A number of you have asked me to sum up my thoughts on the causes of the current crisis.  One way to surmise this is to read some of my some of my posts over the last year, but I will also try to write an extensive post about this at some point soon.
 
In the mean time, at a basic level, my opinion is that the causes of the current turmoil boil down to this:

1. Hubris: People massively overestimated their ability to analyze the future with simple financial models.
2. Leverage: Regulatory institutions encouraged risk-taking by turning a blind eye to capital controls and other limitations on leverage.
3. Innovation: Financial innovation pushed the envelope as securitization driven by 1) and 2) fueled a massive real estate and private equity boom.
4. Incentives: At each step of the process, incentives were put in place for individuals to create deal flow, issue more mortgages, buy more companies, and otherwise push more paper. At no point did any individual feel that the risks they were creating would be born by them personally…and as it turns out, even by their firms.
5. Reinforcement: A continuing rising tide convinced each of the players that the models worked, that the system was properly tuned and that nothing was wrong.
6. Reality: It turned out that the models were vastly over-simplified, that the world was different than expected, and there was too much leverage in the system gone haywire to turn it around.

The key takeaway from all of this is simple: Finance is as much art as it is science, and as such it is much more difficult to model than any other science.

Never forget: Finance is not Physics. The so-called “risk free” rate is not analogous to the speed of light. It is not a truth in any hard sense. 

Nicholas Taleb explains in this article why some risks are difficult to estimate: The Fourth Quadrant: A Map of the Limits of Statistics

When Nassim Taleb talks about the limits of statistics, he becomes outraged. “My outrage,” he says, “is aimed at the scientist-charlatan putting society at risk using statistical methods. This is similar to iatrogenics, the study of the doctor putting the patient at risk.” 

Without any of the above factors, we would not be where we are today. Where to go from here is something I am also hoping to spend some time thinking about soon.

Imagine watching the water rise in your home…first just a trickle through the bottom of the door, then to your ankles, then to your waist…

People in New Orleans and now Galveston have experienced the feeling of literally watching their homes flood before their eyes.

Thankfully, many people in Galveston evacuated before Hurricane Ike hammered the island south of Houston before this weekend’s storm. However, even those who left are now facing the aftermath of a storm that flooded most of Galveston Island.

Some of these homeowners will be able to pick up and start over thanks to the flood insurance policies they purchased. Unfortunately, some homeowners did not buy insurance, and for these unlucky few, when they return home they will have almost nothing left.

A similar phenomena has been occurring in the financial markets.

Many institutions took risks, and rather than buying insurance (in the form of conservative practices), they decided to rough it, perhaps convinced like a few stubborn Galveston homeowners, that because it had not flooded for the last twenty years, that it would not flood this time around.

The horrible irony of the flood analogy is that for many of these institutions, and more offensively their shareholders, they did not have to buy insurance because the federal government stood waiting in the wings to bail them out. At the same time, many home owners will not be as lucky…sure they might get a FEMA check to help with some of their relocation expenses, but they will be wiped out – because they took a risk (living by the water) and did not protect against it (buy flood insurance).

Tonight the Federal Government has agreed to loan AIG $85 B dollars in exchange for a majority stake in the company in order to avoid the dreaded CDS Scenarios alluded to in my previous post (AIG Gets $85 Billion Fed Loan, Cedes Control to Avert Collapse).

In the most twisted of ironies, the Federal Government is acting as an insurer to an insurer who failed to insure itself like any responsible citizen.

Although it is unclear from the current news whether AIG shareholders will be completely wiped out, if they – like their Bear Stearns brethren before them – receive anything more than $0, this is truly a deplorable decision.

As I mentioned at the time of the Bear Stearns decision, I understand that the government feels the need to prevent the kind of systematic calamity that would exist if a massive counterparty failed  – especially one the size of AIG who is a participant as a principal in far more markets than Lehman or Bear Stearns. However, they should do as they did for Freddie and Fannie and eliminate the equity value of the firm. If AIG has truly failed, then let it be so.

The alternative – for the Fed to act as an after-the-fact insurance policy when the storm comes – undermines the very free market that the current administration claims to support.

My heart goes out to the families in Galveston, and the workers at Lehman and on main street who are suffering in the midst of our nations greatest financial challenge since the Great Depression.

I only hope our leaders use these decisions as lessons learned to develop more reasonable principles and to reach fairer decisions in the future…and in the mean time, I hope they have not done what it appears they might have done in jeapordizing the financial wherewithal of the federal government to protect shareholders of irresponsible institutions.

As I write this, according to the Financial Times (here), some of my former colleagues are shuffling out of their offices at Lehman Brothers’ Headquarters on 7th Avenue in New York. The Internet is swarming with news suggesting that Lehman Brothers may be filing for bankruptcy tonight, marking the end of an era for a great firm, who also happens to be my first employer.

Only on a weekend when my hometown of Clear Lake (a suburb of Houston) was hammered by the biggest hurricane of my lifetime and my great-aunt passed away, could the news of Lehman going bankrupt be the third worst piece of news I have received over the last few days.

The failure of Lehman is not only sad because of the fact that so many of my friends and former colleagues will likely be unemployed tomorrow, but it is also scary because it has massive implications for the various different financial players who have contracts with Lehman as a counterparty.

