Tuesday, March 11, 2008

The Terrifying Complexity Of The Credit Markets

I am no expert in macro economic trends. I am an entrepreneur, and if anything a computer scientist. But I have been worried about the economy and have taken some time to really try to understand what is going on. And after reading a fair amount about it, I worry we are headed for a true world wide economic crisis that many are underestimating.

The reason, as far as I can tell, is too much complexity. It reminds me of the Y2K problem. When we were approaching the millennium we realized we had all of this code, much of it in COBOL, a dead language, and much of it compiled and in unreadable object code instead of human readable and changeable source code.

We spent billions of dollars modifying and upgrading code, still with no certainty that we were fixing the problem. Confidence only returned on January 1, 2000, when planes didn't fall from the sky and trading systems didn't grind to a halt, generators didn't stop running, etc.

The essence of the problem was complexity and opacity leading to great fear. We had a sense that things that we used to count on before January 1, 2000, we would not be able to count on after January 1, 2000, perhaps costing untold amounts of money and potentially lives.

The same thing is happening in credit markets. We have "bugs" in these markets which we can't understand or predict. but unlike with the Y2K problem, we have no January 1 witching hour to define the endpoint.

If you want to read in more detail about what is going on, you can read this commentary and this commentary by Paul Krugman, and this other New York Times piece. Each piece relates to a different aspect of a core crisis in confidence in different but related credit markets. In summary, the problem is that Wall Street has been just a bit too smart. They have created financial instruments either containing, or dependent on, opaque bundled loan packages that now no one understands. They are called mortgage backed securities, and they have been sliced and diced across multiple owners and so now not only do we not understand them, we don't even know who really owns what.

Even worse, other credit instruments that are not mortgage backed have insurance that is supposed to guarantee their solvency. But since people now don't trust the insurers ability to pay they don't trust the insured instrument. All these securities, of now questionable value, then sit on a broad range of corporate balance sheets in the form of direct investments, and in the form of equity in other companies that hold them. Banks in particular have proven themselves either unwilling, or unable to accurately indicated their financial exposure.

As a result, no one has confidence in anyone else's balance sheet. Companies that are or should be considered AAA credit are having a harder time getting credit, and in some cases can't.

This is profound.

The capital markets are based, in large part, on the ability for us to be able to trust what balance sheets say. We have complex accounting rules and disclosure rules, particularly after Sarbanes-Oxley, that are designed to maximize our ability to trust what we are reading. And while nothing is ever anywhere near certain, the ability for major blue chip companies to sustain losses that we cannot predict based on the drop in assets that *seemed* solid is scary.

My main concern is that there is no specific time we can look forward to when this will go away. There is no clear tick of the clock that will signal the end of the crisis. I am not saying it won't ultimately be resolved, but I am saying, as far as I can tell, this is not, as some people say, a cyclical recession. It is a systemic problem manifesting itself as an economic downturn. And if the system is broken, letting time pass may not be enough.

Again, I am no economist, but to me, this feels more serious than most people are really giving it credit for. And while I don't think this crisis will impact the tech market in the same way that the 2001 bubble burst did, I still worry. We can also be thankful that our markets are getting more and more global which should have the effect of attenuating the damage here in the US. But all that said, I do believe this is a crisis of major proportion, and I am scared. I'm scared for all of us.


  1. Yup. This is one of the lesser-known "secrets" of Wall St, and economics in general. Although over the long-term markets are rational, in the short-term they're incredibly irrational, and completely driven by the human emotions of greed and fear. Having worked at, and studied, Wall St. for as long as I have, I've grown to understand this well.

    When it really comes down to it, much of the stability of the market, and the economy, really comes down to just a simple matter of whether people have confidence in it! When that confidence is shaken, as it is now, or as it was on "Black Monday", back in 1987, valuations of everything are thrown into question.

    The good news, though, is that the flip side also holds true. What it finally takes to restore confidence, and thus the valuations of the market, is for one or more leaders to make a stand, slap down some big symbolic investments, and say "I'm not scared anymore; I believe that this investment and the economy has value in it".

    That's eventually what snapped the Black Monday stock market nosedive - big buyers coming in as a show of confidence. That's what solved the Long Term Capital crisis too - Alan Greenspan getting all the major Wall St. company heads together to agree as a unit that for everyone's benefit (and the greater economy's benefit) they were going to keep LTCM afloat until it could liquidate its positions at reasonable values, rather than fighting over the pitiful values each of them would have been able to scavenge from its carcass.

    And that's what will (eventually) happen here as well. Someone will put their money down and say, "I don't believe that everything is worthless, and I'm going to buy down here where it's low and make a killing. Who's with me?" Indeed, someone's already made one effort towards that:


    It may take more time (and more help from the Fed) before others join in - and it may even take some time after someone does that for the fear to go away. But it will. Markets don't stay down forever. After a while things get so cheap that the greed emotion kicks in again, and the cycle turns up again.

  2. And here's today's news:

    "The U.S. Federal Reserve and other central banks on Tuesday teamed up to get hundreds of billions in fresh funds to cash-starved credit markets ..."


    Basically, if the Fed keeps showing confidence by be willing to lend, extend guarantees, etc. - and cutting interbank rates low enough that big banks can't help but make money off the borrowing/lending spread - then the economy will eventually kick-start.


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