The fear of looking stupid: how we got into this mess

Dear Eric

If you want to do the astrology, I think this whole financial meltdown was born in (around) 1983 when the Interest Rate Swap Market started and all the rules changed.
The 1981 IBM PC. So familiar; so old. So confusing if you still had a quill pen and blotter. Photo stolen from the personal collection of Bill Gates.

This is a market where you hold onto the capital or bond you borrow or issue and swap the interest payments with someone else.

You had to find someone with an opposite view. If you thought long term rates would be higher than short term rates then you received the fixed long term and paid the floating short term. If you thought short term rates would rise you did the opposite.

The interest payments are considered off balance sheet so you are effectively hiding what interest you are paying.

They also opened the global market so that no-one would know where your responsibilities lay. This became more complicated when two currencies became involved and restrictions were lifted.

These deals required a new breed of banker, one who knew how to manipulate through the computer. This divorced those who had developed an awareness for risk over many years. These people also found it very difficult to admit that they didn’t understand the new products… a process which has continued to the present day.

Computers allowed the new products to get more and more complicated and the understanding of what the dealer was actually doing moved from fact to a kind of fantasy. The amounts involved in these transactions (although nominal) soon outstripped the amount of money in the entire world (since the money actually moving was only interest).

Every year the boss of the section would hand out bonuses and set the amount each dealer and salesperson had to make in the following year. Every year that amount got larger and, as interest rates fell and the spreads (difference between bid and offer) got narrower, the amount you had to trade had to get larger or you had to face being told you were rubbish.

New ideas came along all the time and, once again, the problem of personal humiliation of admitting ‘I don’t understand’ reared its ugly head. The computer geeks were so far removed from what they were actually doing, and making so much money for their institution (supposedly… you can only price something when someone is willing to buy it from you… otherwise it is worth a big fat zero!), that those who might have asked the right questions were effectively silenced by the threat of redundancy.

Then, in 2000 a new idea came along. Debt and insurance against it was played with. It’s cyclical you see. Every new idea is born and makes money, then it becomes mature and makes less money so a new idea has to take its place. It is this that has brought about the present problems. Like a stack of dominos, the toxic housing loans have brought down far more. The computer geeks favourite mantra of ‘It’ll never happen’ has!

How do I know all this. Well I worked in the markets from 1980 and watched it happen. I was eventually made redundant in 2003 and now write.

I saw the bright light of common sense stifled by those who relied on a machine to tell the truth and who sneered at those who tried hard to understand and warn about the possible Armageddon to come.

I think it will get better for us all. It’s like going to have a tooth out. Its terrible before and during but soon the place heals and perhaps a new dawn is breaking. The only problem I can foresee is that the lessons haven’t been learnt and the financial markets will try to return to the recent past. It will take a lot of re-education and humility to admit ‘they didn’t understand’!

Best regards,

Heather