Investment Initiatives » Wisdom Lost Out to Theory

11.06.08

Wisdom Lost Out to Theory

Posted in Blog at 11:38 pm

During the last two decades, American business led the world to a clear preference for theory over experience. Nowhere was this more in evidence than in the financial services industry. The U.S., one of whose most iconic industrialists famously defined history as “Bunk,” had always believed as a nation that a bright new idea could trump the accumulated wisdom of centuries. But this tendency was always partially offset by the conservative influence of the older and more experienced leaders who dominated senior management and government. The widely-admired American ‘can do’ attitude in the face of seemingly insurmountable problems, and the American enthusiasm for innovation, were always offset by American pragmatism; as a nation, and even in some of our most academic enclaves, we believed that the foundation of knowledge was empirical, and the greatest teacher was experience. Others were mocked for placing too much value on vast philosophical systems rooted in theory. Americans would remain hard-headed, practical.

No longer. Over the past twenty years, American business has been deliberately shedding its pragmatic base, dispensing of the services of experienced employees in their fifties and early sixties, and reaching over their heads to find its senior managers among those in their forties and even thirties. Such young leaders are necessarily theorists in the broad sense: unless they are particularly avid students of history, they can have as yet little experience upon which to make judgments. The situation was enormously exacerbated in financial services, where the many innovations in finance, and in particular the creation of sophisticated derivatives, required an understanding of some rather abstruse mathematics in order to be able to utilize them. This led to increasing reliance upon mathematical theorists with very little practical experience of their own, as well as an unfortunate tendency to denigrate the more pragmatic principles of previous generations.

Enthusiasm for these modern innovations, and the purely quantitative reasoning behind them, led many organizations to purge the ranks of anyone who did not buy in to the new ‘paradigm.’ A generation-long bull market in such innovations, with constant rewards for leverage, did the rest. Is it any surprise that we find ourselves in the middle of a financial meltdown based on excessive reliance upon what have turned out to be flawed mathematical innovations?

This phenomenon of such a radical preference for youth and inexperience is particularly striking given the existence of a disproportionately large generation now mostly in or approaching its sixth decade. In the face of the masses of employees belonging to the Baby Boom, business leaders who were members of the smallest demographic group in American history—born in the Depression and during World War II—insisted upon their rights of seniority as long as they could, and then passed the torch of leadership on over the heads of the fiftyish Boomers to the much smaller Generation X, most of whom had only been working for ten or fifteen years. A casual observer of the American business scene could be forgiven for believing that this must have been some mass expression of spite, a belated concession to the nineteen-sixties’ fetish for Youth, only after the former marchers of ‘sixties fame were too old to enjoy it.

What was actually involved was probably more nuanced, of course. Either there was perceived to be a generational mismatch between the skills needed for senior managers and those afforded by the pool of mid-level managers educated in the ‘sixties and ‘seventies, or there was perceived to be a reluctance on the part of these managers to continue the pace of innovation and to take on higher levels of risk after so many years spent in subordinate positions. The desire to appeal to a stock market obsessed by novelty, especially in the years of the dot-com bubble, must also have tempted many elder managers to do something dramatic, and reach out to young and untested managers with supposedly unconventional attitudes. Either way, a quantity generally held in lower esteem in the United States than in the rest of the world was further downgraded, and perhaps rejected entirely: wisdom.

The situation was made more extreme by the fact that this was a period of American financial hegemony, led by the global American investment banks. Very few of the world’s major banks were not infected by the same sort of thinking. Along with this exaltation of youth and rapid computational ability over age and reflective experience came a greatly increased appetite for risk. This was exacerbated by the typical model of compensation of a trader, salesman, or junior investment banker: a laughable base salary, and dependence upon an annual bonus many times the base in order to even meet one’s normal expenses. The idea was to keep some personnel, especially the youngest, continually hungry. It was a model which could only appeal to the young, with few obligations and many years to outgrow any disappointments, or to the least risk-averse, those with a continual desire to roll the dice. Such a compensation system clearly skewed every participant’s risk-utility function, and it just as clearly favored the emergence of youngish gamblers with as-yet uninterrupted runs of luck.

To put such people in top decision-making roles at major banks would seem to be an act of extreme imprudence, but this is what chief executives and boards of directors did. They were following the youth-and-good-technique-beats-out-age-and-experienced-judgment model. This made a rising stock market happy, and resulted in huge capital gains for shareholders, including most of the senior executives of the banks. Theory could confidently predict, as it did in 1929, that the party would never end: it was impossible. Wisdom could assert, based on the experience of 1873, of 1907, of 1929 and after, that the party would end in tears: the higher the leverage, the worse the aftermath. But no one was listening to the voice of wisdom.

It was not wise to lend so much mortgage money to applicants with poor credit ratings and insufficient income to meet payments. It was not wise to believe that so many better applicants suddenly came out of the woodwork once banks assigned the responsibility for screening applicants to mortgage brokers. It was not wise to buy so much paper issued by Fannie Mae and Freddy Mac after it was revealed that most of the loans behind it were of low quality, relying upon the implicit guarantee of Federal intervention to hold up the value of that paper if anything should ever happen to the underlying housing market. It was not wise to assume that derivatives of derivatives would be less risky than the underlying assets, and it was not wise to rely upon some young mathematician’s say so that a portfolio of such instruments could never go down under any reasonable circumstances, because it is not wise to assume that circumstances are always reasonable.

It was not wise to assume that housing prices could never go down because they had ‘never’ gone down in thirty years, and it was not wise to assume that if one was operating with capital base of 10% or 5% or 3% of risky assets that one could avoid a crisis in confidence and a run for the exit if there were a severe external shock. It was not wise to see 80% of one’s profits come from one business segment without calculating what would happen to the rest of one’s organization if that segment suddenly dried up, and without having a ‘Plan B’ to cope with such an eventuality. It was not wise to assume that totally opaque, unlisted and unregulated markets could protect one from failures in the large, liquid, transparent ones, and it was not wise to become involved with a new market which could become a proxy for one’s own solvency, without being connected in any fundamental way with the actual assets one had.

Of course, it was also unwise for regulators to assume that if an organization were ‘too big to be allowed to fail’ that this necessarily meant that it could be prevented from failing anyway. Investors were also unwise in their confidence that their investments could survive all this unwise behavior. Buyers of houses they could not afford were unwise to assume they would not be left holding the bag. There was a massive epidemic of unwisdom, and few can claim to have been entirely free of it.

For the same twenty-five years that all this rejection of experience had been going on, and especially since the Crash of 1987 exposed the fatuity of so-called “portfolio insurance,” there had been at least a few old farts and wise commentators who had noted the hidden systemic risks in the inherent leverage of derivatives. But theory insisted that derivatives were all right, and should be left alone, because rational market participants would always act to monitor and mitigate those risks. If the voice of experience whispered that not all participants were rational, and that not all risks were necessarily assessed accurately, the cascading profits of the risk-takers persuaded everyone that the voice of experience could be told to shut up. Neither the Long-Term Credit débacle of 1998, nor the dot-com bear market of 2000-2002 led anyone in a position of authority to reassess the role of derivatives, nor to reflect upon how to deal with the dramatic increase in systemic leverage the widespread reliance upon derivatives had created. By downgrading Experience, and the role of Wisdom, markets left themselves open for the ultimate surprise: we do not live in a post-historical world, after all. There is still a Law of Gravity, and institutions, like individuals, can still die.

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