Sub-Prime Mortgage Crisis-Explained!

Recently, my favorite radio show teamed up with NPR news to do an in-depth collaboration on exactly what went wrong with the US sub-prime mortgage crisis. It turns out to be a perfect example of how a complex system can go wrong. So I thought I'd give a summary of what they found, and discuss how it relates to what we know about complex systems in general.

The whole thing started with what our radio hosts call "the global pool of money." In the early 2000's, there ended up being a whole lot of people around the globe with lots of money to invest. The amount of money looking to be invested had doubled in the past xxx years, due in part to growing economies in other countries.

The wealth holders of this money needed somewhere to invest this money, to keep it safe and growing. A large subset of them wanted safe investments, where the return on their money would be moderate but reliable. So they and their brokers looked around for safe investments to make.

While this was happening, Alan Greenspan was trying to help the US economy out of the post-internet bubble slump. He did this by setting interest rates extremely low: around 1%. This means that US treasury bonds, one of the safest investments historically, would be getting extremely low returns for a long time. So the pool of money had to look elsewhere.



The lack of traditional safe investment options meant that the brokers had to get creative. So they looked around and they saw this:



All over the country, retail banks (the kind of banks you and I use) were loaning money to homeowners, who were repaying the money with interest. These were safe investments on the banks' part because historically, very few homeowners default on their mortgages. The brokers wanted to get in on this action, but mortgages are too small and detailed to get involved with on an individual level. So they set up a system like this:



The retail banks would lend money to homeowners, and then sell these mortgages to investment banks. The investment banks would buy tons of these mortgages and organize them into "bundles" of hundreds at a time. These bundles would be sold to Wall Street firms, who would create "mortgage-backed securities" out of the bundles, and sell shares in these securites to the global pool of money.

This system worked fine for a while. But by 2003 or so, virtually every credit-worthy indvidual with a home had already taken a mortgage. There were no more mortgages to be bought. But the global pool of money had seen how effective these mortgage-backed securities were, and they demanded more. This sent an echoing voice all the way down the chain saying "GIVE US MORE MORTGAGES!"

To fill this incredible demand, the retail banks started relaxing the standards for who they loaned to. The radio show tells the fascinating story of how every week, one requirement after another was dropped, until they reached rock bottom: the NINA loan. NINA stands for "No Income, No Asset." It means you can get a loan without even claiming to have a job or any money in the bank whatsoever. In the words of one former mortgage banker "All you needed was a credit score, and a pulse."

In the old system, no bank would ever think of giving a loan without verifying the borrowers income and assets. This is because the bank had an interest in seeing that it got its money back. But under the new system, the banks would just sell the mortgage up the chain and wash their hands of it. If the borrower defaulted two months later, it would be someone else's problem.

Still, you would think that someone would realize that an investment system built on no income, no asset loans was bound to fail. And indeed, many people did realize it. But the money kept flowing in from the global pool, and everyone in the chain was getting rich in the process. Saying "no" to the system seemed like ignoring a pot of gold right in front of your face.

Two additional factors prevented reason from prevailing. First, the computer models used by the investment banks and Wall Street firms were telling them that everything was going fine. No one made the connection that the models were using data from pre-2003, when loans were made on the basis of actual assets. Second, housing prices in the US were going up. If a borrower defaulted, then the bank would own the house, which as long as prices were rising would be worth more than the bank loaned originally.

Of course, housing prices didn't keep going up. And the Wall Street firms noticed at some point that some of the mortgages they were investing in were defaulting on the very first payment. So they stopped buying these bundled mortgages. At that point, the middlemen in the system (the retail and investment banks) were left holding mortgages that no one up the chain wanted, and that would almost certainly be defaulted from the bottom of the chain. And they went bankrupt en masse.

That's enough writing for today. Next time we'll use this crisis as a case study for some general complex systems principles.

Pirates are even cooler than we thought!

So this is mostly a "I saw this and thought it was cool" kind of post: An article in Sunday's Boston Globe describes the research of Peter Leeson and Marcus Rediker claiming that pirates were practicing democracy aboard their ships in the 1600's, well before America or Europe ever got around to it.

Before each voyage, pirates voted on a captain and a quartermaster, whose main job was to be a check on the captain's power. Either officer could be "recalled" at any time. Ground rules were laid out in a written charter. They also had primitive forms of trial and workmen's compensation.

The researchers differ on the motivation for this democracy. Leeson sees it as a necessary organizational system for a cadre of criminals who have to work together without killing each other. Rediker sees it as a political reaction to despotic organization of commercial ships, wherein captains hold absolute power and floggings were routine and often deadly. Pirates, according to Rediker, tried to create a utopian alternative.

Inasmuch as there is a single motivation for anything, I'm inclined to agree with Leeson's point of view. The success of a pirate ship depends on the ability of its members to work together. There is a natural check on any one pirate's power in that any other pirate could pretty easily kill him in his sleep. Unlike the case of commercial ships, pirate society is not tied to any larger land-based social structures.

The question then becomes, what is the based way to maintain organization in a small self-contained society where no individual can dominate the others through force? I think the best and perhaps only workable answer in the long term is democracy, or something like it.

