Inside the Doomsday Machine

Risk comes from not knowing what you’re doing.
– Warren Buffett

This article is about the powerful doomsday machine, which by paradox is the same machine, defined by Adam Smith, that has brought market economies wealth  and high standards of living, and at the same time in the information age risks bringing us into collapse.

Financial systems are important servants of the economy, but poor masters. A large part of the activity of the financial sector seems to be a machine to transfer income and wealth from outsiders to insiders, while increasing the fragility of the economy as a whole.

The growth paradigm

Today’s modern economies depends on growth. The lack of growth in a market economy inevitably leads to stagnation and decline. Growth is necessary, as production capital is worn down over time and needs to be replaced, and upgraded by innovations. The challenge for the future is to make that growth in the knowledge economy and avoid destruction of environment, but that is a topic of other blog posts.

In the market economy, businesses get most of the capital they need from investors. In an open, decentralised and free economy, the financial markets are the place where companies seeking financing meet people and organisations with surplus funds. However it is not efficient for larger companies and investors to seek direct investment relationships. Therefore most major companies list on the stock market, where they can make new share issues and get capital from larger numbers of investors.

The financial markets are the links between large-scale economic projects and the investment community. Nowadays, everything takes place on a global scale. Companies obtain the funding to finance their plans, while professional and individual investors find uses for their money, earning increased value or interest rate in return.

The financial markets are the engines that drives the entire economic system. It is where the system draws its strength and where its key players find the most appropriate solutions for their needs. However the system has inherent flaws and that is the topic of this blog post, as illustrated by the books of Michael Lewis.

Calculated risk

In 1989 as I studied financial economics at the Stockholm School of Economics, I also read more popular literature about the financial markets. I had been working in the midst of the floor traded stock market for several years in parallel to my studies and it was entertaining to read the legends.

After all, it was the end of the decade of capitalism. The Reagan era, the yuppie era. The feeling at the time can be illustrated by the election campaign poster on the right, which was published by the left wing (!) Swedish Social Democratic party in 1985.

One book I read that made a strong impression on me was Michael Lewis Liar´s Poker. It was an autobiographical book describing the author’s experiences as a bond salesman on Wall Street. The book is today considered one of the books that defined Wall Street during the 1980s, where Lewis portrays an era where government deregulation, although necessary as it was in an over-regulated and petrified  economy, allowed less-than-scrupulous people on Wall Street to take advantage of others’ ignorance, and grow extremely wealthy.

There’s a moment in the beginning of the book when a spectacular bet is made. The wealthy chairman of Salomon Brothers, John Gutfreund, pulls aside his mortgage bond chief trader and challenges him to a game of Liar’s Poker, a complex game of bluffing.

Gutfreund quietly whispers to the trader, John Meriwether, who would later go on to start Long Term Capital Management, "One hand, one million dollars, no tears." That outlandish sum of money could then be won or lost in one single bet. To play this game was a lose-lose situation, and Meriwether knew it. Yet he also knew he couldn’t back down and lose face. What to do?

Being a gambler with strong nerves, Meriwether returned, "No, John, if we’re going to play for those kind of numbers, I’d rather play for real money. Ten million dollars. No tears." He was gambling that Gutfreund could not stomach the risk, despite the chairman’s deep pockets, and he was right. Gutfreund declined, calling Meriwether "crazy".

In that moment, Michael Lewis distilled the ethos of the financial markets in the 1980s.

The traders were often compulsive gamblers with absurdly quick minds. It was all about making acceptable risks, and in this case Meriwether took the risk before the game was ever played. Such skills made men very wealthy in the in 1980s while trading that most lowly of securities, the mortgage bond.

That era collapsed on the black Monday, October 19, 1987, when the stock markets around the world collapsed, shedding a huge value in a very short time. The crash began in Hong Kong and spread west to Europe, hitting the United States after other markets had already declined significantly. The cause seemed to be the preceding collapse of the US and European bond markets, which caused interest-sensitive stock markets to plunge as well.

I experienced the day in the students trading room of the Stockholm School of Economics, where we had a Reuters monitor showing the falling prices of securities and derivatives in the Swedish markets. I remember the feeling, the prices just fell and kept on falling.

Following the stock market crash, a group of economists met in Washington, D.C. in December 1987, and collectively predicted that “the next few years could be the most troubled since the 1930s”. Luckily the worlds central banks managed to contain the contraction and the world economy recovered, building up to the next bubble.

The new economy

The next book I read by Lewis was published in 2000. It was called The New New Thing – A Silicon Valley Story and I found it fascinating. It is a splendid, entirely satisfying book, intelligent and funny and revealing and troubling, all in one blend and at the same time resolutely sceptical but not at all cynical, full of fabulous scenes and sharp analysis.

It was the time of the internet boom and in the absurd glow of the dying millennium, Lewis set out on a safari through Silicon Valley to find the world’s most important technology entrepreneur, the man who embodied the spirit of the coming age. He found him in Jim Clark, who was about to create his third billion-dollar company. He had first started Silicon Graphics in 1982, then Netscape in 1994, which launched the Information Age, and at the time of the book, he had started Healtheon, intended to reform American health care.

