What Happened In the Financial Industry

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I must admit that I don't really understand what happened. It seems that the AIG disaster had something in common with the Enron disaster, and with others. There has been an influx of highly trained experts in quantitative analysis, supported by high performance computers, who invented new financial instruments. These made money at first by being more efficient, and by allowing firms to better manage risk. Their original ideas were potentially very helpful.

The key factor is that if you can find a variety of investments in which the risks are uncorrelated, it is unlikely that all of them will turn bad at the same time. Unfortunately, experience indicates that you can't really determine whether risks are uncorrelated over the short term.

People who did not have the full understanding of risk management took over from the early innovators (who did). They judged on the basis of several decades of experience that financial risks were uncorrelated. Turns out that in times of economic depression or really major recession, "all bad things come together". So the risks that they in their ignorance thought were small and manageable turned out to swamp their boats.

It sounds like there is a very human combination of ignorance and greed. Investors were more than willing to go with firms that made good profits for a decade by taking heavy risks without understanding those risks; they put confidence in managers who talked a good talk, but who themselves either did not understand the risks that they were having their investors assume, or who didn't care as long as they could take their wealth out of the system in time.

Centuries of experience have enabled many people with a grasp of history to look to government to regulate industry to prevent just such bubbles. Unfortunately in the post Reagan days, free market idealogues had more faith in the "hidden hand" of the market than in government regulators, and handicapped the regulators. We of course put them in office to do so, perhaps because the majority of the voters didn't believe in history and thought they could get theirs before the bust.

I suspect some of the early innovators are very angry, seeing their financial inventions perverted and used to create a global crisis.