liability (slightly less)

Ultimately, however, this is a ponzi scheme, but for society as a whole. Everyone who connects is vulnerable in exactly the same way. Even black gold will provide no release, nor will a "knowledge economy".

As long as the pie constantly grows there is no real problem, as the banks control all money (through association with "government banks", or by simply being those banks). They literally print money, which represents value.

But the system needs an ever increasing input of value, or it falls down. As any ponzi scheme does.

Right now the input of 1 subsystem fell *slightly*. Very, very slightly. Eventually the value input will stop altogether (esp. if "peak oil" theories are right, but if they're wrong that will simply provide a delay).

The system is, as they say, doomed.

*AND* we should destroy anyone who was involved in shortselling any commodity related to loans, they should be prosecuted for making (and winning) the bet that tens of thousands of people would lose their livelihoods, their houses. These people's gains should be impounded, their bets imposed for the total disasters that they were. And all other short-selling should be suspended as too risky to the economy.

Or at the very, very least, banks should be prohibited from loaning money to allow shortselling, and they should be forbidden from using money invested in shortselling practices as collateral for loans.

But we won't do that. If we did, the financial sector would shrink to 10% of it's former size, which would put much less money in Obama's hands to work with. Much, much less. And it will mean telling hundreds of thousands the truth, that they cannot be trusted with enough money to buy a house. Many of them will be "traditional americans", but obviously both the poor and "minorities" will be overrepresented, and won't be able to buy a house. (who are the original spark that started the fire, I do not want to claim it's "their fault", but they are part of the problem)

Re:Can somebody 'splain this?

[SerpentMage]

Oh come on...

Here is a question do you have a mortgage or did you pay for your house UPFRONT?

What about a car? Pay for all of it upfront?

I am not saying over leverage yourself, but to say companies and businesses don't need credit is completely fool hardy.

Credit is needed in a system where you are able to make purchases in certain items. The problem is when people over leverage themselves.

Re:Can somebody 'splain this?

[thpr]

I have always believed that the vast majority of today's financial instruments have been invented out of thin air for no reason other than to ultimately ensure the employment of bankers and brokers.

Actually, many of them have a good basis in logic, but are used beyond their original purpose.

For example.... I see absolutely no reason why a single account could not offer all those features.

Part of the reason there are individual companies that separated items like brokerages and commercial banking is historical structure created in the Great Depression, known as the Glass Steagall Act

Other responders to your post have pointed out various specific details, e.g. reason for commercial paper, but let me cover a more general point of view on why so many different products exist: Risk.

The issue, however, is that risk doesn't come in only one form. There are different types of risk:
- Default Risk (if a company goes bankrupt, you don't get back your principal)
- Inflation
- Interest rate risk (if interest rates change, then the value of underlying loans change)
- Tax Rate Risk (different tax rates due to different income or time)
- Counterparty Risk (risk of entering into a contract, but the other party failing to fulfill the contract)
- Secured nature of the debt (recovery in case of default)
- Opportunity cost (cost of not doing an alternative with the money)
- etc.

Looking at various products we can see how they are different. An IRA vs. a Roth IRA actually transfers the Tax Rate Risk onto the government (you pay a known tax rate, and the unknown benefit or penalty due to the future difference is absorbed by the government)

A TIPS (Treasury Inflation Protected Security) vs. a normal Bond issued by the government transfers inflation risk onto the government (presumably the normal bond is accounting for perceived inflation in the offering price, but the TIPS accounts for real inflation, thus allowing one to eliminate the risk of the perception of future inflation being incorrect.

We can see today that today's 4 week Treasury Bill Auction resulted in zero yield (give money to the government for 4 weeks, no interest). This presumably would mean the return one could get in a non-FDIC insured bank account (over the current $250K limit) is entirely bankruptcy risk premium.

Also there are organizations that do market clearing of bonds and stocks that absorb counterparty risk. Part of the problem with credit default swaps was that the holders of those products actually bear the counterparty risk, as they are not regulated like other products. (When combined with a lack of market data on quantity and concentration of the risks around default of bonds, this led to one of the underlying issues in the problems we have right now)

Lastly, there are also "positive" values that are priced into different financial products, such as recovery in case of default. That's why secured loans of [statistically] appreciating assets (e.g. home mortgage) are lower rates than loans on depreciating assets (e.g. automobile) and those are lower than unsecured personal loans. Same reason bonds will maintain value longer than preferred stock.

As a specific example of what is good (and bad), look for a moment at interest rate swaps. They actually serve a valuable purpose, in allowing an investor (or the loaning company) to convert a variable-rate instrument into a fixed-rate one (or vice versa). This is valuable to companies to be able to "lock-in" lower interest rates when rates fall, for example. What is risky is when someone speculates on interest rate swaps without having an underlying asset. This results in significant leverage that can be wiped out very quickly if interest rates (i

Re:Can somebody 'splain this?

[S77IM]

Our economy is a giant pyramid scheme. Wealth is created through lending by investing in business ventures. It's good for the borrower, who gets the capital to grow their business; it's good for the lender, who gets interest on their loan; it's good for the banks, who take a cut; and it's good for everyone, because savings that would otherwise be sitting in a vault gathering dust is instead flowing through the economy being exchanged for goods and services, etc.

But eventually, when things are going well, we run out of things to invest in. Times are good so people have a lot of cash and they would like to loan it to someone, but all the sensible ventures are already funded. So banks and other financial institutions invent riskier and riskier lending schemes, so that they can get a return on their capital. Eventually the banks, brokers, etc. start making bum loans and the money goes down the tubes. There's a chain reaction as investors pull their money (a run on banks, a selling of stocks, etc.).

Every economic downturn includes risky lending as a major contributing factor. The investors who pulled out early, and the financial institutions that take a cut without accepting any risk, are the top of the pyramid. The people who wind up holding the risky loans during the collapse are the bottom of the pyramid. Those guys thought the interest would always come rolling in.

The complexity of the system is there to try to hide this interaction. The rubes at the bottom of the pyramid wouldn't by into it, except that it is so obfuscated that no one can really tell what's going on. (Honestly, selling badly insured bundles of mixed-risk mortgages cost the taxpayers a trillion dollars? How is Joe Six-Pack supposed to guard himself against that?) And like any good pyramid scheme, the con involves great returns for people who get in early. Remember when your 401(k) was trending ever upwards? "Put some of that in real estate, it's huge!"

  -- 77IM

Re:Can somebody 'splain this?

[DNS-and-BIND]

What, so you should have a ton of money in the bank sitting around doing nothing? I live in China, and everyone here does exactly that...it keeps a lot of otherwise useful money locked away where it can not influence anyone, nor make more money. Leveraging isn't what's wrong with capitalism, the current crisis was caused by breaking the law (mortgage fraud) on a massive scale.