I saw Jim Clark in real life once. I was having dinner outdoors at the Quai des Artistes in Port Hercule of Monaco with some friends a late summer evening. It was starting to get dark. At the main water breaker was a small cruise ship.

Suddenly we say an incredibly tall mast appear behind the ship. It was moving fast and in through the entrance of the harbour came Hyperion, Jim Clarks huge yacht. It came into the port and then moved sideways towards the quay to park. The crew where all young women in uniform. A limousine came up to the spot, luggage was carried to the limo and then Jim Clark, dressed in jeans, disembarked and walked up to the limo and was driven off.

It was a quite entertaining sight and it was a hallmark of the excess of the dot-com era.

At the time of launch, all systems aboard the yacht including engines and sailing systems, environmental systems, lighting, HVAC and entertainment were controlled by a network of 30 customized Silicon Graphics computers and 22 LCD touch screens at various locations throughout the yacht. In the book it was told that the yacht could be completely controlled by remote from Jim Clarks laptop.

The book was written before the dot-com collapse, but what it portrayed was an era of a new economic bubble, the Internet bubble, covering 1997–2000 with a climax on March 10, 2000 when the NASDAQ peaked at 5408.60. The collapse of the bubble started during 2000 with the bubble deflating at full speed in the spring 2001.

Some internet companies failed completely. Others lost a large portion of their market capitalisation but remained stable and profitable, e.g., Cisco, whose stock declined by 86%. Some later recovered and surpassed their dot-com-bubble peaks, e.g., Amazon.com, whose stock went from 107 to 7 dollars per share, but a decade later exceeded 200. However the stock market crash of 2000–2002 caused the loss of $5 trillion in the market value of companies from March 2000 to October 2002.

The doomsday machine

The next book arrived ten years later, in 2010. It was called The Big Short – Inside the Doomsday Machine and it is a masterful deconstruction of the sub-prime mortgage crisis and its aftermath.

When the crash of the stock market became public knowledge in the fall of 2008, it was already old news. The real crash, the silent crash, had taken place over the previous year, in bizarre feeder markets where the sun does not shine, and the SEC did not dare, or bother, to go.

The silent crash had taken place in the bond and real estate derivative markets where mathematical wizards and geeks had invented impenetrably complex financial instruments to profit from the misery of lower- and middle-class Americans who can not pay their debts.

The book describes not the losers but the other side of the market. It describes several of the key players in the creation of the credit default swap market that sought to bet against the collateralized debt obligation (CDO) bubble and ended up profiting from the financial crisis of 2007–2010. The book’s greatest pleasure is in the experience of seeing the financial world through the eyes of these protagonists, who made their bets against the bubble and became billionaires by doing so.

The book highlights the eccentric nature of the type of people who bets against the market, and by doing so it defines the success of smart individualists in our current time.

The crucial question is this: Who understood the risk inherent in the assumption of ever-rising real estate prices, a risk compounded daily by the creation of those arcane, artificial securities loosely based on piles of doubtful mortgages?

Michael Lewis turns the inquiry on its head to create a fresh, character-driven narrative with indignation and dark humour. Who got it right? he asks. Who saw the real estate market for the black hole it would become, and eventually made billions of dollars from that perception? And what qualities of character made those few persist when their peers and colleagues dismissed them as fearful? Out of this handful of unlikely, really unlikely, “heroes”, Lewis presents a story as compelling and unusual as any of his earlier bestsellers, proving yet again that he is one of the finest and funniest chroniclers of our modern times.

Here, in Lewis story, we have the modern moral dilemma of the doomsday machine.

We know no economic system that works better than the market economy in distributing money for investments in an efficient way, and thus allowing for economic growth. There has always been winners and losers in the markets, however before the modern information age, markets moved slowly, it was possible to get out from bad investments in time and the consequences of bubbles were less severe.

Today major shifts can happen over night or even intra-day, and they go viral across the globe. The wisdom of the few who bets against the market can lead to collapse and release forces that are not possible to contain, even for the responsible actors in the financial system, such as the Central Banks, as we could see with the recent euro crises. 

So what is to be done? In answering this question, one has to start from a recognition of the main risks: first, the high-income countries, with their low underlying rate of economic growth and huge costs of population ageing, cannot possibly afford another crisis, second, the big issue is the impact on the global economy when a bubble bursts.

It is important to keep the financial machine running, as the market economy would not function without it, but it needs to be restricted.

Reducing the risks with the financial doomsday machine is going to involve fundamental changes in policy and structure of the financial system.

Since the sub-prime mortgage crises, the financial regulators and central banks, coordinated by Basel, is trying to make the system far safer, by raising capital and liquidity requirements, moving derivatives on to exchanges and enforcing prudential regulation. In Bearing, we have worked with some of these projects for the big banks.

Will this work? Most likely not. The people who bet against the bubbles are brilliant minds, who cannot resist as there is so much profits to gain, and they will always find new ways.