Sub-Prime Mortgage Crisis Part II: Lessons for Complex Systems

Last time, we talked about what went wrong in the US mortgage market, based on the explanation given by NPR and This American Life. What does this debacle tell us in general about how complex systems can go wrong?

The main problem, in a theoretical sense, is that a feedback loop got too long and complex.

A feedback loop is the process by which an action leads to a consequence for the actor. Let's look at the old mortgage system:



Under this system, if the bank made a bad loan, they'd lose their money. So there was a very direct link between action and consequence. Banks have been dealing with this feedback loop for centuries and have gotten pretty good at making only loans that will get repaid.

But in the early 2000's, the system was replaced by this:



There's still a feedback loop here, but it's longer and more complex. Long, complex feedback loops are dangerous because they can fool people into thinking they're making good decisions, when really their bad decisions haven't caught up with them yet. The investors were pouring yet more money into the broken system, because their actions hadn't caught up with them yet, and they were too far removed from the homeowners to see what terrible shape they were in.

We moved essentially from

bad action ---> bad consequence

to

REALLY bad action --- (long time delay) ---> REALLY bad consequence

It's unlikely that investors will make this same mistake again, because they understand much better now how the mortgage market works. But the general mistake of stretching out a feedback loop, and assuming that you're doing well just because nothing's gone wrong so far, will probably be repeated many, many times.