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The complexity problem

rbertrubin.JPG

Earlier in the crisis, the line was that "too big to fail" was too big to exist. I'm coming around to an altogether more radical view: What if "too complex to understand" is too complex to exist?

Listen to Robert Rubin -- the former co-chairman of Goldman Sachs, celebrated secretary of the treasury and director of Citibank -- tell the Financial Crisis Inquiry Commission that "All of us in the industry failed to see the potential for this serious crisis. We failed to see the multiple factors at work.” Listen to Alan Greenspan -- former Federal Reserve chairman, holder of the nickname "The Oracle" -- say that we need regulations that kick in "without relying on the ability of a fallible human regulator to predict a coming crisis."

If you're an investment bank, the stock market has become a bit of a bummer. It's so transparent and user-friendly that there's really no place for a middleman to make major profits. That's normal: Efficient markets reduce margins. To put it another way: It's hard to make money doing simple things in a competitive market unless you have a monopoly. But Wall Street has leveraged incredible levels of complexity into something that's more like a monopoly than a market.

The really neat trick was that this worked even after the market crashed. Because no one could understand it, the people who crashed the place were also given a major role in the rescue effort. And that wasn't just true at the top level. Think back to the AIG employees threatening to quit and make it (theoretically) impossible to unwind the company's financial products division if they didn't get their retention bonuses. Their retention bonuses!

It would be one thing if this complexity had done great things for the country. But not so much, as we all know. Some innovations (pdf) have been good. But the opaque complexity that gave rise to credit default swaps and collateralized debt obligations and risk profiles that no one understood turned out to be almost unimaginably bad. Complexity helped bankers bully ratings agencies and regulators into signing off on products they didn't understand, it helped mortgage lenders entice consumers into contracts that they couldn't fulfill, and it's now helping Wall Street beat back necessary regulations because Congress is nervous about mucking with an industry they don't really grasp. And beyond all that, the complexity that allowed Wall Street to become a more profitable and significant segment of the economy also sucked talent away from other sectors.

How does this translate into regulation? I'm not really sure. It's not like there's a standard measure of unnecessary complexity or useless opacity. But watching these Wall Street titans tell the FCIC that they didn't understand what the banks were doing is making me a lot less sympathetic when their lobbyists tell Congress that Washington simply doesn't understand what the banks are doing.

Photo credit: J. Scott Applewhite/AP.

By Ezra Klein  |  April 8, 2010; 5:07 PM ET
Categories:  Financial Crisis , Financial Regulation  
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Comments

Restricting complexity ultimately translates into restricting interconnectedness.

Fundamental properties of structures in computer science and mathematics called graphs* show that at a certain level of interconnectedness, the corporate graph will show cyclical dependencies that are fairly intractable in terms of answering the questions we want to ask.

Compound this with the fact that you'll only be aware of a subset of the data structure at any time, and any densely interconnected financial system will be "too complex to understand".

*Note, this is very different from a plot or your common bar graph,

Posted by: zosima | April 8, 2010 5:35 PM | Report abuse

Ezra: I hope you do follow the TED conference and their videos. Two key speakers talks about the need to reduce complexity whether it's legal or societal.

http://www.ted.com/talks/alan_siegel_let_s_simplify_legal_jargon.html

http://www.ted.com/talks/barry_schwartz_on_our_loss_of_wisdom.html

Posted by: AD1971 | April 8, 2010 5:48 PM | Report abuse

From reading Michael Lewis it is clear that the subprime/CDO/CDS stuff was really complex--so much so that one had to have Asperger's and spend 6 months at it to understand it. It was way, way too complex, and deliberately so. Moreover, the Rubins and Princes didn't ask someone to explain the products to them. There were people in their firms who understood the level of risk, or at least how the products worked. In addition, there were people gaming the ratings agencies who knew that the towers of mortgages and derivatives were largely sh*tpiles. But no one wanted to upset the applecart, and the people with responsibility never wanted to inquire very far.

So what did Rubin do to warrant his $20 million? Provide access? Cachet? He ought to give most of it back.

Greenspan also won ;t acknowledge the role that low interest rates played in (1) fueling the housing boom and (2) encouraging savers/investors to look for higher yields in products like CDOs.

If we want to encourage genuine savings, higher yields were needed, and it would have provided a margin for easing when things went bad. Now, of course, we need low rates. But still. It is a hell of an environment for savers.

Posted by: Mimikatz | April 8, 2010 6:05 PM | Report abuse

This combined size and complexity is not manageable or controllable in a democracy.

We face very hard choices that we are not socially/politically prepared to make.

