Financial Crisis: What Happened?

My post of a couple of days ago, trying to gauge the economics of this financial crisis, generated some significant comments. I suppose I should be writing about business planning in economic crisis, or startups, or navigating your small business in times of financial crisis. And I will. But I still need to settle in on what’s happened.

I received an email from another favorite reader, suggesting that I read Dept. Of Magical Thinking: Wiz Bucks at The New Yorker magazine site, by Nick Paumgarten. Great article. I gather that appears in either this week or next week’s issue. How’s this for an eloquent introduction:

So many things have gone wrong; so many people are to blame; so many people are now screwed. Often, the media exaggerates the significance of the ups and downs of the financial markets, while the sophisticates in the marketplace take them in stride. Not this time.

Having set the scene, he looks at at least one of the causes:

Over the past thirty years, Wall Street has honed the art of creating and selling financial products with an increasingly tenuous connection to reality. It has been an extraordinarily creative period—a modernism of money, with an equivalent trend toward abstraction. Relatively simple derivatives evolved into ever more arcane contrivances. The risk and the leverage piled up, and, in the short term, the billions rolled in. This is over now.

And, even deeper, the future impact:

In fact, it wasn’t science at all. It was more like what anthropologists and psychologists call magical thinking—the tendency to believe that wishing it so makes it so. For years now, people have clung to the conviction that you can have outsized returns with little risk, leverage without recoil. This is what the clever financiers claimed that their inventions could do. Their colleagues and clients wanted to believe them. They all wanted to believe that their credit-default swaps could continue to insure against debt defaults. 

It’s hard enough to understand credit-default swaps when you know what they are; if you don’t know, forget it. But since they are one of several inventions that may sink this city, and maybe the country, into a new era of penury and thrift, if not downright depression, let’s have a go: a credit-default swap is a financial contract between one party and another which protects against a default on a debt. The trick on Wall Street has been to negotiate and trade them like crazy; there are sixty-two trillion dollars in credit-default swaps outstanding. The question of their worth has mystified even the druids who created them, especially because, it turns out, the swaps haven’t really insured against anything. They are like Wiz bucks, in a world without the Wiz (which is essentially the one we live in, by the way—the electronics chain tanked in 2003).

Truly scary. 

It struck me, as I tried to post on all this, and read the above, that this is exactly what Nassim Nicholas Taleb was dealing with in his brilliant book The Black Swan. I posted about that book here just a couple of months ago, in a post more related to business ethics, but its main thesis is that our intellect fails to deal with the random events. We seek to explain them, but of course after the fact, because we didn’t predict them. So I searched for mentions of that book and the black swam phenomenon this week, and came up with James Quinn’s economic analysis on Spero News. He’s keying on the Black Swan, and quotes this chilling excerpt from the book: 

“Globalization creates interlocking fragility, while reducing volatility and giving the appearance of stability. In other words it creates devastating Black Swans. We have never lived before under the threat of a global collapse. Financial Institutions have been merging into a smaller number of very large banks. Almost all banks are interrelated. So the financial ecology is swelling into gigantic, incestuous, bureaucratic banks – when one fails, they all fall.

"The increased concentration among banks seems to have the effect of making financial crisis less likely, but when they happen they are more global in scale and hit us very hard. We have moved from a diversified ecology of small banks, with varied lending policies, to a more homogeneous framework of firms that all resemble one another. True, we now have fewer failures, but when they occur ….I shiver at the thought.”

That was Nassim Nicholas Taleb in the book. Two years later, we have that on our doorstep. Or so it seems. And, for better or worse, if that’s what it is then it would follow that we didn’t predict it, don’t know when it will stop, and don’t know what caused it. Gulp. James Quinn says:

The same people who never saw this crisis coming certainly can not be trusted to tell us when it will subside. Our political and financial "leaders" have absolutely no credibility left at this point. No one in government or in the financial community can be trusted to tell the truth at this point, and our financial system needs trust to function. The greed and phenomenally excessive risk-taking by these “Masters of the Universe” at our prestigious financial institutions, and regulators asleep at the switch, led to possibly of the greatest financial collapse in history. Our worldwide system of finance is on the brink of imploding. 

The world is in the midst of a Black Swan event. People who fail to recognize what is happening, or deny that it is happening, will suffer catastrophic consequences. Nassim Nicholas Taleb, in his brilliant irreverent book The Black Swan, published in 2007, contends that the world only changes during these events. According to Taleb a Black Swan event has three attributes: (1) It is an outlier, as it lies outside the realm of regular expectations, because nothing in the past can convincingly point to its possibility. (2) It carries an extreme impact. (3) In spite of its outlier status, human nature makes us concoct explanations for its occurrence after the fact, making it explainable and predictable.

So, business planning in times of financial crisis? Wait until the dust settles? 

Late addition: this was added a few hours after the original post: Another good discussion at Avalanche Conditions Still in Effect. Almost the opposite of the Black Swan.

One thought on “Financial Crisis: What Happened?

  1. The New Yorker might make credit default swaps sound mysterious and unknowable, but they're actually pretty straightforward:

    The seller assumes responsibility in the event of default, making the security a more attractive purchase for the buyer.

    That's it. The effects may be scary or chilling or whatever, and certainly the relationships are very complex, but it's a stretch to characterize the concept itself as some kind of financial voodoo beyond the ken of mere mortals.

    There are other bits of financial weirdness out there which may warrant that type of treatment, but I would distrust the opinion of anybody who tries to paint a CDS as the product of conniving "druids".

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