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The Next Financial Crisis Is Hiding on a Hard Drive

By   Follow Me on Twitter     Message Daniel Matthews       (Page 1 of 2 pages)     Permalink    (# of views)   1 comment

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It's been 10 years since the Great Recession. Keep one thing in mind: that recession was spurred on by subprime mortgage bonds that were on the shelves of nearly every financial institution in America.

In other words, every major bank had dirty hands, and neither bond investors nor banks really understood what was getting their hands dirty. Read Michael Lewis' The Big Short (or watch the movie for a quicker catch-up; there's also a digestible article from the author on Vanity Fair) and you'll understand what I'm talking about. Here was a financial product -- the subprime mortgage bond, or asset-back security -- that people didn't understand.

The bonds were packaged with obfuscation, which is part of why hedge-fund manager Michael Burry decided to bet against them, or short them. The subprime bond market wasn't sustainable but no one understood that because they didn't know the numbers.

Fast-forward to our current market -- it's booming. Consumer confidence is near an 18-year high, the stock market is charging ahead on its longest bull rush ever, and the recession seems to be well behind us, at least in terms of anything of that magnitude happening again anytime soon.

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Talk to various economists and you'll get varying answers as to what could cause the next financial crisis. It's as if these people make money to grasp at straws. Three experts gave CNBC completely different takes. One of them says if there's a crisis at all, it'll result from "territorialism and nationalism." She could have just said Brexit and Trump.

The next prophet says it'll be standard stuff: "Interest rates will peak, the economy will slow down and then defaults will peak." The final expert doesn't see anything in the way of a crisis coming. There's just nothing like the dot-com bubble or the mortgage bubble happening now.

All three experts are wrong.

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To see what will be responsible for the next financial crisis, you've got to look at what's embedded inextricably in the system. Britain, Trump, and the Federal Reserve can simply manipulate the market in order to keep it from crashing, and very few countries are likely to shy away from trading with Britain purely because of Brexit. If the Fed Reserve sees a problem coming, it can lower interest rates.

We've got to look for something in the system that's vulnerable, something people in the system don't understand, yet it's a part of every branch of the financial system. And that thing -- if you can call it a thing -- is the algorithm.

Insane combinations of algorithms -- "code piled on code," or "Franken-algorithms," as author Andrew Smith puts it -- are creating unexpected consequences, and algorithms are doing the trading on Wall Street. Indeed, any financial organization that uses computers relies on algorithms to some extent, and that extent is increasing steadily.

One example of algorithms gone awry is the Uber self-driving Volvo that hit and killed a woman in Arizona. The so-called "artificial intelligence" of a self-driving vehicle is a mess of algorithms all crammed together, so much so that the coders don't even know what will happen when the algorithms interact with each other in new situations, learn, and cause the machine to make decisions. Call it the butterfly effect of coding.

In his article about Franken-algorithms, Smith recalls the "flash crash" of 2010, "during which the market went into freefall for five traumatic minutes, then righted itself over another five -- for no apparent reason." It happened because algorithms are doing all the high-frequency trading (HFT), and slower algorithms ("whales") do the trading for mutual and pension funds. The HFT algorithms try to prey on the whales by tricking them as to the state of the market.

Smith quotes Neil Johnson, a physicist specializing in complexity who studied the stock market. Johnson says, "People have talked about the ecology of computer systems for years in a vague sense, in terms of worm viruses and so on. But here's a real working system that we can study. The bigger issue is that we don't know how it's working or what it could give rise to. And the attitude seems to be 'out of sight, out of mind'."

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Now, remember that no one besides Michael Burry and a few others understood the subprime bond market before the crash. Combine the present-day ignorance regarding algorithms with the precarious state of cyber security and you've got a situation much like what preceded the recession. Cyber security underpins the success of finance algorithms, but about 78 percent of employers are having a hard time finding cyber-security experts, and the lack of knowledge reaches across all industries -- including finance.

Furthermore, although consumers are confident enough to make purchases right now, that doesn't mean their finances are where they should be. About 1 out of every 200 homeowners face foreclosure every year, and 60 percent of people who are late on mortgage payments don't know how to keep from losing their homes if they keep missing payments. Combine that with the fact that nearly 25 percent of Americans have no emergency savings, and the fact that algorithms we're ignorant about are controlling a stock market that keeps bubbling towards higher highs, and we're headed toward a bust.

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Daniel Matthews is a thirty-two years young freelance writer and musician from Boise, Idaho. In 2006 he earned his Bachelor's Degree in English with a Creative Writing Emphasis from Boise State University. Boise State's faculty includes two of (more...)
 

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