Fool’s Gold

I’ve been reading Fool’s Gold by Gillian Tett – about how the financial crisis had its roots in credit derivatives. Up till now, I had understood the technical reasons for the financial crisis (helped very much by this awesome video) but I never really understood the real, underlying reasons of why Wall Street did what they did to cause this financial catastrophe.

I’ve read about half the book so far, and I’ve come to a revelation: It wasn’t that bankers were evil and downright greedy (although greed certainly played a part) – the financial crisis happened because there was a problem with the underlying structure of the entire finance system.

1) Investors gave demand for these exotic products because they craved higher and higher returns.

2) The Basel requirements and Fed regulation motivated banks to create derivatives in order to create loopholes – simply in order to stay competitive. Pure, simple, market forces – often upheld as the most efficient solution – turned out to be part of the problem.

3) Banks were driven to innovate and lobby to repeal the Glass-Stegal act – driven partly by profits, but also because they truly, zealously believed that regulation was the ideological enemy of free-market economics. That was also the common sentiment during the liberal Clinton era, and not just of Wall Sreet.

4) Even efforts to control the perversion of innovation contributed to the crisis. Models created to measure and mitigate risk became the industry standard. This would ordinarily be a good thing, but it created a homogeneous situation – all the boats became the same, so they all capsized the same way.

5) The structure of incentives for ratings agencies was just screwed up. They also provided too easy a system for investors to understand the exotic instruments – so easy that no one bothered to do their own research.

6) Risk couldnt be evaluated because good data just wasn’t available since the products were so new. Hence, risk – as an objective, quantifiable number, could not be accurately measured. And here was an important lesson for me – that models were only as good as the data that was fed into them. Models were simply guides, but we take them way to seriously sometimes. As a person who uses models extensively to model past data, I need to remember that the future doesn’t always follow past history.

In some perverse way, I’m actually grateful to be an economics student and live through such a fascinating time to study. It seems almost inevitable that we should be in this mess… how everything, everything was set up so perfectly for it to occur.

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