Re:Can somebody 'splain this?

[mikiN]

No gold no more (for the banks at least). That went in '76 in a puff of heady smoke (remember Nixon?) Just bits'n'pieces.

It's (almost) the oldest trick in the book in a new guise. First they used smoke and mirrors, now they use smoke screens (TFTs and plasma).

Same result: deception.

Re:Can somebody 'splain this?

[PingPongBoy]

How red is the herring?

The masterminds are devious? The ignorance is enforced in the entire system?

Maybe, but could it just be the sheer sustained growth of knowledge and the lack of ability to handle the knowledge? I see people grasping at straws and stepping on each other to acquire not knowledge but wealth. The successes of the few trigger the enthusiasm of the masses. That is exactly what happened until the slippery slope became the avalanche. The funny thing is, what is in this simple analysis that could not find its way into a computer model?

For years, I have heard the occasional debate in the media about how unsustainable the increase in housing has to be. I wasn't even listening to financial gurus. The words of wisdom were coming from typical journalists who were sort of in tune with the common man.

Clearly the missing factor in the computer models, the X factor, is the belief that world progress itself was going to sustain the affordability of the high cost of living. Higher housing costs and education costs were to some people an unavoidable way of life, and a benchmark of progress, and somehow everyone else is able to get into the game no matter how high the stakes are. The message was simple: if you bother yourself in the age of fun-on-the-internet and really-cool-lifestyles to drill down into this mindset, you will see that the whole economy is sound and proper because the wealth is easily sustainable via production on the backs of the third world. Then immigrants will come, cluster, and afford the million dollar 2-bedroom bungalows with no garage, a bizarre effect that will exist in only a few years if housing prices were to maintain their collision course. This mathematics somehow did not appear in a computer model because our ability to control computers has not advanced to the level of simple linear projection.

So what is the data telling us now? The stock market is down because businesses have just focused on raking in as much money as they can from the economic situation of Christmas past. Now it is Christmas present, and there is no real plan for Christmas future. As a result, people are scared shitless to invest anything. The fear can only be allayed with real results. Trust has to be won. These are sweeping concepts that are not that easy perhaps to quantify and observe, not that easy to run on a computer model...

Re:Can somebody 'splain this?

[mikiN]

whoops, first part is about the Gold Standard until '71. The second part still holds.

Must be the jitterbug.

Re:Can somebody 'splain this?

[AlXtreme]

Credit is needed in a system where you are able to make purchases in certain items. The problem is when people over leverage themselves.

And that is exactly what happened. Both businesses and consumers were overleveraged, the realestate bubble burst and the whole cardhouse came crashing down.

Personally I don't see why you would need credit to buy a car though. If you don't have the cash don't buy a new car, get a second-hand one. Cars are a worthless investment, especially new ones. My rule of thumb is to only use credit if you are making an investment that has a very good chance of at least keeping its value.

Homes on the other hand... oh wait, never mind...

(but seriously, even in this market a house will still have considerable value after 10 years, where a car will be close to worthless)

Re:Can somebody 'splain this?

[hey!]

For example, lots of people have a checking account, savings account, credit card, poersonal line of credit, HELOC, brokerage account, and more. I see absolutely no reason why a single account could not offer all those features.

Neither did advocates of banking deregulation in the 1990s.

One of the reasons for this "redundancy" is (or used to be) that different rules apply to each kind of account. You used to have have commercial banks, investment banks, and insurance companies, and each did something different under different rules. Then the rules that had been in place since the Great Depression were repealed by Gramm-Leach-Bliley, and suddenly the legal boundaries between these kinds of financial services was gone.

Subsequently, we are facing the greatest economic crisis since the Great Depression. Coincidence? I'm not entirely sure, but surely some of the problem is that practices and attitudes that were normal in investment banking suddenly started to crop up in other businesses.

Although Hank Paulson is actually, in my opinion, one of the more decent individuals as a person in the administration, he's very much the wrong man at the wrong time. One of the things he did as head of Goldman Sachs was to convince the SEC to get rid of the "net capital rule". That was the rule that required banks to maintain a certain level of cash on hand to cover cash demands in unusual situations. This is obviously extremely expensive for companies who had to keep huge volumes of cash on hand, losing mind boggling amounts of value even against modest inflation.

Had the rule been kept in place, we might not have had to pony up seven hundred billion dollars to bail out Wall Street.

Re:Can somebody 'splain this?

[Anonymous Coward]

What, so you should have a ton of money in the bank sitting around doing nothing?

It's doing something. It's insuring me against a rainy day.

That's not to say I couldn't invest some of it, but the emphasis is on some. If I'm riding month to month on rolling lines of credit, like the referenced businesses are, then I did it wrong.

Re:Can somebody 'splain this?

[Estanislao Mart�nez]

Instead of doing Shady and immoral accounting practices why not do what honest small business do. YOU HAVE THE CASH ON HAND TO PAY YOUR BILLS.

Because once a business gets large enough, the cash flow becomes enormously more complex, and very short term credit becomes a cost-effective way of managing cash flow.

Basically, a business wants to match cash inflows with outflows (and to simplify the model, we'll count "profits" as one of the outflows). The problem is when you know that your business is owed cash that's going to arrive in unpredictable payments over the next 30-90 days. Setting up the cash outflows so that they precisely match the inflows becomes hellishly more complex when the number of transactions gets big enough. Short term debt provides a buffer that allows a business to simplify this.

In principle, yes, a business could do the same thing by keeping cash reserves as a buffer, too. But when you take into account the time value of money, that really comes down to the same thing: by keeping cash, the business implicitly pays the opportunity cost of keeping that cash. (And with an inflationary monetary policy, of course, the cash itself becomes less valuable over time.)

So, to sum up, the money owed to the business over the short terms is its accounts receivable; short-term debt allows a business to convert, for a fee, a large fraction of its accounts receivable into cash, and therefore, to draw upon its accounts receivable to finance its operations. I.e., instead of having n dollars of pure, unencumbered cash at its disposal at any one time, it can have n + ((accounts_receivable * reliable_fraction_of_a_r) - interest_on_short_term_debt)); or, equivalently, to keep less unencumbered cash than it would otherwise need to.

Re:Can somebody 'splain this?

