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Financial Complexity [Dec 15, 2008]

In this tumultuous financial market there are many unusual events. One of the most striking is the Legg Mason Value Trust, run by Bill Miller. He has had an excellent record, beating the S&P 500 every year for the past 15 years. In 2008, however, he lost in the neighborhood of 60 percent. His methods were not revised to fit a new financial environment.

Complexity in General
An overview of complexity is well presented in Harvard Business Review, “A Leader’s Framework for Decision Making” by David J. Snowden and Mary E. Boone in which the following is stated:
A complex system has the following characteristics
– It involves large numbers of interacting elements.
– The interactions are nonlinear, and minor changes can produce disproportionately major consequences.
– The system is dynamic, the whole is greater than the sum of its parts, and solutions can’t be imposed, rather, they arise from the circumstances.
Authors Snowden and Boone also state that complex systems have some major change in them. In such a domain, we can understand why things happen only in retrospect. Leaders who try to impose order in a complex context will fail. But, those who step back a bit, allow patterns to emerge and determine which ones are desirable, will succeed.

Outside the Financial Area
Systemic failure is not limited to the financial sector. The space shuttle Challenger exploded though thousands of NASA scientists had checked and rechecked each of its parts.
Two decades ago, at Three Mile Island in Pennsylvania, the reactor of an atomic power plant came very close to a “critical meltdown”. Atomic power plants are very complex systems. Among the many leading experts on atomic power plants that were consulted, no one fully understood the whole plant. When systems become very complex, they become more difficult to understand.

Current Financial System
All financial crises depend on complexity. The current crisis tops all others in terms of complexity. The degree of complexity is great. It has been stated that the present situation is “Long-Term Capital on steroids”.
In the present financial situation, the basic changes are fluctuating currencies and derivatives. In a world with unfettered capital mobility, we have too many currencies for the amount of international reserves that can be mobilized in a crisis to stabilize the system. Perhaps Iceland should consider using the euro as its currency.
The $155 trillion in derivatives is mind boggling We all are familiar with the CDO (Collateralized Debt Obligation), but there is another derivative that is now the new danger. It is called the CDS or (Credit Default Swap). This new CDS market now stands at a size larger than the entire capitalization of all the world’s stock markets combined.
These CDS bets are based on the future credit worthiness of a country or company. In a global economy made up of thousands of corporations and institutions, many of which borrowed 10 or more times their capital in the past few years, many will be unable to repay their debt, meaning these new derivatives could unwind at a rapid pace making for more chaos.
The developing complex system means that Henry Paulson was in too much of a hurry.
In such a turmoil, patience is needed to find the new financial world order.

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