There are many aspects that need radical redos:
- numbers and types of biz's that financial firms are allowed to participate in
- max. size of a organization allowed before a anti-trust/anti-complexity trigger is hit that results in breakup into smaller pieces.
- regulators that are tailored to various segments of biz that are created after monoliths are outlawed.
- no financial innovation that isn't fully studied and pre-prescribed remedies are enacted to automatically kick in when inevitably things go awry in one of the newly arranged segments/sectors.

It is almost a fool's errand to think about this, since the beast controls the keeper in multiple ways. We haven't and won't learn from our mistakes. Denial is the order of the day. A return to democratic control of our society is probably now impossible.

Learn to love your financial masters, because they are now your destiny.

Posted by: JimPortlandOR | April 8, 2010 7:01 PM | Report abuse

The key to regulation is to make CONSUMER PROTECTION paramount. If rules are made with consumer protection in mind AT ALL LEVELS then it will eliminate most of the cheats frauds and loan sharks.

Especially if we take a broad definition of consumer protection to include pension funds and 401Ks. Protecting consumers by cracking down on loan sharks would have prevented the housing bubble.

Trying to regulate the banksters directly is unlikely to work. What can work is to protect small investors and the types of products that can be marketed. The cost of regulation will be small compared to the huge inefficiencies created by the cheats frauds and loan sharks.

Posted by: bakho | April 8, 2010 8:01 PM | Report abuse

I always though we should just make it a criminal offense to lose $X billion when you can't cover it with assets. Financial meltdowns causes much more societal damage than any particular single criminal act from drug use to trespassing to murder.

You designate a CEO and/or CFO or whoever to be responsible. If the losses include contracts made under a previous CEO, you include him or her.

This is effectively a leverage ratio of 1, but only coming into place when you leverage near the limit. Say, X = $50 billion dollars. I can leverage $4 billion in assets at 13:1 and still make it under the "cap" if it goes bad (4 x 13 - 4 = 48).

But I can only leverage $10 billion at just under 5:1, or else risk 20 years in prison.

But the best part is that no one has to calculate it until after the fact if it goes bad and it motivates people to get it right in the first place. The creditors will act as the police and bring it to everyone's attention because they are making the claims.

Not that I've worked out every aspect of this. You can mitigate sentences for bad luck or duped CEOs.

We used to throw people in jail for debts but got rid of it because it was inhumane for the poor. They can't leverage assets however, so they would just go bankrupt before they reached the limit.

I don't think debtors prison is inhumane for rich CEOs, though.

Posted by: JasonFromSeattle | April 8, 2010 8:20 PM | Report abuse

RobRub?

Posted by: pj_camp | April 8, 2010 8:56 PM | Report abuse

Ezra, you should really sit down with Yves Smith's ECONned: it's a much better book than the new Michael Lewis. It's not about the people, but the phenomena... It wasn't just the "complexity," but the failure to understand the vulnerability implicit in fragile assumptions; e.g., diversified portfolios don't REALLY limit risk if players need to sell fast and need to sell both stocks and bonds (both will plummet). She also goes into the naive acceptance of a Friedman principle (if the model works, who cares if the assumptions are wrong?), because there comes a point when you get outside the relevant range, and the envelope actually pops.

Posted by: franklynch2 | April 9, 2010 7:45 AM | Report abuse

If you want to limit the complexity of financial instruments, it can be done. Essentially, these instruments are just algorithms for determining who will get paid how much under what circumstances, and we know how to measure the complexity of algorithms. In fact, any instrument these days should come with the associated code so that anyone can run it against a bunch of assumptions and see what happens. Failure to supply code or supplying code that doesn't match what the instrument actually does would be fraud.

Posted by: paul314 | April 9, 2010 10:07 AM | Report abuse

In a topic, a blog post, and comments that are all chock full of bizspeak and jargon, the essential value of simplicity is neither new nor radical; it's philosophical. Our basic behaviors are now less about developing a contemplative understanding of the world than about shrewd manipulation of its artificial systems. Biz gurus often talk about leveraging oneself to become indispensible, which creates perverse incentives to make one's work complex and inscrutable to others. On the short term and for limited purposes, that may work. Writ large, it creates Rube Goldberg-esque systems of extraodinary fragility.

Posted by: Brvtvs | April 9, 2010 12:21 PM | Report abuse

Rubin committed perjury here here.

Rubin , former Partner in Charge of Risk Arbitrage at Goldman Sachs, ordered Citi Bank head trader Thomas G.Maheres to geometrically grow the amount of naked credit default swaps written by that institution to grow cash flow and artificaly inflate earnings ,regardless of the fact that the bank had no capital or collateral to back those derivatives that ultimately collapsed the planets banking system .

