Dominic Lawson: I blame computers for this crisis

Electronic calculation is not the same as wisdom. Confusing them is dangerous

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So we taxpayers are called upon to provide another £100bn or so (no one quite knows, least of all us) – and the cry goes up once again: who is to blame for the banking crisis?

The most obvious answer is: the bankers themselves. On the day that the Government injects yet more cash into Royal Bank of Scotland's smouldering hulk of a balance sheet, perhaps there is some weird patriotic pride to be had in the fact that Newsweek has ignored all the notable American candidates to name Sir Fred Goodwin, chief executive of RBS from 2000 to October 2008 as "The World's Worst Banker".

There are many other candidates for blame, however. The economists' own favourite villain is the former Federal Reserve Chairman, Alan Greenspan. Actually it's "Sir" Alan Greenspan: Gordon Brown made sure that he got a KBE too, before it dawned that the owlish American was not, after all, the world's wisest life-form.

Then there is the nexus between the property business and politicians – the former having speculated colossally on the latter's belief that there were votes to be had in keeping that market inflating into infinity. These are also good people to kick as you contemplate your ever-diminishing pension.

Yet with all these human targets, there is one often overlooked candidate for blame which is not constructed of carbon (and which will not feel any pain when you kick it). This is the silicon microchip. The astonishing growth in the calculating power of computers is a wonderful thing, enabling us to do things we would never have dreamed of even a decade ago. Electronic calculation, however, is not the same thing as wisdom; and there are great dangers in confusing the one with the other.

Two early books on the financial crisis have made this point well. The first, an American's account, is the Trillion Dollar Meltdown by Charles Morris; the second, written by a British investment analyst called George Cooper, is The Origin of Financial Crises.

Morris points out that we had already had notice of the havoc that could be wrought by computerised trading programs; first, on 19 October 1987, when Wall Street fell by 23 per cent in one day, as earlier movements in share prices triggered massive selling by computers, quite independently of any decisions by humans. It caused all-too-human panic across the globe.

The second warning sign was the collapse of the hedge fund Long Term Capital Management in 1998. LTCM's partners included two Nobel prize-winners, Myron Scholes and Robert Merton, celebrated for their mathematical models for the pricing of financial derivatives. LTCM scoured the market looking for price relationships deemed anomalous by the Nobel Prize winners' algorithms. These quantitative anomalies were tiny, observable in real-time only by computers, so LCTM needed to back its bets with vast sums (which, of course, were borrowed). Yet their models had not factored in the possibility that the Russian government of Boris Yeltsin would default on sovereign debt. They were left with billions in unsaleable futures contracts, and were dead in the water.

Perhaps, if LTCM had been allowed to go under, this would have caused later so-called "quant" investors and "algo-traders" to exercise more caution; but the Fed instantly decided that the financial markets would have become too destabilised, and twisted the arms of the investment banks to take over LTCM's positions. This prepared the way for a much bigger destabilising financial crunch a decade later – only this time there were no investment banks left to lean on, leaving only the taxpayer to do the mucking out.

George Cooper's account of the crisis makes a further point about the problems caused by basing investment decisions on computer programmes; the computer will always come up with a price which even a very damaged derivative should rationally fetch, based on the possibility of some remaining value in a debt gone sour. Yet because humans react emotionally and in a herd-like fashion, they will refuse to assign any value to such "toxic" paper: hence a bank might think there would be a reasonable limit to the downside of risky investments, while, in the real world, when fear takes over from greed, there is no such limit.

There is also the simple fact that computers enabled the bankers to contemplate, with just a mere push of a button, trillions of dollars worth of derivative contracts. Figures which might cause a nervous collapse, when analysed within the human brain, seem soothingly manageable when generated by the click of a mouse: and, of course, there is the usual tendency to think that because it is generated by a computer, it is in some sense "right"– even if the assumptions on which the computer based its calculations were originally fed in by a human who had never spoken to, still less met, the end user of the financial instrument.

This was especially true of the market in so-called "Collaterised Mortgage Obligations" (CMOs). As the former banker Charles Morris notes: "In 1983, modelling the payout scenarios on a comparatively simple three-tranche CMO took a mainframe computer a whole weekend. But by the 1990s, when Sun workstations were standard furniture, CMO shops gleefully turned out phantasmagorical 125-tranche instruments that no one could possibly understand." Least of all, one might add, the pre-computer age senior non-executive directors of the banks, who were the official guardians of shareholders' interests; but which of them were clever enough to say "I don't understand"?

Actually, one old boy was that clever. Six years ago, Warren Buffett, the world's richest private investor, warned that the computer-generated derivatives markets, already "worth" over $85tn (£60tn), harboured "financial weapons of mass destruction".

Buffett's analogy was peculiarly apt. For the mathematical geniuses working on these computer programmes were called "rocket scientists" by their employers. During the Cold War years of the nuclear arms and space races, such "geeks" would more likely have been working at Nasa or the Pentagon, than on the floors of investment banks.

Perhaps it would have been better for all concerned if they had remained happily involved in designing bigger and better weapons systems. That way, no one would have got hurt.

d.lawson@independent.co.uk

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