Causes of the Credit Crash, Part Two: The Humans

In Part One, the fact that the markets are technologically
turbo-charged was discussed.  Today, it's the humans fault as
technology is only doing what the humans tell the systems to do. 

I could talk about SIVs, CDOs, Credit Default Swaps, Hedge Funds and all sorts of other stuff, but I've done that before (see "Department of the Bleedin' Obvious" and "The Less so Obvious" from last September).

But
there's another dimension to add to this.  It's an idea that occured to
me a while ago which I dismissed as being completely wild, but there
may be some mileage in it, so let's see.  And, if true, bearing in mind
yesterday's comment about the machines multiplying any human error
ten-, a hundred-, a thousand-fold, we really do have a problem.

I was looking at this BBC website, and noticed how regular are the booms, busts, crises and crashes in the investment markets :

2008         Societe Generale Kerviel Crisis
2007-08     Credit Crunch
2007          USA Housing Crisis
2002          Enron, Worldcom, Parmalat and Split Cap Investment Trusts Crisis
2000          Dotcom Crash
1998          Long-Term Capital Management (LTCM)
1998          Latin American Financial Crisis
1997          Asian Financial Crisis
1995          Barings Bank Leeson Crash
1994          Japanese Banking Crisis
1990          UK Housing Crisis
1987          Stock Market Crash
1985          US Savings and Loans Crisis

It just goes on and on and on.

And
many of these have related and similar patterns, e.g. Nick Leeson -
Jerome Kerviel, LTCM - Credit Crisis, UK Housing Crisis - USA Housing
Crisis ...

Between each crisis there's about ten or so years.

Every
time the markets have a big sneeze and billions in capital are lost,
the markets and the regulators all buzz around saying it must never
happen again.  Then the markets bounce back and we all start making
money again.

Much of this is well documented in the classic book, "Extraordinary Popular Delusions & the Madness of Crowds", published in 1841.

So here's my theory, to add a modern perspective to this book.

Every
decade or so, a new wave of traders and dealers come into the markets.
Fresh-faced pups, who are ready and raring to go and sell, bet, deal
and make millions. 

They all run around creating new ideas, new
pitches, new product wraps, new technology plays.  They then start
pushing the boundaries of risk, technology, products, markets and
ethics. 

They should be held in check by their management, but
their management see too many of the rewards whilst the risks are
hidden from their prying eyes by these eager, over-achieving,
over-zealous young bucks.

Then it goes wrong. 

A market does the opposite of what's expected.

A
product play is not hedged, because the confidence was soaring and so
none of the inexperienced youngsters expected that to happen.  Risk has
been created, but is not visible due to the technology, product and
service that the pups have built to fuel it, and these pups have not
been exposed to these risks before.

Therefore, we suddenly see
the same thing happening again.  Something that happened 7-10 years
before.  Markets collapse, front and back office blur, booms go bust,
billions are lost and firms collapse.

So we weedle out the culprits and fire them, whilst demoting and side-lining the managers responsible for the mess.

The
market learns its lessons and says that it will never allow XYZ product
and ABC risk to occur ever again.  The regulators are satisfied that
self-regulation can work and the markets stabilise.

Then a new group of young pups come in.

They're eager and hungry. 

They
hear about XYZ products and ABC risks, but there's no issue as they're
not doing XYZ and ABC.  They're doing UVW and DEF.  It's actually the
same product with the same risk, but it's in a different market sector
and is dressed differently, so it doesn't look the same.

The
young pups create a market that fires itself into orbit with
turbo-charged investing and stellar returns.  It's making billions so
management are happy, the young pups are making millions and the
markets have liquidity and alpha unbounded.

No-one listens to the ex-trader who says: "watch out"; the side-lined manager who says: "this looks familiar"; or the demoted disillusioned whinger who says: "you don't want to do that".

They're
just dogmeat from the XYZ and ABC debacle.  They don't understand UVW
and DEF.  They're just jealous of the billions being generated for the
bank, the bonuses being made by the young pups and the millions being
made by their managers.

High-five.

Then the markets repeat
the mistakes of yesteryear.  DEF risk was the same as ABC; it was just
rolling around in disguise.  UVW product was the same as XYZ; just
under a different name.

So the pack of dogs who created DEF and
UVW are kicked out.  Their managers are demoted, deposed or departed.
A few firms collapse and a few billions are lost.

The market
learns its lessons and says that it will never allow UVW or XYZ product
and ABC and DEF risks to occur ever again.  The regulators are
satisfied that self-regulation can work and the markets stabilise.

Then a new group of young pups come in.

They're
eager and hungry.  They hear about UVW, XYZ, ABC and DEF, but there's
no issue there.  They're doing RST product and GHI risk ...