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Part I
Entry
Disorganized worlds
It is necessary to begin this journey to a land of restored hope at the fracture separating an old era from the new. The financial crisis of 2007â08 and the precipitous failure of a few familiar banks marked the beginning of the end of a capitalist age born in the mid-1970s. This crisis marks the entrance to a time when patching up our ailing sense of meaning is the only way to avoid the crippling state of war.
Thus, Part I opens by shedding light on the end of a capitalist world where a âflawedâ model led to financial disaster. This light, illuminating from under the shadows, provides insight into those neglected entities of analysis: financial organizations, insurance companies and, of course, banks, but also the various agencies that revolve around the markets that make exchange possible.
Beyond the example of the financial crisis, to fully account for the state of loss of meaning and the disorganization of the known-world, it is necessary to bring organizations to centre stage. For a moment, set aside the ready-made thinking that detaches the individual from the market or social classes from one another. Rethink the world as being organized â or disorganized â by these entities, which, over sustained periods of time, amass together multifaceted individuals. Organizations combine resources that are then employed by their members. Different organizations pursue different goals, each orienting its operations towards achieving its goals. An essential characteristic that defines organizations is their conveyance of local meaning. To understand the known-world â as much as the lost worlds â individuals must first understand the organizations to which they belong, or have once belonged, to which they are connected via consumption, expectations or illusion. Organizations, as ephemeral envelopes of local meaning, are the material with which we manufacture our known-world. I am the sum of my multiple memberships and attachments, both enduring and temporary, to various organizations.
To understand the loss of meaning and its reconstruction requires a return to and an analysis of these intermediary entities we call organizations. Imagine yourself from the position of an orgologist, an explorer of organizations and their operations. For a moment, leave behind the tools of the âsociology of the socialâ and the methods of the âsociology of associationsâ â and make room for a reasoned study of organizations.
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1 The flaw in the model
On October 23, 2008, after attending a hearing on Capitol Hill with the U.S. Congress, Alan Greenspan, former chairman of the U.S. central bank, the Federal Reserve, appeared shaky, weakened by defeat, rattled in his convictions, but, nevertheless, not totally beaten. Members of Congress had questioned Greenspan, the ancient sage, the maestro, the oracle, whose every word and every pause had been meticulously interpreted while he decided U.S. monetary policy and successfully curbed inflation for almost two decades until 2006. The financial crisis took hold in the summer of 2007, worsened in March 2008 and drove Greenspanâs successor, Ben Bernanke, to make unprecedented decisions â albeit with the support of then U.S. Secretary of the Treasury, Hank Paulson, and then U.S. President George W. Bush â that contradicted the economic convictions of his predecessors: first, the uncontested bankruptcy of Lehman Brothers, once the fourth largest investment bank in the United States, on September 15, 2008; then, a few days later, a proposed $700 billion bailout to rescue financial institutions âtoo big to failâ; and, later, an industry-specific bailout of automobile manufacturing companies, including the nationalization of General Motors, the flagship symbol of American capitalism.
Certain members of Congress considered Greenspan a responsible party for the economic debacle. For nearly a decade, Greenspan, as head of the U.S. central bank, kept interest rates exceptionally low â too low, some said â after the explosion of the Internet bubble in 2001. Cash was cheap and borrowing easy. Many took advantage of the easy access to money and forgot, wittingly or not, the basic principles of financial risk management. In the housing market, for example, households without sufficient income were approved for loans they could not realistically afford. Nevertheless, these doomed mortgages were assembled in a kind of credit potpourri whose fragrance masked the smell of its toxic elements. Such funds were supposedly guaranteed by competent insurers, giant organizations such as AIG, and the consequent financial derivatives received unimaginable top marks by ratings agencies. Thus, ownership of these assets was legitimized to institutional clients, banks and insurance companies worldwide.
