But first, there was the question of what was going on around me in Canary Wharf. Despite having settled on another career path, I still wanted to understand what was happening to the banking industry. Why had rows of trading desks recently been emptied of their employees? Why were celebrated financial ideas suddenly crumbling? And how bad could it get?
I was based in equities, analysing company share prices, but in the preceding years the real money had been in credit-based investments. One investment stood out in particular: banks had increasingly bunched together mortgages and other loans into ‘collateralized debt obligations’ (CDOs). These products let investors take on some of the mortgage lender’s risk and earn money in return.[4] Such approaches could be extremely lucrative. Sajid Javid, who in 2019 was appointed the UK’s Chancellor of the Exchequer, reportedly earned around £3m a year trading various credit products before he left banking in 2009.[5]
CDOs were based on an idea borrowed from the life insurance industry. Insurers had noticed that people were more likely to die following the death of a spouse, a social effect known as ‘broken heart syndrome’. In the mid-1990s, they developed a way to account for this effect when calculating insurance costs. It didn’t take long for bankers to borrow the idea and find a new use for it. Rather than looking at deaths, banks were interested in what happened when someone defaulted on a mortgage. Would other households follow? Such borrowing of mathematical models is common in finance, as well as in other fields. ‘Human beings have limited foresight and great imagination,’ financial mathematician Emanuel Derman once noted, ‘so that, inevitably, a model will be used in ways its creator never intended.’[6]
Unfortunately, the mortgage models had some major flaws. Perhaps the biggest problem was that they were based on historical house prices, which had risen for the best part of two decades. This period of history suggested that the mortgage market wasn’t particularly correlated: if someone in Florida missed a payment, for example, it didn’t mean someone in California would too. Although some had speculated that housing was a bubble set to burst, many remained optimistic. In July 2005, CNBC interviewed Ben Bernanke, who chaired President Bush’s Council of Economic Advisers and would shortly become Chairman of the US Federal Reserve. What did Bernanke think the worst-case scenario was? What would happen if house prices dropped across the country? ‘It’s a pretty unlikely possibility,’ Bernanke said.[7] ‘We’ve never had a decline in house prices on a nationwide basis.’
In February 2007, a year before Bear Stearns collapsed, credit specialist Janet Tavakoli wrote about the rise of investment products like CDOs. She was particularly unimpressed with the models used to estimate correlations between mortgages. By making assumptions that were so far removed from reality, these models had in effect created a mathematical illusion, a way of making high-risk loans look like low-risk investments.[8] ‘Correlation trading has spread through the psyche of the financial markets like a highly infectious thought virus,’ Tavakoli noted. ‘So far, there have been few fatalities, but several victims have fallen ill, and the disease is rapidly spreading.’[9] Others shared her skepticism, viewing popular correlation methods as an overly simplistic way of analysing mortgage products. One leading hedge fund reportedly kept an abacus in one of its conference rooms; there was a label next to it that read ‘correlation model’.[10]
Despite the problems with these models, mortgage products remained popular. Then reality caught up, as house prices started to fall. During that 2008 summer, I came to the opinion that many had been aware of the potential implications. The investments were tumbling in value by the day, but it didn’t seem to matter as long as there were still naïve investors out there to sell them on to. It was like carrying a sack of money that you know has a massive hole in the bottom, but not caring because you’re stuffing so much more in the top.
As a strategy it was, well, full of holes. By August 2008, speculation was rife about just how empty the money bags were. Across the city, banks were looking for injections of funding, competing to court sovereign wealth funds in the Middle East. I remember equity traders grabbing passing interns to point out the latest drop in Lehman’s share price. I’d walk past empty desks, where once profitable CDO teams had been let go. Some of my colleagues would glance up nervously whenever security walked by, wondering if they’d be next. The fear was spreading. Then came the crash.
The rise of complex financial products – and fall of funds like Long Term Capital Management – had persuaded central banks that they needed to understand the tangled web of financial trading. In May 2006 the Federal Reserve Bank of New York organised a conference to discuss ‘systemic risk’. They wanted to identify factors that might affect the stability of the financial network.[11]
The conference attendees came from a range of scientific fields. One was ecologist George Sugihara. His lab in San Diego focused on marine conservation, using models to understand the dynamics of fish populations. Sugihara was also familiar with the world of finance, having spent four years working for Deutsche Bank in the late 1990s. During that period, banks had rapidly expanded their quantitative teams, seeking out people with experience of mathematical models. In an attempt to recruit Sugihara, Deutsche Bank had taken him on a luxury trip to a British country estate. The story goes that during dinner, a senior banker wrote a huge salary offer on a napkin. An astonished Sugihara didn’t know what to say. Mistaking Sugihara’s silence for disdain, the banker withdrew the napkin and proceeded to write an even bigger number. There was another pause, followed by another number. This time, Sugihara took the offer.[12]
Those years with Deutsche Bank would be highly profitable for both parties. Although the data involved financial stocks rather than fish
