A great American financial crisis - Emperor's new cloth!

A friend of mine asked me to explain the reason behind the current American financial crisis. This post is an attempt at it.

Non controversial and simple explanation: Banks and Financial institutions that are part of this crisis (most of American Banks/Financial institutions) had lots of debts to pay and they did not have enough money to pay :-) That's it!

Reason is simple, but the real difficult question is, how did the Banks and Financial institution get into this messy situation?! Especially if one considers the following facts.

1) These institutions attracted the brightest people
2) Offered highest remuneration
3) Had all the support of government and policy makers (remember we're living in a relative world)
4) No major world disasters, no world war, no calamities, no terrorism (9/11)
5) These institution did not do illegal practice, no frauds, no drug trafficking, arms trade etc. As per books they all had fair business practice
6) World economies were booming until the point of failure.

Then how come this sudden heart attack?!

Well, the last word has the key - "heart attack" affects the 'over' healthy- obese people rather than people who are starved.

Now moving towards analyzing the cause of this sudden financial heart attack. I believe its because of the following 4 reasons. (Disclaimer: these are not researched opinion just another Sunday afternoon thoughts)

1) Emperor's new cloth
2) 'Messy' complexity : Domino effect
3) Social trap : Nazi concentration camp
4) Too much power in one place: Alavuku minjinaal amudhamum nanju - A Tamil proverb which translates to "Over the limit even nectar becomes a poison"

Diving into more details. I'll be using word 'Bank' to denote = Banks and all financial institutions that includes even the glamorous Investment banks.

1) Emperor's new cloth

During early days of banking, Banks offered simple services e.g safe guarding one's money and then moved on to offer lending (loans) etc.

Even buying was simple, early days if you had money you bought stuff or saved money to buy, however this changed to credit cards and EMIs.

Trends shows new products being invented by Banks to increase their service offering and thus fueling their growth. Note, current corporate culture is focused mainly at growth. This puts huge pressure year on year to grow and the going only gets tough as the size of the company increases. Its easy to grow from 1 to 5 than from 5000 to 25000, both has same percentage (500%) growth.

This natural pressure to grow fuels creation of 'innovative' financial instruments, two such examples are Derivatives and Hedge Funds.

These and many new products were churned out by banks/financial institution. These product were not understood (real risks/benefit) by most people but who wants to be seen as stupid - Just like the Emperor's new cloth.

There are exception - Warren buffet calls derivatives a 'time bomb'

2) 'Messy' complexity: Domino effect

Level 1:

In good old days it would have been easier for the bank branch manager to look into books and sort things out if there were any transaction flaws. Now a top manager in any bank can't help without an army of database administrators, system administrators, business analyst, domain manager and support staff working on to address certain flaws.Technology that drives the systems in these Banks has added to the complexity. It is now beyond a human capability to understand the entire system of even a single bank.

Level 2:

The financial product have became interwoven, repackaged and re-sold to others. No body understands the fundamentals of these products. I'm not denying that there weren't any shady practice like wrong rating by credit firms etc., fact is that I don't know about them so I'm leaving it out of the analysis.

However I'm convinced that even if you put the smartest mind, now, to dig out the risks of these products he/she will do a very poor job. There is just too much inter linking and assumptions.

Level 3:

So much interwoven and complex were these products and services that one event like 'sub prime debacle' had a domino effect that is threating to pull the entire financial system down.

Why the word 'messy'?

Truly complex system are simple to interact e.g the Google search system, you don't need to spend hours and hours to understand how to use Google. However building a Google like search engine is complex. (I tend to give Google as example, only because its an easy example)

3) Social trap: Nazi concentration camp

I've read about the greed of the Wall street people, I would strongly argue against it. Even if you or me were in the place we would have done the same thing because it was considered the smartest and typically a great business sense.

The power of social trap is so strong that even high IQ and highly paid people can be made to do stupid things without their knowledge.

The social trap is also one of the reason for bizarre human behavior like concentration camp, motivating suicide terrorist, Hindu's attack on churches etc

The competition to grow and harness opportunity was a Zero Sum Game that all the banks had to play otherwise they would have supposedly lost business. It was considered normal as everyone were into these kind of products and service.

4) Too much power in one place: Alavuku minjinaal amudhamum nanju - A Tamil proverb which translates to "Over the limit even nectar becomes a poison"

It is easy to make more money with money than anything else and Wall street was the shining example of this. People at Wall street made more money than any hard working researcher, entrepreneur, manufacturer or worker.

The power of Wall street was so huge that CEOs and company's board made short term decision that would please Wall Street.

Folklore has it that Google had avoided going to IPO for long time because of the fear of power of Wall Street on its free decision taking.

The Wall Street was beyond the regulators and could decide fate of many companies. The bankers and financial honchos ruled the engineers, workers, entrepreneurs, creators and became the heart of the economy.

Concluding remarks:

Real growth will only come by scientific discoveries, technology breakthrough, creation, enriching the culture, Art, building a healthy community and producing clean and green goods and not by manipulating numbers, power point, conferences or networking events.