[Spasemunki]

...,who are the original spark that started the fire, I do not want to claim it's "their fault", but they are part of the problem)

This whole post is total bullshit. The notion that, somehow, attempts to counter historic discrimination against blacks and other minorities set off the economic crisis is just foolish. The regulations imposed on certain banks were very modest, and were essentially designed to prevent worthy borrowers from being denied due to where their house was located ("redlining"). Nothing in the CRA requires banks to extend loans to people who can't pay them back. Most of the banks that were hit hardest by the mortgage crises weren't even subject to the CRA, because they weren't commercial banks. Yet the whiners in the pundit class persist in arguing that armies of poor people strong-armed poor, defenseless banks into making bad sub-prime loans. Never mind the studies that have shown that CRA-regulated banks were less likely to make subprime loans, and less likely to re-sell their loans. Never mind the fact that only one in four sub-prime loans originated from a CRA-regulated bank. Yep... poor people. The secret masters of our economy.

And Jimmy Carter? He might have been a tool of a president, but blaming him for Iran is bizarre. Horrible policy making in the region going back to WWII sunk Iran. Jimmy was just lucky enough to be there when the music stopped.

Re:Can somebody 'splain this?

[agslashdot]

Take a hollow toothbrush. Fill it with toothpaste. Then take a hollow shaving razor. Fill it with shaving foam. Now glue the toothbrush to the razor. For kicks, lets also glue a fork, a knife and a spoon to this appartus.

Now I claim you can brush your teeth, shave, eat your breakfast, butter your bread, drink your soup - all with this one appartus.

So then why do we have a separate toothbrush, razor, spooon, fork etc ? Is it because we want to ensure the employment of spoonmakers worldwide ?

Without CP, MBS, CDOs honestly there is no way you can run a modern industrial economy. You can glue them up into one savings account, but it would be as unwieldy as your toothbrush-cum-razor-cum-fork.

I built most of this financial gobbledegook in a previous life...

Re:Can somebody 'splain this?

[Chris Burke]

Credit is needed in a system where you are able to make purchases in certain items. The problem is when people over leverage themselves.

Well, that's how the problem starts.

The problem gets compounded when you treat debt like it's a magical source of new money. As in, if I loan you $10, then you have $10, but then I also have a "debt asset" worth $10, which makes a total of $20. That's exactly how people were explaining it to me as recently as 2007 when suggesting that debt is good and actually "creates wealth". But that's bullshit. Ultimately there's not $20, there's the $10 I used to have but instead gave to you, and at the end of the day I can at best expect to end up with that $10 back plus interest. But people kept treating the debt itself like it was additional money, selling the debt, and making additional loans with debt as collateral -- debt-backed debt! So there were trillions of non-existent dollars spinning around in a big financial machine and everyone loved it. It reminds me of Worldcom who made billions of dollars selling unused bandwidth to a subsidiary and then buying it back, tons of money spinning in circles but none of it actually real.

Now this was all fine and dandy for a while, but eventually the system only works if that debt is paid off, which is when the problem became apparent. It turns out that a lot of that debt was never going to be paid back, which means the big debt-amplification-machine was not just running based on a false premise, is was running on nothing. When the debt failed to be paid, that failure was amplified up the system and soon our entire financial system is at risk because of an unusual number of home mortgage defaults. The bubble was burst, the curtain was lifted, and now we're all paying for it.

Credit is essential to our economy. That's for sure. But we can't keep treating debt like it's wealth when really it's a negative asset that you hope to recoup with some payoff. Too much of it is bad, building a whole economic system on it is, well, what we're seeing the consequences of now.

Re:Can somebody 'splain this?

[Red Flayer]

Your understanding of accounting is way off (and so you shouldn't claim to speak for accountants when you write that gibberish).

Also there are a few uncertain assumptions in your little 'analysis' -- one, that the seller chooses to reinvest his sale profits with the bank. You claim that most cash proceeds from the sale of houses was deposited in banks -- this is false. Most was actually reinvested in other real property or elsewhere.

Plus, you ignore the opportunity cost of the funds the bank is due and the risk of default (hence the interest rate on the loan).

I know the banking industry has its problems, but claiming it's a ponzi scheme is just uneducated. The banking system is NOT dependent on influx of new investors to pay their creditors (leaving a gaping cash hole when new investors stop appearing). They are dependent on the stream of payments from existing debtors. When that stream dries up, their ability to lend dries up, since they become cash-flow negative, and eventually have no capital to lend.

The problem is that the banks are unwilling to lend when the expected return on their capital outlay is negative. Due to the fluxed up state of the economy, banks in general have decided that lending is unwise, since the risk of default is so high. The big problem is that banks did not properly assign risk to certain loans, so that they undercharged on the interest rate. The reason this slightly relates to a Ponzi scheme, is that as long as another bank was willing to underwrite a risky loan, then bank could get rid of its risk when the property in question was sold. It was a game of hot potato -- whoever was left holding the risky loan when everyone stopped lending lost. And the big problem was that it continued for too long -- eventually the amount of risky loans was so large that almost *everyone* was left holding a sack of hot potatoes. If credit rules had been tightened, rather than loosened, then a few banks would have gotten burnt early, and the problem would not have spiraled.

Re:Can somebody 'splain this?

[kgskgs]

Commercial paper or financial complexity is not the real problem. The real problem is reality. Let me explain.

There were three fishermen in a village. They were not able to do fishing because they lost their nets. One day one of them heard of a fishing net weaver in the neighboring village. So he went and rented a net from the weaver. To pay rent, he borrowed the money from the same weaver. He could go fishing now. The second one found out and he did the same thing. The third one went to rent a net as well. The weaver had only two nets. But he smartly figured out that the three fishermen never go fishing at the same time, so there will always be one net idle. He smartly figured out scheduling algorithm. So also started renting the two nets to three fishermen.

All four were happy. The fishermen always assumed that they will have net whenever required. The weaver was happy to be able to rent two nets to three people.

One fine day the assumptions made in weavers scheduling algorithm broke down and all three fishermen needed the net. They came to realize that there are not really enough nets and sometime they might end up not getting the net. So each fisherman started renting the net for more time than required to avoid the risk. This increased the net renting price (Inflation), also the nets started staying idle for long times (Dropped output). The fishermen could not pay their rent loan installment in time. The weaver started losing money and he could not maintain the nets. Ultimately everyone was poor again.

Nothing changed from start to beginning but everybody's risk perception. Originally, with the false perception of zero risk and abundance of resources was created by the weavers assumptions. This perception broke down and everybody started paying high insurance to avoid the risk and this left little money for investment.

In today's case, the net weaver is the bank and fishermen are consumers.

Do you know what is the biggest difference between developed countries and developing countries /third world? In developed countries people keep less for the rainy day and invest more. In third world, people stack up more for rainy day and invest less.

K

Re:Can somebody 'splain this?

[kgskgs]

I forgot to add last couple of lines.

