Did Innovation Cause The Crisis on Wall Street?

Posted by: Bruce Nussbaum on September 15, 2008

The stock market is crashing, housing prices are plummeting and the economy is poised for a severe downturn so I’m reminded of the criticism I heard at the World Economic Forum in Davos in January that innovation is responsible for this mess. A European banker came up to me and and said, “isn’t innovation at the root of all our problems?” “All those new financial instruments failed, right?”

He’s right. So what went wrong? I’ve talked to a lot of folks and the answer lies in the innovation process that took place on Wall Street. Hundreds of hugely complex products based on hugely complex mathematic financial models were created and sold around the world—without first being tested out. There was little or no real-world iterative process. Commercial ankers, hedge fund managers and investment bankers didn’t know what would work or not work in a troubled economic environment, such as one where housing prices fell sharply. In fact, the complex financial instruments were supposed to spread and reduce risk. In the end, they did the opposite. In short, the innovation process was flawed. New inventions were not stress-tested in a real enviroment.

Second, the new financial products were flawed. They were opaque—not transparent. They were sold to investors who didn’t really know what they were buying. Instead, they relied on the rating agencies to tell them the value of the products—if they were AAA or BBB. But that didn’t work. The rating agenices had mathematical models that didn’t work in a period of sharply falling housing prices. In the end, no one really knew what the new products were worth. Worse, when trouble came, those who sold them didn’t know how to fix the products. And they didn’t take responsibility for replacing them—in part because they didn’t know what they were worth. Again, bad innovation process.

There is a great new book out by my friend and colleague Stephen Baker called The Numerati. It’s about the rise of a new class of mathematicians, computer scientists and numbers people who collect the growing mass of data we emit and create new things based on the patterns and similarities. Think Google. The Numerati are the people who rule the data—and our lives.

My one question to Steve—have the Numerati caused the crisis on Wall Street by innovating new financial products based on bad models and poor process? And do we have more to fear from them?

Reader Comments

Gong Szeto

September 15, 2008 8:26 PM

bruce,

some responses to a number of questions and statements you made in your post:

1) the main question should be reframed to "What was the role of innovation that led to the current crisis?" innovation, per se, did not cause it. it was multiple innovations happening concurrently in a system of many actors and no macro checks and balances system. therefore, many individual innovations with an uncoordinated system can lead to chaos.

2) complex products and mathematical models: the products themselves were not that complex, bruce. a mortgage is a mortgage. a security is a security. both have operated with a set of audit rules that work fine, as independent systems. once you mix the system, you have a tower of babel problem.

3) transparency: totally agreed. but this is not a ratings issue. it is a macro rulemaking issue. and testing in the for of simulations when the two systems mixed obviously wasn't done effectively if at all.

4) role of regulatory bodies: rules and audit trail. the securities industry (brokerages, exchanges) where i work is regulated by FINRA which has imposed the OATS system (Order Audit Trail System) which tracks all transactions all the time in the securities market. it is onerous, inefficient, and most players would rather get rid of it...until the s*&t hits the fan. then they are glad they have a paper trail. the mortgage industry (banking) have their own audit trail. guess what? there is no current standard audit practice for the mixing of these two systems. therefore when mortgages become securities, with both tied to different credit requirements, the left hand has no idea what the right hand just did. now multiply this problem times however zillions of transactions that took place. doh. big trouble.

see the diagrams here:
http://www.fdic.gov/news/news/speeches/archives/2007/chairman/spapr1707.html

they are in reduced form naming individual actor "types" in this hybrid mortgage-securitization system. but just add up all the different players and actors involved in the multiplicity of transactions here. mind-boggling complexity and many places for things to break. but as you can see, each individual system has its own methods checks and balances, but there lacks one for the overall system. who should be responsible for this macro checks and audit system? only one answer: government regulation.

5) general commentary about your post: it does the public a great disservice to reduce these issues to a binary innovation +/- argument. is is not about that. it is about the complex interplay of individual innovation (products/services), the actors and their motives, the rules of the system, how the system can be gamed, and the role of referee in any system (in this case, capitalism and policy). to pose any question about innovation in this complicated mess is to ask what are the limits of innovation and who is responsible for "externalities" and "unintended consequences"?

6) lastly, thanks for the book reference. i will read. i would add as an addendum to your own question to the Numerati -- what is their primary motive for modeling something and what part of this system are they modelling? and are they trying to model the ENTIRE system? and if not? why (the hell) not?

