Intelligent Enterprise

When it comes to analytics, Wall Street is clearly the leader. The best of the best head there after school to grab six-figure starting salaries. Some even see seven figures, based on their performance. They are the rara avises, the crème-de-la-crème, and whenever we speak about "Competing on Analytics," it goes without saying that Wall Street analytics represent the exemplar of what is possible for an analytic culture.

So why is Wall Street melting down?

Clearly, analytics aren't everything. Our financial system is pretty complicated and subject to abuse and fraud. The current crisis is aligned with the greed of the mortgage brokers and the mortgage bankers. Once in a while the financial press will point the finger at the hedge funds and investment brokers that shoved mortgage-backed securities down the throats of other investors.

Hmmm.

Wasn't anyone watching this? After all, interest rates started to creep up a few years ago, the economy started to turn down, default rates started to appear at around the same time. Is it possible that the quants were so buried under leveraged layers of derivatives and other exotic instruments that they didn't see the coming storm? This seems like a pretty big movement to miss. After all, if you're sitting on top of a few billion in debt that is on the razor's edge of liquidity, wouldn't you spend some time looking at it more closely, especially with such broad macroeconomic factors staring you in the face?

Maybe the problem was just that — too much attention to the monetary and business-related factors and not enough attention to the movement of markets on a broader scale.

In the early '70s, I had the unique opportunity to take economics classes from the legendary (but until recently, obscure) Hy Minsky. Minsky is known for the "financial instability hypothesis," which proposes economic expansions become unsustainable booms ending in crisis and economic unraveling. Speculation. Greed. Disaster. I first heard the phrase "Chaos Theory" from Minsky thirty-five years ago.

Minsky has suddenly become very popular (unfortunately he passed away in 1996). One of his memorable quotes in class (there were many) was: "All panics, manias and crises of a financial nature have their roots in an abuse of credit." He used the Dutch Tulip mania of the 1600s as an example. He believed that financial systems experience rounds of speculation that, if they are severe, end in crises. Minsky was considered a radical for his stress on their tendency toward excess and upheaval.

Minsky showed that bubbles are an inevitable result of market activity. Buyers who show gains with a successful strategy encourage other buyers until it stops working. When investors have to empty their portfolios of even their prime holdings to cover their positions, markets start to circle the drain. At that point, the "Minsky moment" is obvious.

And it's here — Bear Stearns, Countrywide, Lehman Brothers, Merrill Lynch.

So the question is, why didn't the best and the brightest see it coming? We need to do some soul-searching. Is there really any benefit to advanced analytics and an analytics culture if doesn't see the train coming through the tunnel? Or is it something else? I think that no one wants to believe a "Minsky Moment" is coming.

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