The problem with reality is that it does not issue one way ticket. Life always runs in circle. You cannot theorize something without assumptions. And rest assured there will be one day when your assumptions will not be true anymore.

That's why reality is the problem.

Re:Can somebody 'splain this?

[StormyWeather]

Your exactly right, except that homes really don't go up in value at all, and never have. People just think they go up in value because they go up in price. What they really are is a hedge against inflation.

Re:Can somebody 'splain this?

[againjj]

It sounds like those people were talking about the ideas of M0-3 and trying to extend it to debts. There is a reason M3 is no longer measured: as you go up the scale, the values become more and more meaningless/useless.

Re:Can somebody 'splain this?

[B4D BE4T]

...thanks to the CRA...

CRA really had very little affect on this whole situation. Here is a good argument against the "Blame-CRA" theory. To summarize, from the link:

...half of sub-prime loans came from those mortgage companies beyond the reach of CRA. A further 25 to 30 percent came from bank subsidiaries and affiliates, which come under CRA to varying degrees but not as fully as banks themselves... Most important, the lenders subject to CRA have engaged in less, not more, of the most dangerous lending.

I don't think that your description of the whole mortgage securities buying/selling process is entirely accurate. My understanding is that it is like a game of musical chairs. Banks bought and sold securities for ($loan_amount + $loan_future_interest). As the interest rate went up on adjustable rates, people were no longer able to pay the loans off and the loans defaulted. So a large percentage of $loan_future_interest was immediately lost by whoever was stuck holding the securities when the music stopped. And a significant percentage of $loan_amount also could not be recovered by taking possession of and selling the property because the property had lost value due to the housing bubble.

...they should be prosecuted for making (and winning) the bet that tens of thousands of people would lose their livelihoods, their houses.

I think prosecution goes a little too far. In most cases, everything was legal. Although I don't think that they deserve to be bailed out either. They made a bad decision, both borrower and lender (the people who took those unaffordable loans are as much at fault as the banks who gave them). Suffering monetarily is punishment enough. Personally, I think that the banks should lose the money (no bank bailouts) and the borrowers should lose their homes (no homeowner bailouts). Why should anyone else (the taxpayers) have to pay for the banks' or the homeowners' bad decisions? Sure, many banks would go under, but is that really such a bad thing? The only decent argument I've heard against letting these banks fail is that it will reduce the amount of available credit. But isn't credit (the idea that property can be obtained now while the money is paid later) what got us into this mess in the first place? Personally, I think the sooner our country loses its addiction to credit the better.

Re:Can somebody 'splain this?

[Gription]

The part I want 'splained is: Why does anyone think that the stock market is a serious indicator of the state of the economy?

These types of exchanges (stocks, commodities, etc...) are Gambling dressed up for high society. That doesn't mean that they aren't reasonable investments over the long haul. Any reasonable person looking at them over the short haul will see that they are driven by everyone trying to guess which way everyone else is going to jump. This is simply gambling.

Everyone knows the market is going to be way up in a few years because it is currently highly undervalued but because the vast majority of investing groups are buying and selling with short term gain in mind the market is bouncing around like a superball. Maybe if someone was required to hold a stock for a minimum period of time it would make stocks an indicator of something.

Off to the side of this:
I really think that the government could free up a huge quantity of the credit blockade by lending directly to the enduser to force the various credit companies to wake up and try to compete for their markets.

Example: Home loans. 30 year fixed rates have usually floated at around 2+% over prime. Now because the mortgage companies wrote unserviceable loans so they could sell them instead of service them, they are all licking their wounds and are currently loaning at 5+% over prime. This works out to a subsidy to the mortgage companies so they can make up for their idiot losses. At the same time no one can sell their house because no one can get credit and if the houses don't move the price drops screwing home owners. At the same time banks are dumping foreclosed homes further driving down the home price comps. (Oh and the banks DO make loans for the houses they are dumping!!!)

If they would just refinance the so called "Toxic debt" mortgages at 3% over prime it would drop the payments down to a point where most of the "toxic" loans would be workable for the debtors and then they wouldn't be toxic. At 3% over prime it would be plenty profitable too. If they would force the mortgage companies to carry the paper on a portion of the loans (selected at random) it would guarantee that they wouldn't write fraudulent loans either...

(now get off soapbox...)

Re:Can somebody 'splain this?

[Lumpy]

Which is why I will never EVER become Incorporated. I prefer honesty and doing things right.

What you say makes ZERO sense. I'm not having "tough times" right now. In fact I have CASH and am sucking up lots of gear being auctioned by my competitors at $0.10 on the dollar. I recently got a $4800.00 Beta cartoni tripod for $500.00 at a Grand Rapids business auction.

Sounds like I'm doing it the right way and all my competitors are not.

Re:Can somebody 'splain this?

[johnsonav]

The part I want 'splained is: Why does anyone think that the stock market is a serious indicator of the state of the economy?

If you're looking to the stock market as a barometer, you're in for a let down. The price of a stock depends on so much more than just the state of the economy. The only real rule is: historically high stock prices usually indicate overconfidence, and historically low stock prices usually indicate undue pessimism.

Everyone knows the market is going to be way up in a few years because it is currently highly undervalued...

You sound like the prognosticators in 1929. But it took 22 long years for the Dow to surpass its pre-depression highs. Don't commit the same sin of hubris that got us here in the first place.

Maybe if someone was required to hold a stock for a minimum period of time it would make stocks an indicator of something.

But that would remove one of the main reasons to own stocks, their liquidity. We don't need stocks to be an indicator of anything at all. All they represent is the value the market places on projected earnings.

I really think that the government could free up a huge quantity of the credit blockade by lending directly to the enduser to force the various credit companies to wake up and try to compete for their markets.

Now here's where you lost me. You think that banks are going to try and compete with the government, which can borrow money to lend at almost zero cost. Banks have to get their money from somewhere, and their risk of default is seen as so much higher than the government's, that the interest rates they can borrow at are sky high right now. Why would they try to compete with the government at all? They're almost guaranteed to lose.

If they would just refinance the so called "Toxic debt" mortgages at 3% over prime it would drop the payments down to a point where most of the "toxic" loans would be workable for the debtors and then they wouldn't be toxic. At 3% over prime it would be plenty profitable too. If they would force the mortgage companies to carry the paper on a portion of the loans (selected at random) it would guarantee that they wouldn't write fraudulent loans either...

I think you underestimate the scale of the mortgage problem. There is too much debt out there on homes that are worth nowhere near what is owed. What incentive does the homeowner have to repay a loan when they are $100,000 underwater? Even at a zero percent interest rate, it just doesn't make sense for the borrower. Those toxic loans are called "toxic" because there's really no good way to fix them.