At the hearing, Greenspan addressed the mechanisms for failure one by one: mortgage companiesâ inability to properly price risky assets, Wall Street banksâ foolish risk-taking and numerous financial actorsâ deficient risk management. Soon after, he added: âThis modern risk management paradigm held sway for decades. The whole intellectual edifice, however, collapsed in the summer of last year.â1 Intrigued, the U.S. congressional representative who led the discussion, Henry Waxman, then asked: âDo you feel that your ideology pushed you to make decisions that you wish you had not made?â To which Greenspan replied:
Well, remember that what an ideology is, is a conceptual framework with the way people deal with reality. Everyone has one. You have to â to exist, you need an ideology. The question is whether it is accurate or not. And what Iâm saying to you is, yes, I found a flaw. I donât know how significant or permanent it is, but Iâve been very distressed by that fact.
âYou found a flaw in the reality âŚâ, added Waxman, puzzled. âFlaw in the model that I perceived is the critical functioning structure that defines how the world works, so to speakâ, corrected Greenspan.2
Models in question
Greenspanâs admission is symptomatic of a way of thinking about the world that is shared by many policymakers at the head of U.S. financial institutions and has been promulgated by many academics in economics and finance, including those who have earned international awards for their work, such as the âPrize of the Bank of Sweden in Economic Sciences in memory of Alfred Nobelâ, often abbreviated as the Nobel Prize in Economics.
This classical model of the world is premised on the notion of self-correction: that is, any miscalculations by actors operating within the markets will be adjusted for by the markets. The price at which transactions take place reflects all available information in the market at that time. Whatever the nature of the implicated actors â individuals, small businesses or multinational corporations â an adjustment principle prevents anyone from consistently beating the market because of its unpredictability. Those who succeed during certain periods are likely to lose during subsequent ones. During the 1970s, however, investors seemed to find martingales that allowed them to estimate more accurately and act more quickly than their counterparts on the trading floor.3 Derivatives, such as options to buy or sell certain securities at certain prices in the future, provided opportunities to hedge more efficiently than the previous traditional investment strategies. For these opportunistic individuals, the ability to raise money from peers and then institutions â from banks to universities â allowed them to liberally apply their investment strategies more and more elaborately and to rely on experts in mathematics, statistics, physical sciences and programming to find arbitrage opportunities favourable to the markets.
These statistical models thus formed the basis for a new segment of the financial industry. Researchers in economics and financial professionals convinced themselves of the validity of their theories, then, gradually, they converted policymakers and regulators to their way of thinking. In 1996, well before the black week of September 15, 2008, Mark Rubinstein and Jens Carsten Jackwerth assessed that the stock market crash of October 19, 1987, nicknamed âBlack Mondayâ had been statistically impossible, or more precisely, that the probability of such an event was infinitesimal under common (log-normal distribution) assumptions.4 However, these events began to occur more frequently than predicted: modellers, theorists and practitioners of finance were thrust back into a reality that failed to obediently follow the formulas used to predict them â and led to their innovating and proposing new models. The actual distribution of events did not follow a normal or Gaussian curve but fat-tailed distributions in which extreme values were more likely. Reality is stubborn: extreme events are de facto more common than expected. The real market does not slavishly abide by the assumptions contained in this model âthat defines how the world worksâ as originally conceived by Alan Greenspan, Mark Rubinstein or Nobel Prize winners Milton Friedman and Robert Merton.
