Much Reviled Financial Innovation

One of the stories of the past couple months has been the dissection of the financial instruments that fueled the boom and bust of the mortgage market. I want to add my two cents on the roots of the problem. Because it is not in the instruments themselves. It’s in how they were used. These kinds of financial transactions will not go away but they will hopefully be used more efficiently in the future.

There are countless sources on this subject but two good background pieces can be found here in Portfolio magazine and here in the Wall Street Journal. The Portfolio article examines the roots of the credit derivatives markets at J..P. Morgan in the 1990′s. It gives some good background on how securitization and credit derivatives were combined to fuel an enormous boom in the financial markets. It includes a timeline entitled “Death by Derivative” outlining the evolution of the market over the past couple decades.

This particular article from the Wall Street Journal examines one specific case where these instruments led to serious problems through the failure of AIG’s risk models. It explains how AIG came to over-rely on computer risk models designed by a finance professor from Yale and includes one of the many warnings given by Warren Buffett in recent years, “All I can say is, beware of geeks…bearing formulas.”

I am not here to defend what happened. Just to tell you that the problem is not in the technology. This kind of instrument is inevitable given the advancement of computer technologies.

The first half of my career was spent in high-risk lending. I received my bachelors degree in 1981, the year that IBM released the first personal computers. I went straight to business school and, after a brief stint teaching in a business school in Latin America, ended up in banking. I was a mid-level banker at Citicorp working in the LBO boom of the 1980′s which was also fueled by technology: the invention of the spreadsheet. Bankers at my level were the ones staying up until all hours running multiple sets of projections to justify ever higher bids on public companies by private investors. It was a lesson to me.

We would work for days on our spreadsheets. In those days, you had to hit a “calc” button in Lotus 123 and go get a cup of coffee while the screen pulsed and the program recalculated the model based on changes you had entered. After careful analysis, we would settle on a value (and the amount that we would lend) and go through an elaborate process to get our loan amount approved. Often, a week later, the investor would come back to us, needing to raise his bid and we would find places where we could adjust the model and get a higher value.

There was great faith in these models. They were important forms of analysis. But, most of the time, they were tempered by the experience and good sense of a large team of bankers expert in different aspects of the company, its industry and the credit markets that would need to step up to make the deal happen. If you ask me my greatest lessons from that experience, it would be an appreciation for the power of numbers, a healthy skepticism of the “objectivity” of numbers and an understanding that human weaknesses that were so well described in Greek tragedies thousands of years ago (greed and pride chief among them) still drove most business deals.

The LBO business boomed through the end of the 1980′s but by 1990, there was a bust in the market and a recession overall. LBO’s and their investors were demonized for dismantling the heart of industrial America. It was not that different from the tone of the many articles today, blaming securitizations and derivatives for the fall of our financial system. These two situations have a lot in common–both booms ended based on the same greed, pride and arrogance that caused what, in retrospect, was a correction in the market. Financial technologies played a role in both busts but are far from being the sole cause.

The LBO business didn’t go away. It actually rebranded itself as “private equity” and has continued to boom. The “technology” of LBO’s is better controlled today and operates as an accepted part of our economy. The same will happen with securitizations and derivatives.