Re:Can somebody 'splain this?

[symbolset]

Inflation has not been a cumulative 400% in the last 10 years

And deflation in general won't be 75% as home prices come down over the next three years. That's why it's called a bubble.

The value that your home has is that it keeps the rain off of you, and keeps you from being arrested for sleeping in the park. It also makes a handy place to store the stuff with sentimental value you accumulate over time, like offspring.

There will be some interesting side effects from this boom and crash. Right now home prices are crashing at the same time interest rates hit unsustainable historic lows. Generally that's a good time to buy a home if you don't have one -- but get a fixed rate with a payment you can afford. If you don't, the inevitable inflationary spiral that follows will break you. With a fixed rate, inflation actually works for you by raising your income and reducing the real value of your debt. In the 80's I heard SO many stories about older people who had a nice home that cost $20,000 on a 30 year fixed 6% rate loan at the same time my parent's variable rate swelled to over 18% that the idea stuck. As soon as the market starts showing signs of life the rates will start going up again so don't miss your shot. The opportunity time is coming around again as it does for every generation -- it's almost time to fire your landlord. When it's time many will make the deal of a lifetime. Everybody else gets to spend the next 20 years kicking themselves for missing it, while they do it the hard way.

In short, GP was exactly right. In a perfect market the average home costs exactly as much as the average buyer can afford to pay. The games they've been playing with finance drove the prices up and make getting loans easy for a while and it will be followed by a time when the prices are driven down and loans are difficult to get because the market is not perfect: People always try to game the system and all systems can be gamed and so buyability swings wildly from completely impossible to ridiculously easy and most folks have to take care to get in when the time is right. The minor cycle seems to be roughly 20 years and the major cycle 80.

If inflation gets totally ridiculous, everybody with a fixed rate home loan gets to pay off the loan very easily, though other stuff starts to get harder to get. That's why it's smart to own some gold and silver too - not certificates or shares in mining companies that can be shams or go bust; real soft metal coins and bars. You don't need too much of it because the crisis can't last longer than a few years before things straighten out. Only once you've taken care of these things should you start to think about putting your extra money to work at interest.

Re:Can somebody 'splain this?

[mr_death]

Everyone knows the market is going to be way up in a few years because it is currently highly undervalued but because the vast majority of investing groups are buying and selling with short term gain in mind the market is bouncing around like a superball.

True, but this situation may not be an ideal time to go long. As the old saying goes, the market can be wrong far longer than you can stay solvent.

Caveat emptor, your mileage may vary, and no platypuses were harmed in the making of this posting.

Re:Can somebody 'splain this?

[billcopc]

Banks have to get their money from somewhere

No, they don't.

Fractional reserve is the root of our problems today. The system is designed to lend out more money than actually exists, thus the economy is overloaded by design, and inflation is guaranteed.

Well I don't know about you, but I'm pretty sure them cows don't produce 3% more milk with each passing year, nor do they yield 3% more meat. You can say what you want about wealth, but there is a fixed amount of natural, life-sustaining resources in the world, and printing more money isn't going to change that.

Re:Can somebody 'splain this?

[FooAtWFU]

On the contrary. Even the New York Times, in their 1999 article Fannie Mae Eases Credit To Aid Mortgage Lending, recognized that 'If [the subprime market] fail[s], the government will have to step up and bail them out the way it stepped up and bailed out the thrift industry.' (The thrift industry episode was back in the 1980s, before my time). Fannie Mae is to entirely to blame. The rest of the world didn't help, but Fannie Mae is entirely the core and the cause of the current crisis, and the destructive policies sending us on the road to Hell originated with a well-intentioned attempt to improve credit access to minorities.

That said, grandparent post does contain a modicum of Bullshit too. Consult with your local Ph.D. economist, not zanies on the Internet.

Postscript. Congress is complicit. That goes for both Republican Congress and Democrat Congress. And the Presidents. Extra for Obama, who is the second-biggest recipient of Fannie Mae campaign contributions ever.

Re:Can somebody 'splain this?

[Captain Nitpick]

Well I don't know about you, but I'm pretty sure them cows don't produce 3% more milk with each passing year, nor do they yield 3% more meat. You can say what you want about wealth, but there is a fixed amount of natural, life-sustaining resources in the world, and printing more money isn't going to change that.

Wrong. The cows do, in fact, produce more milk every year (not the individual cow, but the average cow). More importantly the dairy industry becomes more efficient every year, making it possible to have more cows using fewer resources..

"The greatest shortcoming of the human race is our inability to understand the exponential function." -- Albert Bartlett

Production and efficiency in a single industry can only increase for so long before the results become absurd or impossible.

The average dairy cow in the US produces ~20,000 pounds of milk annually (rounded for simplicity). If we pretend we can get 3% improvements annually, then after 100 years we'll have nineteen times the milk we started with. At the end of 200 years, each cow is producing a pound of milk every four and a quarter seconds. In 300 years, 4.5 pounds/second. You'd have to stick a pipe down its throat just to prevent dehydration.

And as far as more cows using fewer resources goes, you run up against basic physics. Calories in >= calories out. Efficiency improvement is constrained by the universe.

Re:Can somebody 'splain this?

[Capt James McCarthy]

"I prefer honesty and doing things right."

Well, you are not going to get rich with that attitude. From what I've seen if you are not back-stabbing, vindictive, willing to fire people to keep the stock prices high, pay yourself more then you are worth, consider people leaches and just a number, and use tax dollars as a personal corporate safety net, then you are not a true corporate leader.

Re:Can somebody 'splain this?

[Spasemunki]

Why? The point is there, the delivery isn't well formed though. Lending money to folks regardless of race, creed, or gender, who don't have the means to pay it back is going to lose every time.

Because nothing about the regulations that the GP poster was talking about ever required banks to lend to people who were unable to pay. Because banks who were subject to those regulations were not responsible for the majority of the sub-prime loans that trashed the market. You're correct that lending to people with bad credit, who can't possible repay their loan, is a bad idea. The idea that banks were compelled to do that by legislation that put an end to certain discriminatory lending practices (like "redlining", the practice of identifying minority neighborhoods and declaring that no resident of that neighborhood, and no home within it, was a reasonable credit risk) is complete nonsense. Banks started extending sub-prime mortgages to unsafe lenders because they thought there were profits to be made in doing so, not because they were compelled to lend by anti-discrimination laws.