The âquantâ manifesto
If measurement errors do exist, if the risks taken by some investors threaten the financial system as a whole, it is because too many players believe in the merits of traditional models. Three months after the âBlack Septemberâ of 2008, on exactly January 8, 2009, two quantitative trading specialists, Emanuel Derman and Paul Wilmott, published on their blogs a new kind of manifesto.5 It was addressed to quants, or modellers of contemporary finance, those who apply the mathematical, statistical and econometric principles used in the physical sciences to financial valuation, to buy and sell assets and options traded on markets. Since the 1980s, this new breed of trader has replaced the traditional investors, for whom gut feeling and professional clout once served as irreplaceable compasses.6 The use of computers enabled those strong in maths â programming geniuses â to beat the mass of investors using simple and eventually more refined models. Assets traded on financial markets multiplied, and the data sets used to make more accurate predictions became more accessible, further enhancing the effectiveness of those organizations that entered this strategic domain, often grouped under the term hedge funds. Before long, banks of all kinds had created divisions within their organization similarly dedicated to quants.7
The debacle of summer 2008 and the months to follow were unprecedented since 1929. Soon, voices rose to rationalize the causes of the disaster, among them, the manifesto of the financial modellers. To prevent this upset from happening again, Emanuel Derman, a professor at New Yorkâs Columbia University, who published his research in physics journals in the 1970s before turning to finance, and Paul Wilmott, educator and business entrepreneur of quantitative finance, created in their manifesto a new type of Hippocratic Oath, one destined for financial modellers:
⢠I will remember that I didnât make the world, and it doesnât satisfy my equations.
⢠Though I will use models boldly to estimate value, I will not be overly impressed by mathematics.
⢠I will never sacrifice reality for elegance without explaining why I have done so.
⢠Nor will I give the people who use my model false comfort about its accuracy. Instead, I will make explicit its assumptions and oversights.
⢠I understand that my work may have enormous effects on society and the economy, many of them beyond my comprehension.
Scott Patterson, author of The Quants, commented, âIt was a cross between a call to arms and a self-help guide, but it also amounted to something of a confession: We have met the enemy, and he is us.â8 The manifesto is addressed to those who confuse economic models with the real world. Deeper still, this misguidance is attributed to the seductive elegance of these models and the illusion of closing in, or touching, on the truth of how exchange markets truly operate. The ever pedagogue Wilmott encourages everyone to return to a practice of modesty and to remember that the mathematical or physical models that represent the current or future value of assets are based on primary assumptions, and that these primary assumptions are the ropes and cables that we try to hide, but whose purpose is to support the scenery, a role we need always to be mindful of. After all, the social and human world neither unfolds as estimated by mathematical functions, nor follows exactly the predictions of the most commonly used models.
An incredible absence
Beyond the easy access to credit that existed at several levels at the heart of the economy pre-2008, the âflaw in the modelâ, or the desire to believe that models could loyally represent an in-flux reality, many other primary elements made up the toxic alloy that precipitated the rapid contraction of markets in autumn 2008, whose effects are still being felt. Other frequently given explanations suggest that greed became a destructive madness; the markets became absurdly deregulated and trade dangerously globalized. Explanations refer to either a macroscopic view of the phenomenon (the market, globalization) or a microscopic one (the greedy trader torn between the computer and a new Hippocratic Oath). But to report and analyse events with clairvoyance, the focus should also be elsewhere, at an intermediate level: that of companies, banks and insurers, and of organizations of all kinds that âcreateâ the market, regulatory bodies, rating agencies, consumer associations and minority shareholders.
As such, is it not amazing that this intermediate level, that of diverse organizations, is not detailed and theorized in the vision of the world promoted and defended by Alan Greenspan or other decision-makers in the public and private spheres in Washington, London or Paris? Is there not an element missing in the call for modesty, in the Hippocratic Oath by âquantsâ that can keep them from acting the sorcererâs apprentice, that will curb their enthusiasm for modelling? Between the individual â the trader working under the glow of a computer monitor â and the market, instantly valuing billions of dollars in assets, is the missing link, what we call the organization, the collective actions organized according to certain principles and rationales. The âFedâ of Alan Greenspan, the insurer AIG, âhedge fundsâ, âquant fundsâ, the investment banks, all of these organizations were led â and continue to be led â by individuals who share a certain view, a certain fallible view, of the functioning world, with far-reaching repercussions that they can neither understand entirely nor fully anticipate.
These organizations are invisible to economic explanations and have been surprisingly absent during calls for caution contained in manifestos and other recommendations directed at investors. Organizations are treated as the dust of efficient market ...
