WELCOME TO THE INFORMATION AGE

The current financial mess just might be the first large-scale disaster of the Information Age. Why? Because the fundamental cause of the crisis—setting aside, of course, human greed—is the tool that ushered in and is synonymous with the Information Age, the computer. The computer has given us great analytical power, increasing exponentially our computational capabilities. But it has also increased exponentially our ability to create mischief, much of it inadvertent, but mischief nevertheless.

What has been the computer’s role in the financial meltdown? At the center of finance are the concepts of return, risk, and leverage. Participants in the financial marketplace want a return on their money. They want to understand the risk involved. And they often use leverage, or debt, to increase the return, but at the expense of an increase in risk.

As a result of the computer, the tradeoffs and relationships among return, risk, and leverage have become increasingly difficult to understand. Megabytes, gigabytes, terabytes, bytes almost without end, can be fed into the computer and massaged in an infinite number of ways. Data and assumptions can produce models, which in turn can produce predictions. The data, assumptions, models, and predictions can be pyramided upon one another to produce still more models and predictions. The process has few meaningful constraints.

The complexity enabled by the computer has made financial instruments and the strategies for trading them opaque in the extreme. The assets represented by a security might be a bundle of other securities, each of which might in turn be backed by its own bundle. At the bottom of this multilayered concoction might finally be assets representing ownership of something “real,” such as mortgage loans. In constructing a bundle, Wall Street’s financial engineers often sliced and diced the component assets into groups, called tranches by the professionals, of allegedly different degrees of risk. One result of all the bundling, layering, slicing, and dicing is that the determination of an accurate value for the resulting security has proven to be little more than guesswork.

Another result is that as financial assets were created and pyramided upon one another, the fundamental economic structure of the nation, and the world, changed. Financial assets, which include the whole range of financial products from the basic savings account, to stocks, to the most complex asset-backed security, came to comprise a much greater proportion of the economy. For example, in 1980 financial assets in the U.S. economy amounted to $13.9 trillion, or five times the gross domestic product. At the end of 2007, financial assets totaled $141.9 trillion, which was over ten times GDP. Considered another way, the annual average growth of GDP from 1981 to 2007 was 6.1 percent; the annual average growth of financial assets was 9.1 percent.

A more common group of statistics used to show the shift in the structure of the economy concerns debt. Debt, of course, is also a financial asset, a financial asset to the lending party. For the period 1981 to 2007 when GDP was growing at an annual average of 6.1 percent, total domestic debt was growing an annual average of 9.2 percent.

ROLE OF PATENTS

Evidence that the computer has increased the gap between the financial world and our understanding of it can be found at a place that at first glance seems odd: the U.S. Patent and Trademark Office. The USPTO issues patents not only for tangible things but also for a variety of intangibles, many of which fall under the rubric of “business methods.” How these controversial business methods patents came about is a story in itself, a story that is ongoing but that is well beyond subject at hand. Suffice it to say that some patents issued for business methods support the assertion that the computer, the foundation of the Information Age, is not a totally benign instrument.

Remember Lehman Brothers? Its failure last September brought the growing financial problems front and center. Like many organizations in contemporary high finance, Lehman Brothers had been assigned patents for financial “inventions.” Presumably, Lehman Brothers and its fellow patentees were proud of their “inventions.” One of Lehman’s patents, issued in August 2007, was entitled “Methods and Systems for Analyzing and Predicting Market Winners and Losers.” The patent involved massaging, with a computer program, performance and volume data for securities. Perhaps this particular computer program wasn’t quite up to snuff, eh Lehman?

In December 2007, JPMorgan Chase Bank, N.A., whose parent would rescue Bear Stearns a few months later, received a patent for a computer-implemented financial model involving asset-backed commercial paper. The model produced lower estimates of the liquidity—backup cash—allegedly needed to support a portfolio of assets financed in the commercial paper market. But insufficient liquidity has proven to be central to the current economic troubles. Some patent, huh JP?

Other notable Wall Street denizens that hold patents on alleged computerized improvements to high finance include Goldman Sachs, Morgan Stanley, Barclays Bank, and Credit Suisse First Boston. Big name Wall Street firms are not the only players. For example, IBM has a patent for a method to analyze financial derivatives. The Trustees of Columbia University have a patent for providing “Robust” investment portfolios. Indeed, with business methods patents in the financial field as sources, a decent history of the current financial predicament could be attempted.

The problem would be comprehending those sources. The patents are rife with dense mathematical and statistical jargon. For example, IBM’s patent for analyzing financial instruments describes a process involving the calculation of first and second density functions, calculus integration, and “a convex superposition of mutually-translated delta functions.”

Incidentally, IBM does not really like business methods patents, having railed against them on a number of occasions. But for defensive reasons Big Blue plays the game, and does so quite well.

The point is not to blame the world’s current financial difficulties on patents. The patents are just evidence of how the enormous computational power of the computer has been used to construct a financial system that we mere mortals do not understand and that is now crumbling.

Welcome to the Information Age. What’s next on the agenda?