A conspiracy theorist { remember that its only a 'theory' unless they actually are out to get you} would say that Rubins {&Paulsons} loyalties were to the Chosen Ones' at Goldman Sachs.

This predatory ORDER was given for 3 reasons;

1) To have a conduit to back all Goldman Sachs and others toxic collateralized debt obligations that Rubin knew were going to implode. Goldman was already setting up shorts for the Greenspan Put.

http://www.associatedcontent.com/article/543223/alan_greenspan_joins_john_paulsons.html

2) to eliminate a Goldman Sachs competitor that the former Secretary of Treasury and Goldman Sachs partner KNEW that the U.S. taxpayer would be forced to bail out because it was the largest financial services company in the world with 300,000 employees.

3) to enhance Rubins own compensation at City Bank as he knew that this would be his own last giant bite at the apple.

Like apples?
How 'bout them apples?

http://www.takeitbackday.org/Takeitback_Page.php

Posted by: bruiserND | April 9, 2010 1:29 PM | Report abuse

Brilliant as usual. I would note a few things.

Investment banks aren't just middlemen. They have huge own accounts. They can make major profits in the stock market -- by buying stock. Middlemen haven't been able to make really major profits, since they were forced to compete in the 70s long before the market became any more user friendly than it had always been.

The stock market definitely isn't efficient. Huge profits are made in the stock market. I mean you know Warren Buffett and all that.

Investment banks didn't browbeat ratings agencies -- they paid the ratings agencies to design securities which the ratings agencies then rated AAA. The corruption was much much more blatant than you imagine.

Personally, I think the ratings agencies/structured finance consultants believed their ratings, but they had a huge massive blatant obvious conflict of interest.

Now as to the regulatory implications, they are simple but radical. There is the argument that tighter regulation is unacceptable because it would prevent innovation. Clearly your view is that this is a feature not a bug. If so the regulatory implication is that everything financial is to be forbidden unless it is specifically allowed (German regulation for finance no English regulation). New financial products are allowed only when regulators are convinced they understand them.

It is easy to block innovation, just say that only the following financial contracts are valid and can be enforced and then list the traditional ones plus set up procedures to evaluate new products (at the expense of the inventors). If new financial instruments were approved the way new pharmaceuticals are approved (must be proven to be safe and effective) there wouldn't be much of a problem. You clearly think this would be a good idea. It would also be a radical proposal.

Posted by: rjw88 | April 9, 2010 4:18 PM | Report abuse

You forgot to mention two additional undesirable side effects of the magic albeit complex potions Wall Street mixes and sells. They are zero-sum instruments that allow purchasers to avoid performing the research they should to assess risk in the securities they purchase. And money spent on such instruments, whether as hedges or bets, is money not invested in growing America's industrial and service base. Enriching Wall Street doesn't count in that regard.

The answer? Dismantle TBTF banks, adopt a new form of Glass-Steagall, prohibit public investment in equity of investment banks and require all instruments to trade in open and transparent markets.

Posted by: jimb-5 | April 10, 2010 1:39 PM | Report abuse

COMPLEXITY IS A FUNDAMENTAL FUNCTION OF EVERY DYNAMICAL SYSTEM. THE FUNCTIONALITY OF SYSTEM IS PROPORTIONAL TO ITS COMPLEXITY. However, the "issue" is the man-made complexity in the form of opacity. This has, undoubtedly, been a major failing in the financial sector! Too much sales and marketing and not enough (reliable) science and math.

Who ever really thought that the work of rating agencies could be objective and that Quants could predict the future (PoD)?

Every system has an upper level of complexity around which the system becomes fragile and unpredictable. The level of complexity MUST be measured, managed and, if necessary, reduced. As, beyond the point of "critical complexity" the system loses functionality and, sooner or later, crashes.

Complexity and opacity are the enemies of simplicity and transparency

Nassim Taleb suggests that we should: "Counter-balance complexity with simplicity" and it is difficult not to agree.

When you consider that a system can be defined many different ways, from our own bodies, to companies, markets, entire eco-systems the scale of the benefits of analysing and managing complexity becomes clear.

I am happy to discuss solutions with parties seeking a (model free) means of preventing the effects of operating in or around the point of critical complexity.

David

Related blog links:
http://davidgwilson.spaces.live.com/blog/cns!7DF3163703347130!1165.entry


http://davidgwilson.spaces.live.com/blog/cns!7DF3163703347130!1217.entry

Posted by: davidlongshanks | April 13, 2010 7:59 PM | Report abuse

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