It's pretty simple. In the old days, two people walk into a bank. They both have modest, working-class jobs and good credit history from auto loans and store credit cards. They are both asking for loans in about the same amount. One guy is buying a house in a working-class white neighborhood. The other is buying a house in a working class black neighborhood. What happened before the CRA was that the first guy got a loan, and the second guy either got denied or had his fees and rates jacked up. The CRA simply said that if you were challenged on it, you had to be able to show that you were consistently following through with your risk calculations without regards to race or the ethnic makeup of certain neighborhoods. A good borrower asking to buy a house fairly appraised at $200,000 in a historically black neighborhood couldn't be charged twice the rate as the same borrower buying in a white neighborhood.

Now if the person asking to borrow is an obvious credit risk- bad history, no income, loan principle vastly in excess of their income or earning capability- you can still deny them under the CRA. You just can't deny people who's mailing address is in one zip code, and lend to people from another zip code. Nothing compels you to lend to bad risk borrowers.

Some right-wing pundits are claiming that this was somehow responsible for the sub-prime meltdown. They claim that in order to avoid the appearance of discrimination, banks were making bad loans to minorities in order to pad their numbers for loans to minority borrowers and neighborhoods. But this simply isn't true; in fact, most of the lenders making sub-prime loans were never subject to the CRA. Even if the CRA was compelling banks to make loans they otherwise wouldn't (which there is no evidence for), the private lenders who wrote most of the sub-prime loans had no need to give the appearance of compliance, and could make decisions purely based on the risk/reward profile of their customers. They decided that people with low incomes and poor payment histories were a good bet, because they could re-package the debt as mortgage-backed securities and resell the risk. They didn't make loans to poor people who couldn't pay because the law compelled them, or out of the goodness of their hearts; they did it because they believed there was a profit to be made. Meanwhile, the CRA regulated banks, which conservatives claim were being forced to lend to bad borrowers, were making far fewer sub-prime loans, and weren't attempting to commoditize their debt aggressively the way the private lenders were.

The real truth is that the growing housing market, low interest rates in the wake of the dot com bust, and the unregulated market in debt-backed securities created a toxic environment. Private lenders saw great potential profits in lending to the sub-prime market, and believed that debt-backed securities gave them a way to avo

Re:Can somebody 'splain this?

[Abcd1234]

They don't loan out more money than they receive as deposits.

Actually, they do. In most modern fiat currency models, banks must hold a minimum reserve relative to the amount of loans they give out, but can otherwise issue loans up to that ratio.

In fact, banks quite literally create money by making these loans, which is how the US money supply grows (and is one of the reasons why adjusting the interest rate affects inflation... if you reduce the rate at which loans are granted, you reduce the rate the money supply grows, which translates to lower inflation). It's actually a pretty fascinating, if confusing, topic. I'd recommend reading up on it!

The source of the problem

[Anonymous Coward]

has nothing to do with computers. The source of the problem is the source of money. Who decides how much money there is? Who reaps the benefits of creating money which is not backed by real productivity? If you're truly looking for the root of the problem instead of symptoms, then you have to find out about the inner workings of the money system. In other news, the "Federal" "Reserve" bank has once more lowered the interest rate. The dollar is now less than 0.25% away from being free (i.o.w. worthless) money.

Re:The source of the problem

[megamerican]

Don't worry, I'm sure Congress will audit the Federal Reserve and we'll get to the bottom of this mess!

The Federal Reserve recently refused to disclose $2 trillion in loans requested by a FOIA request citing "trade secret" clauses.
http://www.bloomberg.com/apps/news?pid=20601109&sid=aGvwttDayiiM

In response to Bloomberg's request, the Fed said the U.S. is facing "an unprecedented crisis" in which "loss in confidence in and between financial institutions can occur with lightning speed and devastating effects."

In other words, we'll tell you when we're ready to finally destroy the economy!

No wonder Congressman David Scott said we've "been bamboozled!"

The real number of the bailout is actually $8.5 trillion (as of two weeks ago and is probably closer to $10 trillion now.

http://www.sfgate.com/cgi-bin/object/article?f=/c/a/2008/11/26/MNVN14C8QR.DTL

Re:The source of the problem

[DragonWriter]

That's not what a .25% interest rate means. It means that a dollar a year from now is .25% away from being worth the same as a dollar today.

It doesn't mean that, either; the fed funds rate might rationally be expected to have some loose correlation with the value of the dollar over time, but its not the same thing. It relates to how many future dollars someone privileged to borrow at the fed funds rate must sacrifice to get a current dollar, not what the dollar will be worth at the time that bill is due.

(Of course, for anyone to borrow at that rate, the borrower must expect that the expected return of what they can do with the dollar exceeds the interest rate by enough to compensate for the risk of failure, but that's about return, not value of the final dollar.)

Right, this is all a big computer crash

[BadAnalogyGuy]

Funny how all the computers seem to be working properly when the prices are going down, but not working half the time when prices need to go back up.

I guess it's like how gas pumps will correctly increase the price of gas when the price per barrel of oil goes up, but are buggy and won't reduce the price later when the costs come back down.

Re:Right, this is all a big computer crash

[amliebsch]

No it isn't.

For one, the price of gasoline is not directly tied to the price of crude oil - it's also affected by refinery capacity, supply and demand of other petroleum products, and the varying supply of gasoline in particular.

For two, I've recently witnessed gas prices fall from around $4 to almost $1.50. Am I hallucinating this?

Economics models are like goat entrails predict...

[tg123]

Economics models are like using goat entrails to predict the future so this wouldn't surprise me. sorry just had to put my 2 bits in

pointing fingers

[girlintraining]

I'd just like to point out the bleedingly obvious: That people programmed these computers. They are functioning exactly as they should be. If they weren't, we'd have heard about it by now. So the problem is not the computers, or the network, but rather the people who control them. Thank you. You may now resume your regular ranting, already in progress.

Re:pointing fingers

[dosh8er]

which, i believe is why the garbage in garbage out syndrome is affecting 'users'. I can't imagine what the 'QA/QC' is like involved in the development of the modeling software for financial sector. shouldn't it be as regulated as, perhaps, the nuclear industry? Or maybe nobody can maintain all those lines of COBOL...

Re:pointing fingers

[girlintraining]

It's very tightly regulated, and the source code must be independently reviewed prior to certification. They're very ugly about that kind of thing. Computer models might be a problem, but only because they were based on bad assumptions made by the designers... That is a human failing, not a machine one.

Re:pointing fingers

[AJWM]

Two words: "emergent behaviour".

No one group of programmers programmed all these computers, there was no single set of specs for the whole network. All the components may well be "functioning exactly as they should be" (although in reality I'm sure there are a few bugs in the systems, but that's irrelevant here), but the system overall may behave in an unexpected way.

(That said, I don't think that's the whole problem either -- too many people playing a bit fast and loose and less than honestly with other people's money is also part of the problem.)

