Archive for September, 2008

Modern Finance Engineering & Social Engineering are cut from the same Defective Cloth Patterns By Alice Travis

Tuesday, September 23rd, 2008

Imprudent financial policies have led to the crisis on Wall Street. For the moment in supporting unprecedented solutions, Treasury Secretary Henry Paulson says in effect he’s playing the hand dealt by his predecessors. And as for his role in essentially advocating nationalizing financial institutions, Federal Reserve Chairman Benjamin Bernanke is quoted as saying there are no ideologues in a financial crisis just as there are no atheists in a foxhole.


For decades, seasoned financial titans argued against the most egregious social engineering pork while erecting “lego” financial houses structurally outfitted from the same genre of ‘engineering’ blueprints. As recently as 2005, Federal Reserve Chairman, Alan Greenspan acknowledged,  “Where once more-marginal applicants would simply have been denied credit, lenders are now able to quite efficiently judge the risk posed by individual applicants and to price that risk appropriately. These improvements have led to rapid growth in subprime mortgage lending.”


Certainly in theory, there is nothing inherently dangerous in the growth of subprime mortgage lending in a capitalistic economic system. Had that been the sole goal, the goal was met. The ultimate objective however was to creatively create new wealth while simultaneously slightly altering selected wealth distribution patterns pursuant to government mandate. Instead, the subprime mortgage industry spiraled out if its orbit and became the unrestrained buying and selling of serviced ‘risk’ packages predicated on debt obligations that were unlikely to be honored which in turn were collateralized by overvalued properties. The buying and selling of risks when there is virtually no chance that the debt obligation on which the risk is calculated can be serviced and liquidated is illusory wealth, like a large glittering fake diamond.


Viewing the financial upheaval from a cerebral biological perspective can be instructive and fascinating. Significantly, the chaos in the financial markets is a demonstration of the thought processes that produced it. At the core of the sub prime mortgage crisis is the absolute separation of the mortgagor from the mortgagee. People who initiated mortgages were relieved of the worry of whether the loan ever would be repaid. Others packaged the risk of non payment and sold it to third, fourth, fifth and sixth parties, through the use of securitized bonds. And as the risks were increasingly spread there literally reached a point where those buying and selling shares, simultaneously encouraging the lending of new money to produce ever increasing available shares, never for a moment associated any of this trading to have any relevance to a real family living in a mortgaged house on Main Street, USA. At the end of the day, as we have witnessed, the last man standing was holding worthless paper, and the dreams of home ownership for the affected were dissolved as sugar does in water.


Clinical psychologists have observed this detachment syndrome in people, young professionals who have relegated their essential memory function to externals such as laptops and electronic schedulers, depriving the brain of meaningful sorting experience. In the most severe cases up and coming executives have literally forgotten not only the location of their next appointment but even why it has been scheduled. In the most extreme instances this has led to total psychological and physical collapse, and no one saw the implosions coming.


Neither was the implosion in the financial markets detected despite all the indicators of trouble brewing. Financial giants appear genuinely shocked that without massive government intervention Wall Street is on the verge of collapse. Investment banks Goldman Sachs and Morgan Stanley now require subsidiary commercial banks to remain fiscally functional, let alone competitive.

Princeton University’s Uwe E. Reinhardt, the James Madison Professor of Political Economy and a professor in the Wilson School, writing as a columnist in the Daily Princetonian had this to say about the roots of the current crisis,

“The bankers’ instincts told them that, through a modern financial engineering feat called “securitization,” the risk inherent in dodgy mortgages can be so vaporized and diffused that the risks somehow evaporate altogether. With the aid of computers, the bank’s financial engineers manufactured synthetic securities called Collateralized Debt Obligations (CDOs) whose promised cash flows were backed up (“collateralized”) by the contractual cash flows of other financial securities, among them – you guessed it  – zillions of dodgy mom-and-pop mortgage contracts that had been purchased by the big banks from local banks, the original lenders. For handsome fees, CDOs based on dodgy mortgages could be “securitized” in this way into yet other CDOs, which, in turn, were securitized for a fee once again until, in the end, no one could trace any more the risk in a dodgy mortgage to the final CDO. In the minds of the bankers and of the rating agencies they pay to rate those CDOs, the risk thus vanished.”


While the direst of sagas may be postponed for a decade or even two, this panic shall revisit us unless we understand what actually has happened and what now must be done. This statement does not encroach upon the terrain of esteemed economists, who will dissect economic theories, crunch numbers, and turn out thousands of power point charts. No, this prediction is predicated on a continually evolving realization that our institutions reflect our biology, and that this globally threatening crisis is essentially the result of layers of flawed thinking calling for the resurrection of belief in the old fashioned understandings of how the brain actually and effectively solves problems, even when aided by external memory.


The most cogent comments with long term significance, regarding the financial crisis have been those which recognize that the model of the investment bank is itself flawed. This fundamental realization, if heeded will lead to needed restructuring. Indeed, we are at a cerebral crossroad when private financial institutions “too big to fail” can only be sustained by government bailout in a premier capitalistic system. This is uncharted territory; but it is essential that those charged with creating new models of financial engineering recognize the fundamental flaw in most of our social engineering projects, the failures of which do not collapse the nation’s economic system but which teach valuable lessons.

The theory of Cognitive Evolution holds that we demonstrate what we know. For example, “Most of the social engineering blueprints for educating the cognitively less able over the past four decades have failed to demonstrate improvement because they have assumed that learning can take place without the acknowledgement of a deficiency, that is a confrontation with ignorance, and that learning is painless. Models of success illustrate quite the opposite.” In social engineering these models are few and far between. The 2008 SAT and ACT scores for major racial and ethnic groups announce that for some populations measured competence is at a 20 year low point, establishing that the adopted social engineering model for academic progress among the disadvantaged is patently defective.

On Wall Street, the current crisis is different from that of the Depression era. We had not attempted the kind of finance engineering that we now know is flawed.  “Learning requires a change from the state of not knowing to the state of knowing. The journey is fraught with anxiety, and unpredictability. The chance of failure increases, and self doubt is inevitable.” “At the end of the learning experience being and behavior have been altered.” “To remain as we are mandates that we do not learn. To learn demands that we change.”


Alice Travis is an information theorist. She is the author of Cognitive Evolution: the Biological Imprint of Applied Intelligence and may be contacted through