Page last updated at 00:03 GMT, Wednesday, 14 January 2009

The rocket scientists of finance

By Evan Davis
Presenter, The City Uncovered

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How a bank's balance sheet works

When the Mars Climate Orbiter took off from Cape Canaveral in December 1998, the engineers at the Jet Propulsion Laboratory in Pasadena were undoubtedly elated.

They were managing the project for NASA. It was a textbook launch and the spaceship was on its way to break new ground in mapping the red planet.

Nine months later though, it was only their red faces that were on show. The spaceship vanished. Instead of orbiting the planet, it had burnt up as it descended too low into the Martian atmosphere.

It turned out there had been an unfortunate mishap somewhere between the guys in Pasadena and their contractors in Colorado.

One group was using imperial measures of force in its navigation programming, while the other was working in metric.

On such occasions, one inevitably finds oneself asking how such clever people can make such silly mistakes.

Predictable outcome

The answer is perhaps that only such clever people can make such silly mistakes.

Most of us down here would not have been sending space ships to Mars at all. It is when intelligent life on Earth becomes ambitious that things get complicated.

And when things get complicated, no-one on the planet is intelligent enough to avoid the occasional silly error.

If it is true of aeronautic engineering, it is equally true of financial engineering.

Evan Davis explains securitisation

The rise and fall of the financial services industry in recent years is really a story of several appealing financial innovations falling into the hands of institutions ambitious to defy the natural gravity of their business and to push profits into the stratosphere.

The rocket scientists they employed were among the cleverest people on Earth, but their technology was complicated and fragile. It was bound to end in tears.

Tricky task

You can see this pattern in the world of hedge funds and derivatives, and perhaps even more plainly in banking and the rise of securitisation.

A bank is fundamentally a rather dull old business.

It keeps a small amount of its own money - capital - ready on stand-by should anything go wrong.

But on that modest base, it builds an enormous balance sheet of two huge towers of cash: one of money borrowed, and the other of money lent or invested.

It is hard to make serious money this way. The trick is somehow to charge more for the money the bank lends than it pays for the same money it borrows.

Bankers know how to drive that vehicle into modestly profitable terrain - you make it your business to borrow short-term and lend long-term. But it is still not a terribly exciting money-spinner.

Over the generations they have found there are ways to push profits higher, but experience suggests the higher they push them, the more vulnerable their institution.

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For example, they can economise on capital on stand-by. But then they have less to protect them if things go wrong. Or they can lend at higher rates to riskier people. Again, they make more money but then they stand to lose more.

You can see how anyone with a bit of nous might want to smarten the business up and find a way to build a bank that is both more profitable and more secure.

Well, that is what the technology of securitisation promised.

It allowed banks to lend in copious quantities without carrying all the risks of their loans, which they could sell off as securities. It appeared to be a magic bullet, enabling them to shed risks and make some of their lending margin.

Suffice to say banks took the magic bullet and fired it upon themselves by allowing the quality of their loans to be absurdly degraded.

Plus to cap it all, they bought securities as well as selling them, so when the loan defaults came, it was the banks who were suffering from them. They had not got rid of risk after all.

It is every bit as silly as confusing metric and imperial units. But only bankers who could see beyond the pedestrian world in which they operated would have tripped up in these ways.

Essentially, it is just one example of the way our natural human instinct to be innovative has served us very badly in finance.

It is too easy to allow optimism and self-interest to cloud the judgement and to foster confusion between the very occasional genuine advance with the more common illusions that apparently allow profits to be conjured up from nowhere by disguising the risks that are being taken.

The answer is not to ban innovation, but to be wary of it.

Interestingly, some of the Wall Street rocket scientists behind securitisation were actually real rocket scientists, from the very lab in Pasadena which had managed the Mars Climate Orbiter project.

The real lesson is not that we need to find even cleverer people to take over the world of banking. It is that we would be more likely to avoid mistakes if we could breed them a little stupider.

Evan Davis presents the three-part series The City Uncovered on BBC2. The first programme Banks and How to Break Them airs at 9pm on Wednesday 14 January.



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