As I noted here in January: The Fan, the risk of a major CDS counter-party failing has been my biggest fear about the credit crisis since I first started blogging about all of this last summer.  This post explains CDS: CDS = Crazy Derivatives Stuff.

Thankfully, the Federal Reserve appears to have orchestrated an emergency trading session today (Derivatives Market Trades on Sunday to Cut Lehman Risk) in an attempt to avert disaster Monday morning.

However, given the fact that the various players in this market were unable to anticipate Lehman’s failure, how can we have confidence that they will be able to anticipate the wide-ranging implications that Lehman’s bankruptcy will have?

It is hard to imagine that it was only last week that the government decided that it would be necessary to bail out Fannie and Freddie: Government Bails Out Fannie Mae and Freddie Mac

Apparently Mr. Paulson and the SEC orchestrated meetings with all of Wall Street’s leading players on Friday and over the weekend in an attempt to find a savior for Lehman. That no one was willing to step up to the plate only indicates how dire the situation truly has become.

If I had to guess, I would imagine that the challenge of estimating the potential liability associated with Lehman’s massive balance sheet in addition to the challenges in valuing its large real estate portfolio were stumbling blocks.

However, the larger reason why no one saved Lehman may be because no one could. Although some commentators at the WSJ speculate that Potential suitors were selfish in their analysis, the more likely reality is that any potential buyer is facing large challenges of their own today.

Remember, the Federal Government, the buyer of last resort, has already been tapped to support the entire real estate market through its support for Fannie and Freddie, suggesting that another Treasury backed purchase is not only impractical but likely infeasible. Furthermore, Goldman, Morgan Stanley and the other Wall Street players have billions of dollars of illiquid assets and untold counterparty risks of their own to wrestle with.

Apparently, Bank of America may be swooping in to save Merrill Lynch from the backdraft from Lehman’s implosion, but even this move is not without a large degree of risk for the largest domestic retail banking institution who has already taken on the risk associated with its Countrywide purchase last fall.

And if all this news isn’t bad enough, AIG is also on the brink of a downgrade which may force it to tap the Fed for up to $40B in loans as it seeks to avoid Lehman’s fate (AIG Seeks $40B Bridge Loan). As an insurer, AIG’s failure would have even broader implications for the derivatives markets than Lehman’s failure will.

I hope that by some miracle we wake up tomorrow and Lehman is still standing with no bankruptcy filing in hand. (Update: Just after Midnight EST Lehman confirmed that the holding company is filing for Chapter 11). I sincerely believe Lehman is a great firm filled with brilliant and good people, which is what makes its failure all the more difficult to stomach.

Unfortunately, it is also a product of a system that has collectively overestimated its ability to predict the future and assess risk. The collective machine that is our financial markets was ruled by hubris and incentives that created innovation and leverage based on a worldview that turned out to be flawed.

And as we continue to witness the unwinding of this leverage, which unfortunately still has a long way to go, we will unfortunately continue to see more failures and losses borne by individuals who are a product of this system that is beyond anyone’s control.

This was a sad weekend. Let’s hope for a brighter tomorrow.

Transitions in life seem to come up more often when one is in graduate school…or at least I have convinced myself that I am at yet another transition point as I head into the final year of my four year JD-MBA program.

On the one hand, this next year will be just like any other in my life:  it will consist of 365 days, some of which will be good and some bad. I will meet people, get back in touch, travel, do things, learn…

But I guess the idea that the world is my oyster waiting for me to paint the canvas down the path less traveled into the wild blue yonder only has so much of a half-life.

I used to morbidly joke with friends that if I hadn’t become famous or successful by the age of 27 then my life would be over – figuratively and literally.

That year came and went, but thankfully I had school in my back pocket to justify why I was still waiting to make my mark.

Now that the prospect of graduation is looming on the horizon, I guess I am realizing that I don’t have any more ready-made society-tested excuses for not yet being “great”.

When I was in junior high school, the disciplinarian assistant principal, used to sit me down in his office and tell me about how his next-door neighbor “had so much potential, but never made anything of it…because he was a jerk.” Although the story didn’t get me to joke less or pay attention more, the idea of being stunted in realizing my potential has subconsciously haunted me for as long as I can remember.

So now as I head into the final year of this important-sounding program, I look in the mirror and search for the potential-realized, and when I am honest, I know that it has not yet happened.

A friend of mine who is successful by almost any measure recently talked with me about this feeling, which is exemplified by the test crammed for, the race ran three-quarters speed, the first-draft of a blog-post hastily thrown out into the Interwebs. By never putting a full effort forward, we avoid both great accomplishment and disappointment because we have a built in excuse…of course we could have done better if we had only given it our “full effort.”

So maybe this year marks the transition to when I finally need to stop putting my accomplishments in the distant future. I want to give it my all-or-nothing, everything-at-once very best effort.

The only thing is…I still don’t know what to do with or where to put all of these so-called efforts.  That’s the trouble with life: it doesn’t come with a guidebook.

So maybe instead, these “transitions” will keep coming…at moments where reflection dominates, places change, faces are new, and questions of the future direction of the current chapter come into focus.

That doesn’t mean I will stop fretting about this transition year. But maybe it means I have a bit more time before I have to stop dreaming about doing something truly great.