Re:pointing fingers

[BigTom]

What is tightly regulated? Half the Quant algo trading models get thought up in the evening, coded overnight and activated in the market the next morning.

If you try and slow them down they just run to the head of the desk bleating that the "nasty IT man stopped me making $1000,000,000 for the bank with his silly QA nonsense" and whoosh, its in production. It is prop trading so its their risk.

Re:pointing fingers

[girlintraining]

the systems are designed to have transactional integrity. it doesn't prevent someone from making idiot trading decisions.

Re:pointing fingers

[Znork]

Considering the fundamental basis of the whole system is based on the flawed assumption that credit can be infinitely expanded the current failure is hardly surprising. The Austrian school pointed out the fallacies that caused both the last depression and the current one almost a hundred years ago.

Computers have very little to do with it. Constructing models to fit political economics rather than to reflect reality is closer to the actual problem.

Re:pointing fingers

[DragonWriter]

Two words: "emergent behaviour".

Its not emergent behavior of computer systems. Its the exact same kind of behavior markets have displayed without computers.

Sure, things haven't been this bad recently, so some elements of it are new, at least in the short term, and the details change always. But none of the big picture stuff has much to do with computers, fundamentally. Economic markets are vastly interconnected because their substantive outputs and inputs (not just data outputs and inputs of the computer systems currently used as tools in managing them) are directly linked.

Blaming computers is about as justified as blaming witches.

Re:pointing fingers

[girlintraining]

No one group of programmers programmed all these computers, there was no single set of specs for the whole network. All the components may well be "functioning exactly as they should be" (although in reality I'm sure there are a few bugs in the systems, but that's irrelevant here), but the system overall may behave in an unexpected way.

There's a bug in Internet Explorer. That must mean the entire internet is broken. No. Financial transaction systems are heavily audited, rigorously tested, and subjected to heavy regulation. They are the most hardened systems in wide use in the commercial sector. Period. That doesn't mean there aren't problems, but a problem big enough to cause a network-wide malfunction are very, very low.

What we're dealing with now are people who made bad assumptions about the economy, got cocky, and now we all are paying the price for the lack of oversight and auditing done on the decision-makers responsible. Looking for simple solutions (ie, "the computer did it") to complex problems is naive at best. This took many several thousand people, all making the same bad decisions, to bring us to where we are now. I will say it again -- this is not a technological failure, it's a failure of people. And if you ask me, we should start publishing the "bugs" -- ie, the names and faces of these people, so the rest of us know to never let them anywhere near the financial sector ever again.

But that would just be too easy.

Re:pointing fingers

[martin-boundary]

They are functioning exactly as they should be. If they weren't, we'd have heard about it by now.

Not always. Many finance outfits use Excel a lot, which doesn't do statistics properly. However, modern finance has become very statistics heavy in the last ten years, so this shortcoming matters now a lot more.

Re:pointing fingers

[BigTom]

The plumbing is not the problem here. It is the Quant models that _are_ the market in many cases (certainly where ever hedge funds are significant players).

Understand the System Dymanics of Emergence

[Anonymous Coward]

It is not just the computers, but the humans as well. The entire interconnected system of humans and computers in one planetary collective. A planetary economic dynamical system emerges from this, and takes on a life and behavior of its own, including organizing itself towards a "self-organized criticality" state that would eventually avalanche as it is doing so now.

The system grew far faster than it's underlying resources would allow for, ultimately driving it to a point of exhaustion and shock, leading directly to a cascade of failures spreading around the globe to nearly all segments of the market. It was inevitable, and I saw it coming many years ago, though I could not predict when it would transpire.

It's kinda like earthquakes. You can see the tension between the tectonic plates building up, but you can never be sure when that pressure will release itself. So it goes with the global financial marketplace.

Many parts of this market is zero-sum, yet predicated on the fallacy of "infinite-growth". You cannot have it both ways, my friends. It must fail, and that can "easily" be shown mathematically.

And so my "Greater Fools" theory of the market stands. If you hold a stake in it, your only hope is to find a "greater fool" than yourself to take it off your hands at a higher price. Since the supply of fools are finite, and the resources they hold are also finite, someone *must* be left holding the bag, due to the zero-sum dynamics of the market.

Computers being in the mix only make the shocks more severe and dramatic; but the same applies regardless.

Can't model in human traits

[HW_Hack]

How can you model in greed - corruption - and the ever popular human trait of freaking out ?

Tech bubble - Real Estate bubble ... next time I even see/hear the word bubble in the markets I'm cashing out for a while

Re:Can't model in human traits

[Timberwolf0122]

Bubbles would not be an issues if when they happen (it's not like they are hard to spot) everyone just held back and let it deflate, however this will never happen as everyone will want to get in while they can. It's like watching lemmings being herded off a cliff.

Does the argument support the conclusion?

[MoellerPlesset2]

Seems to me the author is repeating the mistake himself: By drawing a conclusion not supported by the data, in this case being the evaluation of the role played by computer models here.

And I agree with that datas: The problem isn't the computer/mathematical models. It's how they were used. In particular, people were using models designed to evaluate one kind of mortgage asset, and plugging in an entirely different kind of mortgage, etc.

The author grants that conclusion, but then makes the claim that although the problem wasn't caused by the computers themselves, that it was somehow exasperated by them. - I don't see how that's the case.

Computers and computer modelling makes it easier to create advanced derivatives and such. But it doesn't make us do it. Just look at the engineering world; We don't choose technically advanced solution just because we can. In fact, the tendency is to go for the simplest possible solution. ("KISS rule")

There's only one reason why you would create advanced, incomprehensible derivative structures: To con people, essentially. To obfuscate the risks. To create money out of nothing. (the most profitable way to make it)

That's not a new problem. There's a reason we created financial regulations, why we have book-keeping, demand financial transparency, auditing, etc. This happened because it was allowed to happen. Because nobody stepped in and stopped this obfuscation from happening. I don't blame the computer models. If someone cons you into signing a bogus, misleading contract - the problem isn't with the paper it was written on or the language that was used. The problem is with the law allowing such contracts to have legal force (which is a regulatory problem from another century).

To extend that analogy, this is a bit like standing in that situation and asking whether or not written contracts are a bad thing, and whether we shouldn't go back to simpler, oral contracts. The bottom line is: As long as it's profitable, there will always be people trying to obfuscate and hide information for economic gain, and there will always be a need for regulation and oversight to stop people from doing that. But blaming the methods by which it's done is pointless.