Life's Universal Scaling Law

It ain't easy being green. Biology has long suffered under the label "soft science," a term used (often disparagingly) to draw a contrast with the "hard sciences" of physics and chemistry, whose laws are guaranteed with the certainty of mathematics. But this picture is not altogether true. While biological processes are more complex than physical ones, making simple mathematical formulas harder to come by, there are yet some mathematical rules that hold with a remarkable degree of consistency.

One famous example is the relationship of a animal's mass to its metabolism (the rate at which it expends energy). This relationship is expressed in the simple formula

R = R₀M^3/4,

where R is the metabolic rate, R₀ is a constant, and M is the mass of the organism.

Separate laws exist for mammals, birds, unicellular organisms, and even living structures like mitochondria within cells. The values of R₀ are
different for each law, but the mysterious 3/4 exponent stays the same.

These laws have been observed since 1930, but the reason for the 3/4 exponent has been a mystery until recently. The discovery by Geoff West et al of a mechanism underlying this law was a major triumph for the complex systems movement: a universal law of life explained by complex systems principles.

Specifically, West showed that the 3/4 exponent comes from the way a living thing distributes its resources. If the cells in an animal acted like independent beings, each gathering and consuming its own food, the metabolic rate would be a simple multiple of the mass, that is

R = R₀M

with no exponent. But the cells of an animal aren't independent. They work together to collect, process, and consume energy. To do this they need networks (such as blood vessels) to move resources around. West and his collaborators showed that the 3/4 exponent is determined by the requirements that the network a) reach every part of the animal's body, and b) waste as little energy as possible.

Extending this approach, they were able to explain other scaling laws like the relationship between heart rate and mass. Currently, West is investigating scaling laws in large-scale living communities, such as forests and cities.

I haven't talked much about network theory (a topic for another time perhaps) but West's work suggests the great potential of this complex systems subfield to explain some of life's mysteries.

Is Life Fractal?

I'm sure you all know what fractals look like, but a few pretty pictures never hurt anyone:



Isn't that cool? The key thing about fractals is that if you look at just a small part of it, it resembles the whole thing. For instance, the following picture was obtained by zooming in on the upper left tail of the previous one:



One of the original "big ideas" of complex systems is that fractal patterns seem to appear spontaneously in nature and in human society. Let's look at some examples:

Physical Systems: Pop quiz: is this picture a close-up of a rock you could hold in your hand, or wide shot of a giant cliff face?



I don't know what the answer is. Without some point of reference it's very hard to determine the scale because rocks are fractal: small parts of them look like the whole.

Other examples in physical systems include turbulence (small patches of bumpy air look like large patches) and coastlines (think Norway). These two examples in particular inspired Benoit Mandelbrot to give fractals their name and begin their mathematical exploration.

Biological Systems: Here's an example you're probably familiar with:



And one you probably aren't:



The first was a fern, the second was a vegetable called a chou Romanesco, which has to be the coolest vegetable I've ever seen.

In the case of these living systems, there's a simple reason why you see fractals: they are grown from cells following simple rules. The fern, for example, first grows a single stalk with leaves branching out. These leaves follow the same rule and grow their own leaves, and so on.

Of course, the pattern doesn't exist forever. If you zoom in far enough, eventually you see leaves with no branches. This is an important feature of all real-world fractals: there is some minimum scale (e.g. the atomic scale or the cellular scale) at which the fractal pattern breaks down.

Social Systems: Some people like to extend this reasoning to the social realm, arguing that individuals form families, which form communities and corporations, which form cities, nations and so on. You can try to draw parallels between behavior at the nation level or the corporation level to behavior at the human level.

Personally, I'm a little dubious on this argument. My doubts stem partly from my personal observation that humans seem to act morally on an individual scale, but that corporations on the whole behave far worse than individuals. I think there's something fundamentally different about the centralized decision-making process of a human, and the more decentralized process of a corporation. But this is all my personal opinion. Feel free to debate me on it.

Is Global Complexity Worth It?

I had a wide-ranging lunch conversation with my friend Seth
a week ago. We touched on many things, but kept circling back to the above question. More specifically, I was wondering if our current level of global complexity could ever be sustainable, even with the best international governance and planning.

Let's define what we're talking about. In today's world, actions you take have consequences around the globe. For example, if you buy a computer, it likely was not made in a workshop down the road. The parts that go into your computer come from many different countries. These parts had to cross vast distances to come together, burning oil from other countries in the process. These parts were assembled in yet other countries, shipped several more times, and finally delivered to you. The money that you paid for the computer feeds back into all these various countries and processes, strengthening and perhaps changing them.

The effects of this global entanglement have been amazing. Without it, we wouldn't have computers, cellphones, airplanes, plastics, television, cars, or curry powder in the supermarket. None of these products can be made in any one local community; they all require cooperation on a continental, if not global, scale.

But I'm worried by globalization, on both a theoretical and practical level. It's clear that as humans, we aren't living within our means--I won't go into the details of that argument here. What concerns now is whether the very structure of our global society may be preventing us from ever living within our means.

