A bit over-the-top, but Richard Dooling's essay in today's NY Times ("The Rise of the Machines") has some ring of truth to it, to my eyes. It blames the financial crisis, in effect, on computers -- or, more precisely, on the networked machine intelligence without which the complex financial instruments now unraveling before our eyes could not exist:
"As the current financial crisis spreads (like a computer virus) on the earth’s nervous system (the Internet), it’s worth asking if we have somehow managed to colossally outsmart ourselves using computers. After all, the Wall Street titans loved swaps and derivatives because they were totally unregulated by humans. That left nobody but the machines in charge. . . .It was easy enough for us humans to understand a stick or a dollar bill when it was backed by something tangible somewhere, but only computers can understand and derive a correlation structure from observed collateralized debt obligation tranche spreads. Which leads us to the next question: Just how much of the world’s financial stability now lies in the “hands” of computerized trading algorithms?"
There's something to it, I think. Nobody knows what to do about this crisis, at least in part because no one has the necessary information about the effects of small changes -- adding capital here, letting banks fail there -- in a complex interlocking network of financial instruments all linked to one another. I don't know if it's a case of the machines taking over (as Dooling suggests), but it's not like other crises we've seen before and will require some real innovative thinking to get it under control.
The computers were nothing more than tools, and very useful tools. The real problem was human hubris - those very smart investment bankers with advanced mathematics degrees thought they were too smart to fail. Even the pricing mechanisms they used for derivatives like credit default swaps were based on probability models, but they forgot that probability models are only as good as the data and the underlying assumptions used to construct them. You can't accurately estimate the probability distribution of future mortgage defaults based upon historical data if your historical data is based upon one set of lending criteria (i.e., minimum down payments and stringent credit qualification), while the future you are trying to predict is based upon a completely different, much looser set of lending criteria.
I don't know that any innovative thinking is needed to get it under control. I can tell you one way that won't work is to have the government subsidize the highly risky bets by bailing out those who lost lots of money through sheer arrogance.
2) The reason that it is often hard to predict what the effects will be certain decisions that must (perhaps) be made now is that Human society is very complex. Computer programs might help with this problem, or might add to it, but they are not to blame for this complexity.
3) I believe there have been instances in the past where networked computer programs have unpredictably caused financial problems. It might happen in the future, and in a setting where shutting down computers would just make things worse. In this case we will simply reprogram the computers. The system is not Skynet and the unibomber is not John Connor, and I think the comparison is disgusting and dangerous.
But seriously, I don't think this guy really understands. "After all, the Wall Street titans loved swaps and derivatives because they were totally unregulated by humans." This statement is groundless, as is the next one: "but only computers can understand and derive a correlation structure from observed collateralized debt obligation tranche spreads"
None of that is true. Everything the computer does could be done by hand--laboriously. Most of these computers are running very well understood optimization algorithms. What's changed is that people used to have to do these things by hands using slide-rules, then calculators... but even with a calculator, much of the work was assisted with printed tabulations of statistical distributions, etc. Enter computers.
It became possible to recompute very quickly which made is possible to profit from transient pricing errors. He who finds the pricing mistake first, wins.
It also became possible to compute every more complex things quickly rather than laboriously.
Perhaps what he is reaching for is that only a small number of people understand the mathematics... and these people are almost certainly not the traders, turn bankers, turned CEO, turned members of the board.
Paulson and Cox were even beaten back on shorting securities. Where in real life, can you "short" an asset? you can't short the value of an automobile, a house or farm. Yet it has become accepted wisdom that selling things you do not own is a part of the market and contributes to orderly markets.
But what if the laggard produced more profit that the speedy? Well, when things were booming and the computer recommendations seemed right the laggard simply couldn't. The speed of computers will now beat any human thought - if the computer program is right. e.g. chess.
So the computers were relied upon more and more and warnings from humans were disregarded. There was no money in caution.
