The First Disaster Of The Internet Age
Sometimes a brief exchange can capture an essential truth better than reams of explanation. That happened recently when a Financial Times reporter suggested to an investment banker that the credit crisis had snuck up on investors and regulators because of how hard people like him made it to get good information. The banker, with evident irritation, pointed out that all the information you needed was widely available. Why should he be blamed if nobody paid attention?
It was an eye-opening comment. Financial mavens have long had access to comprehensive data on credit markets and subprime mortgages. It apparently didn't cross this banker's mind that the average LCD-TV-buying consumer can't afford to shell out $1,700 a month for a Bloomberg. But in a sense, he was right. The information is out there—free, on the Internet.
The Internet has broadly delivered on its promise to bring information to the masses. All the information needed to diagnose the current credit crisis—the latest and best information about the collapsing prices of mortgage securities, ballooning numbers in the subprime mortgage market, bizarre behavior on the part of bond rating firms and so forth—has been freely available to anybody who knows how to use Google. But what good is it all if the data went unnoticed?
For more than a decade the Internet has been hailed as the great democratizer of information. It was supposed to empower individual investors, make murky financial markets more transparent, and create a new generation of citizen investors who were free to put their savings in everything from the S&P 500 to palm oil futures. It was supposed to shrink the world and turn it into a village, where everything happened in the public square and corruption and greed would have no place to hide. As the 1990s mantra goes, "information wants to be free." The 21st century was supposed to be the culmination of this philosophy.
One of the biggest proponents of this view was Alan Greenspan. Most economists now agree that Greenspan, as chairman of the U.S. Federal Reserve, kept interest rates too low for too long. What's less widely appreciated is his role as a technology booster. In March 2000, at the peak of the dotcom bubble, he gave a speech about a revolution being built on the Internet. It was transforming finance, he said, making it possible to "reallocate risk" via the "creation, valuation and exchange of … complex financial products on a global basis." In short, Greenspan saw that the tandem of the Internet and fast computers were perfect for splitting mortgages into tiny pieces, repackaging them and then shunting them to yield-hungry investors across the country and around the world. But he should have known it would create what his fellow economists call an "agency problem": Remote owners of teensy mortgage pieces didn't police loans, didn't worry enough about loan quality, and were impossible to negotiate with should a loan become troubled. They just wanted cash flow. And so the fuse for a future credit crisis was lit.
To be clear, the Internet has done many important and useful things for the world financial system. Earnings calls are available to all comers, not just analysts; electronic trading has driven commissions to near zero; trading can happen wirelessly from anywhere at any time. Investors can track stock picks and stock pickers on Web-based scoreboards. These innovations were long overdue. But by accident, the Internet was also an enabler of the current credit crisis. It brought us together, but it also did the reverse, creating communities with narrow affinities. These are often echo chambers where people can find others like themselves—scrapbook makers or train-spotters or builders of exotic new products for the now $668 trillion (not a misprint) derivatives market.
At the same time, in making information free, the Internet has buried us in data, keeping most people from seeing the building credit storm. Rather than turning the world into a global village of empowered investors, the resulting data fog helped some Wall Street wiseguys hijack the global economy as easily as playing videogames—with instant messages and trillions of dollars in complex derivatives.
The dotcom crash of 2000 and 2001 may have involved Internet stocks, but the underlying cause was old-fashioned "irrational exuberance" (at least Green-span got that one right). It was a kind of adolescence period for the Internet. Now, by contrast, we are in the midst of the first financial crisis of the mature Internet age—a crisis caused in large part by the tightly coupled technologies that now undergird the financial system and our society as a whole.
The fiasco raises important questions about how to regulate financial markets. If information is freely available, does that mean the onus is no longer on Wall Streeters to tell the rest of us what's going on? What role do regulators play in keeping tabs on all these complex financial shenanigans?
The Internet has made it possible for anybody with an online brokerage account and a broadband connection to become a global investor, but with that freedom has come a great responsibility: to know what you're doing without relying on government oversight. And in a world where our ability to trade exotic financial instruments vastly exceeds our ability to understand and value them, that is a very dangerous thing indeed. It behooves us to pause and take a look at the forces that led us here, and what we might do to prevent another occurrence.
The information was out there, and this problem had been building for years, so why did no one notice? Part of the problem is that the relevant data, while available on the Web, is spread around in a zillion places. You can go to Yahoo Finance to check the recent share price of Wal-Mart, its market capitalization and its current sales. There is no one free place where you can do the same thing across subprime mortgages, asset-backed securities, credit swaps and all the other arcana inherent in taking the temperature of modern global markets. Instead, you have to wander from site to site, sort of like building a jigsaw puzzle from disguised pieces strewn around an entire city. It is part treasure hunt and part puzzle-building.
That's not the end of the problems. Information about financial time bombs, like derivatives, is veiled in acronyms that make you want to gouge your eyes out. (Consider two different measures of the performance of mortgage securities: ABX.HE.AA.06-2 and ABX.HE.AA.06-1—such lovely and lyrical names!) There is an entire language required to understand this new generation of financial technologies, from credit default swaps to collateralized debt obligations to residential mortgage-backed securities, not to mention the corresponding three- and four-letter abbreviations. There's also data on current account deficits and yield spreads. Most people, faced with this tsunami of data, do the only rational thing: they give up.
