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In the October 20, 2008 eweek magazine, Editor Eric Lundquist listed “The 10 techs Gartner Missed” in response to the Gartner Group’s annual list of the top 10 strategic technologies. Since there are many strategic technologies and selecting the “top” ones is a fuzzy judgment call, there is certainly justification for an editorial listing of alternative choices.
But one of Lundquist’s alternatives was something called “BLI”, which he says stands for Business Leader Intelligence: “…systems that will alert the boss (and maybe the SEC) that the business practices of the company are putting not only the company in jeopardy, but maybe the entire economy. Think of it as Sarbanes-Oxley with a big stick.”
Being the rash, impetuous partisan that I am, I fired off the following riposte:
“There was an old saying that artificial intelligence was not the cure for natural stupidity. The same can be said of BI and corporate greed and incompetence, but it doesn’t scan so well. Who do you suppose was behind the predatory lending, the default swaps, and other toxic derivatives? This stuff doesn’t happen without the knowledge and consent of the CEO who’s counting on big returns to fatten his bonus.
“Alert the SEC?” I went on. “How much good would that have done this time, with the agency eviscerated and a White House policy supporting unbridled ‘capitalism’?
“We don’t need any more acronyms. BI does what it is supposed to do. Add this kind of watchdog features [sic] you suggest and all you do is give somebody another system to game.”
Techies like me (and probably Lundquist) are predisposed to see a tech solution to nearly every headline issue, because it is something we understand and believe we can apply for the good of all. It is both idealistic and arrogant, and more than likely counterproductive. We need to look at these ideas with a little humble objectivity.
The financial services industry, especially the Wall Street Masters of the Universe, is pretty tech savvy and utilizes application systems that go far beyond typical BI. They make extensive use of computer models to predict market behavior, and place bets on those models’ ability to make the right call.
Computer models are based on assumptions about the business environment. The best model is only as good as those underlying assumptions. To keep the model on track, it needs to be calibrated with periodic reality checks, including verifying that the underlying assumptions still hold. One of the assumptions underlying derivatives like mortgage-backed securities was the rate of default. The idea for pooling, packaging, slicing and dicing mortgage investments was created at a time when there was no market for the securities, and when the quality of the underlying investments was higher and more uniform. When securitization was shown to generate large returns and no downside risks materialized, that market gained traction and volume. Lenders began selling mortgages they previously would not have to borrowers they would not previously have considered, and recouping the money by churning out more and more mortgage backed securities.
The increase in the mortgage asset base to include lower quality, higher risk mortgages led inexorably to an increase in the rate of default. Default rate is a metric that is regularly reported and scrutinized in the credit industry. Nobody could have missed seeing that increase, yet nobody took any serious action to turn this around. The cash was flowing and it looked to be a banner year in the derivatives markets.
Worse still, the increase in the default rate led to an increase in repossessions, which led to an increase in unsold homes on the market, which began to drive down prices in the real estate market, thus undermining another assumption that home prices would continue to rise indefinitely.
Would better BI systems have really done any more to raise the red flags? I sincerely doubt it. I am convinced that all of the effects cited above were known to both the SEC and the Federal Reserve well before they reached the tipping point that led to the recent collapse.
So why was no corrective action taken? Because none was possible. There was a time when banking regulations in this country prevented lenders from overreaching. The Masters of the Universe didn’t like that, and beginning in the Reagan years pushed to deregulate everything because regulation made American banking less competitive in the emerging global economy. The ideological position was that the free market is the best regulator. Self interest was supposed to prevent anyone from doing anything really destructive. (How’s that working out for ya, Alan Greenspan?)
In mechanical systems that involve oscillation and feedback loops, cycles of activity can reinforce one another and intensify vibration. To keep these oscillations from shaking the system apart, dampers are applied. Financial markets also involve oscillation and feedback, and in the last two decades we have witnessed periods of roller coaster volatility, such as the dotcom boom and now the real estate boom. What Federal Reserve chief Alan Greenspan referred to as “irrational exuberance” was simply this feedback-induced volatility, and had adequate regulatory dampers been in place, the economy might never have experienced either the record highs or the ensuing lows.
Better BI systems, under any name, cannot force decision makers to make rational decisions. It’s probably just as well. Sometimes, whatever the analysis tells him, the decision maker needs to go with his gut and take a risk. And that’s ok. It is what makes free enterprise work. On the other hand, if he makes a bad call, he needs to be held accountable and collateral damage needs to be kept to a minimum. Those are the functions of regulation, and it is the regulatory apparatus of the American financial system that is most in need of repair.
BLI is a tech solution to a political and economic problem. It is not a strategic technology, and doesn’t merit a place in the top ten of anyone’s list.
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