Stock market terror

2008-10-03 12:34

Alistair Fairweather

Amid all the hand wringing and finger pointing of the current financial crisis, it's interesting that no one blamed the technology yet. Usually our machines are the first to be cornered as the culprits - poor defenseless brutes. "Pilot error? Poppyock! The plane was clearly defective."

You might think this is because technology has little to do with the real work on Wallstreet. We've all seen those iconic pictures of mobs of sweaty traders clutching pieces of paper and shouting orders for arcane things like pork bellies and junk bonds.

In reality, like the porn industry, finance has always been at the vanguard of shiny new machinery (Ferraris included). One of the first uses of the telegraph, for instance, was to transmit stock prices between the world's major markets (presumably straight after the first telegraph sex chat line).

More than a decade before the World Wide Web was born, financial professionals around the world were getting up to the minute data on all the market indicators they needed via networks of dedicated terminals.

And they continue to lead the charge with tech like biometric security (that's "fingerprint scanning" in English) and artificial intelligence to aid snappy decision making.

So the question is, if the finance fundis have all this kit, why didn't they see this monumental meltdown coming? The simple answer is - they didn't want to.

Regulated and centralised

Most assets traded by financial firms are regulated and centralised into exchanges which act as clearing houses. The New York Stock Exchange is a famous example, and as its name implies it's a place to buy and sell the "stock" of companies.

The advantages of such exchanges are obvious - they are transparent, central, trusted, regulated - everyone knows the rules and (normally) plays by them. This means that changes in the market are seen immediately and dealt with quickly.

But during booms the rules reign in financial barracudas, forcing them to keep cash aside for rainy days when they would rather be betting it all on skyrocketing markets. This is healthy - it prevents dangerous bubbles (at least in theory).

The problem is that wily bean counters always find ways around the rules. The latest trick - the one that got us all into this mess - is to package up homeloans into complex bundles called "securities" which can then be traded like you would shares or currency.

This had two effects. Firstly, the original lenders get rid of the risk they would normally have to carry, neatly sidestepping one set of rules and allowing them to gaily go and lend some more.

Secondly, it created a huge off-exchange (over-the-counter) market for these wandering home loan bundles. Nestling in a comfy regulatory crevice, this market grew into a trillion dollar affair, full of exotic loans with insanely complex structures, with prices that were part guesswork and part maths PhD.

Technology helps

And the banks and hedge funds liked it this way. Without annoying centralisation, they could buy and sell their Franken-loans for whatever prices they chose. Without transparency their shareholders didn't have to get all nervous about the trillion dollar bets they were making.

But that comfortable opacity has come back to haunt heavy hitters like Bear Stearns and Lehmann Brothers. When the housing market in the USA - the bedrock and engine of all these loans - started to go South, no one could be sure whether the bundles they owned were actually worth anything anymore.

Were an exchange in place, financial houses would at least have a central place to compare prices, and us non-finance schlubs would have had a better chance of seeing this coming. An exchange wouldn't have prevented this crisis - but the lack of one has certainly deepened it.

Case in point: the US Senate first refused to approve a vital bail $700bn out package for the sector. One of the main reasons? There's no way of telling the actual price of the assets they are buying.

So, as is so often the case, it's not technology at fault but human error. Servicing planes is a costly business, but crashes are even more costly. After all technology can only help us if we let it.

Send your comments to Alistair.

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