The trouble with giving up, however, is that the world goes on without you. And one of the obligations of being a citizen in a free society is vigilance—watching what is happening in your neighborhood, whether it's financial or physical. A lack of regulatory oversight certainly played a role in the current crisis, but over-relying on regulators is a dangerous practice. Citizens need to take responsibility. Apathy and indifference in the face of a complex and fast-changing world is a path to ruin.
Nevertheless, if the Internet's data smog has bludgeoned the average consumer into indifference, it has also enabled traders to act more swiftly and decisively. Traders, bankers and financial engineers have built up the mental shortcuts needed to keep track of a hundred credit default swap spreads, or 10 favorite bonds to watch, or myriad structured-mortgage finance product prices. This generation of bankers is the first to be truly Web aware, and they use the technology to the maximum. That's meant lower costs and faster trading, but it has also helped aid and abet the current crisis. We have used the Internet and modern communications technologies to create a shadow-banking system, an unregulated lending network that was, by 2007, as large as the traditional banking system. It is now shrinking, but its remnants must be dragged into the light, with over-the-counter derivatives pushed onto central clearinghouses.
Consider that many unregulated financial transactions are carried out over instant messaging. Want to set up a $100-million credit default swap on the bank of your choice? No problem. Just IM a few trader friends at other hedge funds or banks, propose the idea, and then seal the deal with whoever likes your terms. No phone conversations, no messy paperwork, just a few quick messages and it's done. This kind of easy access to peers has turned trading into a high-stakes, low-documentation videogame, and in doing so it has encouraged and facilitated many risky behaviors, like having too many overlapping trades to keep straight. "I bought credit protection on Wells Fargo, and sold it on AIG, so I'm now hedged! Or did I do both twice and accidentally double up? Ooooh!" By some estimates close to a trillion dollars in credit default swaps out there were created electronically and are now undocumented and little understood. Think of them as virtual Post-it notes somewhere in the ether, waiting for someone to notice.
The trend toward treating derivatives as a cross between gossip and videogames is insidious. Trivial conversations over instant messaging can mutate into trades. Everything gets flattened, with chatter about the weather right alongside setting up a $100 million default swap. What matters when everything looks the same and is bookended with a happy face?
In recent months most firms have raced to get this derivatives mess under control. Company CEOs and boards have all read the stories about there being in excess of $50 trillion in credit default swaps out there, and they are in blind panics to understand their financial risks. They rightly see it as a race between them getting their derivative exposure straight, and owing billions on defaulting companies to which they are overexposed because of ill-hedged swaps. While it would make for boring television, the race is terrifying as hell if you're part of it.
While the Web reduces economy-wracking derivatives to the level of a quick IM chat about baseball, it also allows people to find and support one another, whether they are history buffs or financial engineers. Just as it's easier to find fellow fans of the Flying Banana, it is easy to find someone who can quickly steer you through creating a collateralized debt obligation. Just head on over to the forums at financial engineering sites like Wilmott.com. Run by Paul Wilmott, a smart and savvy quantitative finance guru, the site's forums have long been a hotbed of discussions about engineering financial instruments. Back in 2005, when swaps were newer and really booming, if you wanted to get in on the action you could just post a message there and wham, within hours, if not minutes, you'd have a host of people steering you to working papers, resources and all the latest information on building your own bomb. There's nothing wrong with hosting an online discussion forum about finance. But without the help of forums and related resources, most of which never really see the light of day, the credit innovations (and I use that word advisedly) that helped spur the current crisis would never have gotten off the ground so quickly.
The Internet, of course, is just a technology, to be used for good or ill. Is there a technological fix that would help prevent a similar mess? One of the ways of averting the next crisis is to make the Internet better at consolidating information. Right now when you go to financial sites you are deluged with information about stocks and major market indices, plus some news headlines, and on and on. What if, instead, you saw something akin to the dashboard of a car—with dials and knobs corresponding to what's going on in credit markets, derivatives, commodities and stocks. Instead of giving endless tables—the sort of thing that used to clutter newspapers—imagine heat charts (red is bad, green is good) and simple graphs. The financial dashboard would interpret information: here is what is currently working properly in financial markets, here is what isn't, and here is what you should be terrified about. If you want to know more you can click and find out. A well-designed dashboard will at least make sure you know enough not to be surprised.
Instead of giving everyone a Bloomberg workstation, we can ask that our personal-finance providers build us a better dashboard over the Web. We need something that lets us know more than the balance of our 401(k)s, something that connects us to the ebb and flow of live financial markets around the world. It wouldn't be hard. No new technology is required—people just need to demand it (loudly). All that is required is our active interest in making sure that the world doesn't come down around our ears. We are part of this system, and we need a window into it.
One window must look in on what goes on between traders—including instant messages. By all means let the 20-something traders set up derivative trades via IM—just make sure all the trades take place in full view. Compliance regulations from the SEC and the exchanges already force messages to be archived, but firms need to do a better job of making trades, however they happen, go straight from private electronic channels onto public exchanges. We simply can't have opaque financial instruments traded via IM turn into trillion-dollar markets that no one understands or can see. No more "whoops!" should be allowed. Instead, the solution is to use the Web to force the outcomes of traders' actions into the open, even if their private conversations themselves remain private.
Instead of helping cause a financial crisis, next time around the Internet needs to be part of the solution. And it's up to us—engaged citizens, at least as much as government and flawed regulators—to make sure change happens long before the next inevitable financial crisis breaks. We can use technology to make financial markets safer. And that includes making them safer from the collateral damage of Alan Greenspan's irrational exuberance for risky financial technologies.