Economists and market analysts at these firms made perhaps $500k and had no authority and brought no profit to the bosses. And who wants to listen to warnings? That isn't fun!
Traders made a million plus - often a very big plus - and that made tens and hundreds of millions for their bosses.
The stock market is real life. To short a stock:
1. Borrow the stock
2. Sell the borrowed stock to a buyer
3. Buy back that stock in the future
4. Return the stock to the lender.
If I owned an Escalade and thought gas prices were going up, I could
1. Sell the Escalade
2. Buy the same model, year, and milegage Escalade later for much less than I realized on the sale.
If I own a house now and am convinced prices will fall even further if Obama wins, I can
1. Sell the house
2. Buy a comparable house later for less than I realized on the sale.
Economic models for the computer programs were extremely complex, devised by people of the highest prestige such as Nobel winners, and marketed as almost magic - no one believed they were actually magic - but they almost seemed to be.
The terrors of investing losses were gone forever. An infallible aide was being run by the smartest guys in the universe.
Really? Who wrote the program? Would you say only a computer can understand 876,876 divided by 459?
If the top 10 principle officers of a firm dealing in derivatives cannot explain exactly what that derivative is and how it works, in 200 words or less, the derivative cannot be sold, traded, bought, or otherwise handled by the firm.
The same 200-word rule applies to all Congressional committees required to oversee/regulate those derivatives.
No Tele-Prompters, no cheat sheets. Just live explanations.
It's immaterial whether a Nobel Prize-winning mathematician can explain it or whether the IT guru can explain how he modeled it. If those responsible cannot understand it fully, then it is not a product fit to be on the market.
This is different from products like HDTVs or a new hybrid car. Those products are complex, but evolutionary. Everyone can basically understand the mechanics behind them. No so with ephemeral derivatives.
but the answer isn't to ban computerized trading, or exotic derivatives. Its to make computerized trading and exotic derivatives unprofitable by graduated taxation (higher taxes on more "complex" derivatives and on investments held for shorter periods of time, no taxes on "simple" investments when they are held for longer period of time.)
south sea stockasset values will continue to appreciate forever.Human error, not machine. Whether this is human or machine, is hard to say, however.
The basis for commodity trading at the origin was to establish a market for crops and commodities that had yet to be produced. That is slightly different than going short or long on existing assets and it is easier for me to see the utility of that earlier arrangement.
Sure, now you tell me.
An example is trading a contract calling for March2009 delivery, and making that trade in November 2008. That corn is sitting in an elevator.
It is also possible to have a future contract for delivery of a bushel that has not yet been planted. For example, in November 2008, trade a contract for March2010 delivery. That corn hasn't been planted yet.
Similarly, one can blame the South Sea Bubble on the development of extremely seaworthy sailing ships during the few centuries immediately preceeding, which made global trade possible on a large scale.
In finance, as in every other field of human endeavor, a technical innovation usually becomes widespread *before* the academic or professional community develops any meaningful understanding of how it works in practice and how it fits into the larger scheme of things. Changes in institutions typically take even longer, and often come only when forced.
When is the last time you heard the phrase 'triple witching hour'?
It seems we hardly needed all those sharpies after all, we could've outsourced everything to Bangalore. The Bangaloreans couldn't have done a worse job, and we've have saved money.
Joy also references the passage from the Unabomber that Dooley references (it figured prominently in Ray Kurzweil's book, The Age of Spiritual Machines (1999)).
Somebody does own that stock. They loan it to you so you can sell it. Now you have a debt which must be repaid in stock. When you buy the stock, you pay that debt by giving the stock back to the lender.
You may not own the stock initially, but you are assuming a debt equal to the initial value of the stock.
I will be happy to make an agreement with you that lets you sell my Escalade, keep the revenue, and then give me a comparable Excalade in six months. During that period, you will pay me a monthly fee.
In six months, I have an Escalade back in my garage, I have all your monthly payments in my pocket, and I haven't had to look at the pig for six whole months.