Chris Tacy

September 15, 2008 8:48 PM

While your argument is compelling at a surface (and facile) level, saying that the crisis was "caused by innovation" not only stretches the currently understood meaning of "innovation" but also stretches credibility to the breaking point.

By your logic, not only was the dot-com crash also caused by "Innovation" but so is Global Warming (not to mention the war in Afghanistan and for that matter the Second World War).

If I were going to be reductive to the point of ridiculousness and say that a single word could define the (incredibly complex and inter-related) causes of the current crisis - the word I would choose is not Innovation but rather Greed.

Rajeev B N

September 16, 2008 12:30 PM

Hi,

This was a time bomb waiting to explode. Numbers are used by one and all to cover the mess they have created or to save themselves from being neglected at work. Human sentiments and behaviour knows no numbers and to create a world with numbers (statistics, analysis etc) to predict them is as criminal as any other criminal act. No one can say what happens tomorrow with numbers as base but still we all live in a world where top executives from most of the companies roam around the world with presentations depicting how the world behaves tomorrow. This is like looking at the window and predicting whether it will rain in the coming month or dry weather. What we need is close association with people or society in which we live and cater to. Goal may be long term, but strategy to achive that must be revised at frequent intervals depending on the nature of the business. For ex: The land price appreciation these days in a city like Bangalore is unimaginable and has no reason to substantiate such high prices. The greed of some businessmen to make quick money normally upsets the stable industry. The urge to grow aganist nature is one another factor which eventually leads to disaster. Hope numbers will now be used as a pointer to take decisions and not as the only basis to make extra money.

joycewashere

September 16, 2008 6:49 PM

Bruce.
A small comment on little vocabulary nuances. Sadly, I don't have the answers to my own questions maybe you do.
Is there such thing as an innovation process? Can one be sure to innovate? There is however a design process. That can be taught; it is taught in design schools. Isn't innovation something to strive for, but you can never be sure until the product changes the standard. Isn't it about seeding for innovation and reaping the benefits once the product is widely accepted and has changed user behaviors? Oh, and, couldn't "new inventions" simply be new designs? If not, why not? To sum up, I am wrong to think that design is a process where as innovation is a possible consequence that can only be determined after the actual launch?

Akhil Jain

September 16, 2008 11:13 PM

I completly agree with Chris Tacy.
Although innovation might have played some part the bigger culprit is Greed. Everybody invested blindly into things they are not sure about completely depending on the rating agencies who themselves are equally confused.

I think we should have a more robust system where in the credit rating agencies should be held accountable incase a AAA rating doesnot turn out to be what it should have been.

jay

September 17, 2008 12:26 AM

@ Joycewashere

I would agree with you on this one.
"the innovation process was flawed. New inventions were not stress-tested in a real enviroment."
Something can not be innovative and flawed its a contradiction. Innovation is not a process Joycewashere is correct in saying design is a process which has tools and methods, innovation doesn't have tools or methods it has metrics.
So is innovation to blame??? you can try but I don't think you will be successful, I think Bruce is correct in saying the design and development process used to create this complex products is to blame. It clearly wasn't UC if you know what im saying.

openconceptual.com

September 17, 2008 3:06 AM

It isn't merely the innovations themselves to blame, it's the fact that they didn't tend to create a good platform for further innovation. They were too sophisticated and opaque (as you said) to contribute to broad, effective process and business model innovations.

We need to talk about how to 'nudge' innovators to innovate in ways that tend to facilitate future innovation and learning.

Innovation is inevitable. Regulation needs to take advantage of that, rather than denying and suppressing it.

Bourgogne

September 17, 2008 6:22 AM

As hard as it is to swallow, what we are seeing now in the markets IS in fact the iterative innovation process.

Failure has been peddled for years now in the "innovation" community.

Back to the drawing board...

Navin Kumar

September 17, 2008 6:28 AM

Hi Gong,

I like your insights and concer with your points. It is the interplay of different established innovative methods, that is unregulated. This uncalled for action is cause of the problem.

Navin

James Todhunter

September 17, 2008 8:52 AM

Hi Bruce,

Two quick comments here...

To ask if innovation is the cause of the current financial crisis is like asking if air was the cause of the crisis. (We all beathe, therefore...) Our systems (not just financial) are constantly evolving and changing; innovation is always a factor in the dance of change. Some change has good consequences, some change has bad consequences. The complex system of changes which led to the current financial situation was decades in the making and had a predictable outcome. Was innovation playig a role along the way? Sure, but that is not the same as being a primary cause.