Gaming the system

[Anonymous Coward]

I was actually pretty involved in automated trading systems until a few months ago. The over-arching problems with the systems is they can either be tactical or strategic. Tactical systems make trades in milli-seconds and make decisions based on a dozen or so parameters. There is no human intervention. The money is made getting your trades in faster than the other guy. The problem is there are a lot of reactionary traders out there who see this movement and then react... without really determining what caused the movement. They just see a large percentage of stock moving and follow the lead.

Strategic trading is data-mining and looking at hundreds of factors and incorporating expert opinion into and making decisions based on long term movements and not singular announcements.

A very good example is Enron. Tactical trading systems would have always bought it because it meet or exceed it's numbers. A through analysis such as the one done by Daniel Scotto would have seen through the fraud.

Unfortunately ... tactical trading is fast and sexy and attracts the Gordon Gecko/Boiler Room types. Very few college grads aspire to be Warren Buffet.

The model assumptions were ideological

[grandpa-geek]

There are two equally valid descriptions of markets. One is by Adam Smith, with the "unseen hand" guiding the markets. Smith markets are well behaved, efficient, and amenable to analysis by what amount to small-signal statistics.

The other description is by Charles Mackay in his book "Extraordinary Popular Delusions and the Madness of Crowds." In that book he describes the Dutch tulip craze and other bubbles in history prior to the mid 1800's. This economic crash is more of the same.

The models, probably because of "free market" ideology, assume a market where Adam Smith's "unseen hand" is at work. The modelers don't consider the kinds of markets described by Charles Mackay. Most of the models are based on the Black-Scholes option pricing theory. If you look at the assumptions underlying that theory, they describe good behavior, efficiency, and changes describable by what amount to small-signal statistics.

Mackay markets are boom and bust, with greed and lies and herd behavior all around. That's what we had. The underlying mathematics has been studied, but not for markets. If you have a pre-LCD TV, an electronic circuit that is non-statistical but related to boom-and-bust market behavior creates the sawtooth sweeps that paint the picture onto your screen.

Turner

[Elektroschock]

Probably the best comment on the current financial crisis comes from Mr. Adair Turner.

It is not the computers or the communication standards. Sorry, not our poor computers, not the right target for the blame game.

The challenge of the crisis is intellectual. Look, I remember that economists always explained me that they have no clue where the US growth rates come from systemically or can explain where the financial markets make all that money. The surprise was that it didn't crash earlier.

Taleb's explanation of the Narrative Fallacy

[icke]

http://en.wikipedia.org/wiki/Nassim_Taleb "Narrative fallacy: creating a story post-hoc so that an event will seem to have an identifiable cause."

My investment advisor ...

[PPH]

...Bernie Madoff assures me that my portfolio is safe and I shouldn't worry.

Let's try...

[Estanislao Mart�nez]

Besides consumer banking, can somebody explain to me why we NEED "commercial paper"? Yes, I've read the wikipedia page and I know how it's used, but I don't understand why it's needed. If you can't make payroll then you're pulling from your credit one way or another - why do we need separate instruments for a 2 week loan versus a longer term loan, or a credit card, or whatever?

Because the risks, terms and structures of the loans are different between the different products, and it requires different expertise to successfully make loans of one kind vs. another. Not to mention that the borrowers are different for each product. This means that the separation of the loans into distinct product types represents a division of labor among lenders.

Just to list some of the important factors:

1. Commercial loans vs. consumer loans
2. Large corporations vs. small businesses
3. Large loans ($100k+) vs. smaller loans
4. Fixed term and rate vs. revolving loan
5. Secured vs. unsecured loans
6. Secured loans with different types of collateral
7. Large volume of small transactions vs. small volume of large transactions
8. Prepayment options
9. etc.

This is not to say that the line of product offerings doesn't have any significant overlaps, but most pairs of products you can think of are differentiated along at least one of these, if not others. The commercial paper market, for example, exists because large corporations seeking large ($100k+) short-term loans can get better rates than at other kinds of credit product. Large corporations with good credit ratings also get better rates on long-term borrowing by issuing bonds than they could by going to a bank. Credit cards feature point-of-sale networks and allow for a large volume of small transactions, while personal lines of credit require you to borrow in much bigger chunks at a time in exchange for a better rate (a volume discount, so to speak). And so on.

Don't blame the computers

[deodiaus2]

There are lots of problems in the financial system that have nothing to do with computers. If anything, computers have brought these problems to light.
You see a lot of this pointed out on Jim Cramer's show "Mad Money", http://madmoney.cnbc.com/
Most of our problems have to do with the lack of transparency in financial systems on supposedly public traded companies. As Cramer pointed out, "How can you have these levels of fiction after Sarbone-Oxley?" Moreover, with the recent Ponzi scheme uncovered, it makes you wonder just how interested is the SEC in maintaining the integrity of the financial system? That and allowing the short sellers to destroy the banks, leaving the tax payer to bail out the investors in order to preserve the financial system.
Thank god, we have the best form of government money can buy. Unfortunately, it even works to preserve the status quo when the original players are bankrupt. Nothing new here, after all, Japan's emperor was able to maintain control long after he had been defeated.
I am sure the US empire will survive this minor setback. The Hessian empire was bankrupt for hundreds of years before it ultimately collapsed. Maybe we can drag this on until the next Ice Age or until we poison all life to extinction, so who cares about the messes in the meantime?

Re:Garbage In - Garbage Out

[lenski]

Everything worked as advertised.

Absolutely not.

The individual quantitative analysts ("quants") built redundancy into their individual company's systems by counting on external "randomness" (approximately), insuring against possible losses emanating from their highly leveraged transactions through insurance contracts (credit default swaps).

However, All the other quantitative models were built on essentially the same set of assumptions: That their insurers had sufficient capitalization to cover the CDS contracts. The triggering event, a loss in home valuations is particular markets, started an avalanche consisting of lots of finance companies invoking the CDS contracts, all at once. That's when they found out that the insurer (AIG, for example) was just as undercapitalized as everyone else. (There's way more to this sordid tale, so this is a necessarily compressed synopsis.)

Unless one counts "we got ours, you're fucked" as implying "working as advertised", then it didn't work by any stretch of the imagination.

Read Nassim Nicholas Taleb's comments on the Black Swan Event for a properly thought and documented analysis.

BTW, The Edge is a great resource for the intelligent and curious reader. I have no financial interest in these guys, but I've found their insights to be highly informative and balanced.

Re:The scariest thing about high finance these day

[Red Flayer]

You're serious, aren't you? Have you any evidence to support that assumption, or did you pull it out of your ass?

Financial transaction processing is done via relational database in almost all cases. Or do you really think the volume of transactions handled by a decent-sized bank, even on a daily basis, could fit in 65k lines?