And to the comment by Joycewashere: Yes, Joyce; there is an innovation process. And, it doesn't have to be driven by happenstance. Check out InnovatingToWin.com for some insights in the area.

Nicol Erasmus

September 17, 2008 11:38 AM

All these "fancy" guys with the "glamor" jobs and plasma screens - are the culprits and I agreed 100% with Bruce Nussbaum as per September 15 insert!!! They devise systems with other peoples' monies and with our pension fund monies AND we suffer in the years to come!! It is NOT their funds they are working with!!!

munidas pereira M.B.A (McGill)

September 17, 2008 11:50 AM

In my opinion this is caused by GREED which was allowed to go on due to poor regulatory oversight.

Sen P

September 17, 2008 9:54 PM

Bruce: I totally agree with you. However, those who created these complex mathematical models to form derivatives and those who used those derivatives or governed those derivatives are different creatures. Many of these users did not even understand the model however used them for their own personal benefits. This is fundamental problem in managing innovations. Innovators create goods or services for the people's welfare, however users or investment communities take them to a new direction for their own personal welfare without understanding the underlying complexities.

farley

September 18, 2008 12:54 PM

In reality , in my veiw,crisis caused in early period is a complex process,To some extent , innovation indeed play an impact on the ocurrance of the crisis.But all problems were caused by the innovation ,at least most parts .
At any rate , I agree with the opinions from Bruce.

Peter Plum

September 19, 2008 4:30 PM

When did 'innovative' become synonymous with 'short-sighted' or 'sleazy'?

Personally, I wouldn't have characterized the practice of lending money to people who can't demonstrate an ability to pay it back as "innovative".

stephen baker

September 22, 2008 5:13 PM

Hi Bruce, I'm sorry I'm jumping into this so late. I agree with Sen P. The Numerati created risk models. Others chose to leverage them to the max. These were business decisions. But I think it's also important to point out that statistical analysis is great for day-to-day forecasting, but useless when it comes to predicting big surprises, what Taleb calls black swans. When we see what the Numerati can predict in grocery stores and at the work place, we may be tempted to count on them for the bigger jobs, ie. protecting us from another 9-11. That's where we get into trouble.

Payday Loan Advocate

October 27, 2008 11:51 AM

Mortgage lending played a big part in our current economic crisis, which has been a significant topic that is disturbing the standards and values of America. Conversely, this problem does not target the American people alone, but has navigated to other parts of the world. The International Herald Tribune explicates the worldwide credit crunch that is happening in Europe as well. Small businesses like Dominique Boudier’s printing company, outside of Paris, generally depend upon credit with its suppliers in order to maintain the functioning of the company, and her creditors are cutting back their offerings by half. The suppliers’ credit insurance companies approved this. Like many others, Boudier’s business needs added cash flow to make up for their major fallbacks, considering a typical 60-day lag time in which clients pay. The future of her company appears shackled without the assistance of her own bank. Her bank, like many other banks across Europe, began to put their money to sleep instead of investing it back into other banks or the economy in general. When the banks began to fall short and liquidity was disrupted, the credit began to dry up. More or less, the European Central Bank is quite similar to America’s Federal Reserve Bank. They utilize a method, which is based on the ability to create as much fiat money as necessary. Fiat-money currency, which in fact is credit money, loses value once the government refuses to further guarantee its value. We see this in high inflation rates as the world’s credit crumble. People believe stronger private banking systems that make responsible decisions can solve this problem. Until then, payday advance loans will surely be manageably obtainable for consumers who need immediate short-term help. This is one of the most convenient and easiest ways to get cash if you are trapped with this sudden financial problem. And can no longer depend on a faltering central banking system.

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Want to stop talking about innovation and learn how to make it work for you? Bruce Nussbaum takes you deep into the latest thinking about innovation and design with daily scoops, provocative perspectives and case studies. Nussbaum is at the center of a global conversation on the growing discipline of innovation and the deepening field of design thinking. Read him to discover what social networking works—and what doesn’t. Discover where service innovation is going and how experience design is shaping up. Learn which schools are graduating the most creative talent and which consulting firms are the hottest. And get his take on what the smartest companies are doing in the U.S., Asia and Europe, far ahead of the pack.

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