First, feedback loops are getting too complex. Suppose we lived in a simple, hundred person community, and someone was stealing from his neighbors, dumping trash in the public square, or doing other undesirable actions. These actions would become apparent to everyone in short order, and the community could punish the perpetrator in various ways; economically, socially, even physically.

In theory, we have a legal system now to provide these kinds of punishments. But the more complex our society becomes, the harder it is to identify those who are screwing things up. Furthermore, laws and enforcement vary wildly across countries. Multinational corporations can get away with dumping trash in the ocean, toppling Central American democracies, intentionally creating blackouts in California, or supporting sweatshops in China because a) the actions might be legal in whatever location they're operating out of, b) they can obscure their practices behind a wall of complexity that regulators can't penetrate, and c) the consumers usually have no idea what the company is doing and therefore can't exercise moral judgment in their purchases. It could be decades before any consequences (legal, economic, or environmental) catch up with the perpetrator. And decades is too long to be an effective deterrent.

Second, we are increasingly interdependent. Witness how the mortgage crisis spread throughout American economic sectors and is now spreading through the world. Infectious diseases like avian flu have the potential to go global due to the volume of international travel. Even our environmental problems have globalized--we worry about global warming now, whereas the environmental agenda in the past was more about local pollution issues.

I see this as a problem because it means we have only one chance to screw up. The inhabitants of Easter Island destroyed their ecosystem and suffered for it, but the damage was contained to the island. In our current connected world, one disaster could ruin things for all humanity.

Can we do anything about global complexity and interdependence? I've been thinking about ways we can promote some simplicity in our economy, like buying local food or supporting local independent retailers over mega-chains. I'm not advocating we go back to preindustrial tribal society, but a little extra simplicity seems like a good thing.

Tragedy of the Commons in Evolution

Based partly on the feedback from last column, I'd like to probe a bit deeper into the connection between altruism, evolution, and space. Not outer space, mind you, but space here on planet Earth.

We all know that in Darwinian evolution, the species that survive and reproduce best in their environment are the ones that persist and evolve. We know from observing nature that this system tends to produce sustainable ecosystems in which every species seems to play a useful role, even if they are also competing for survival. In particular, no level of the food chain eats so much of the level below as to cause it to go extinct.

Now suppose that in a grassland ecosystem, some animal speices got really good at eating grass. So good, in fact, that it could devour an entire field, roots and all, in a season, and use all that energy to reproduce faster much than its competitors. It would seem that this species has an evolutionary advantage over its slower peers. Of course, this advantage would be very short-term; the grass couldn't grow back the next season, so all species, including this super-eater, would starve.

This situation might be called a Tragedy of the Commons, a phrase popularized by a 1968 Science article by Garret Hardin. This phrase refers to a general situation where there is a shared resource everyone depends on. Without some check on everyone's behavior, some individuals may be tempted to take more than their share, and if this happens too often, the resource is depleted and everyone suffers. (The current depletion of the global edible fish population is one of many real-life examples.)

The question is, why hasn't this tragedy wiped out life on earth by this point? What's to stop a super-eater from spontaneously evolving somewhere, multiplying rapidly, spreading throughout the planet, and destroying all life everywhere?

Several studies (May and Nowak, Werfel and Bar-Yam, Austin et. al.), each taking different approaches, point to a common answer: space. If a selfish overeater evolves somewhere, it will exhaust the resources around it, but then it will die off while other species in other ecosystems live sustainably. As long as there is sufficient space in the world, an overzealous species will cause its own destruction before it can spread very far. In this way, evolution on a sufficiently large planet actually favors organisms that live in harmony with their environment.

Now, if there was some species that could not only suck its environment dry, but also move fast enough to outrace the devastation it was causing, we'd have a real problem on our hands. Fortunately, it seems this has never happened.

Or has it???

Altruistic and Selfish Bacteria

The Boston University Physics Department hosted a very interesting talk yesterday by Robert Austin of Princeton. Austin has been studying the social behavior of bacteria, in order to help understand the social dynamics of other organisms, including humans. He shared with us some intriguing results about selfish and altruistic individuals, and the social dynamics between the two.

Indeed, Austin and his collaborators found a single gene that controls bacteria "selfishness." If it's off, bacteria slow down their metabolism and reproduction rate when they sense their environment has been depleted of nutrients. This prevents them from completely destroying their living space. However, if this gene is turned on ("expressed" is the technical term) the bacteria go right on eating until nothing is left. They even develop the ability to feed off of other dead bacteria.

Interesetingly, the gene is off by default when bacteria are found in the wild. But if you put them in a petri dish, mix them together, and cut off their food supply, you rather quickly (after only about 4 days!) see selfish mutants emerge. These mutants rapidly consume all the remaining food, including each other, and then starve.

This is an interesting conundrum. The petri dish situation seems pretty dire: first the cheaters win, and then everyone loses. This is another prisoner's dilemma situation: cheaters seem to have the advantage over the self-restraining altruists, but if everyone cheats then everyone is worse off.

On the other hand, bacteria in the wild exercise restraint, so there must be something different going on in the wild than in the petri dish.

Intrigued, Austin and his colleagues set up a different experiment. They designed an artificial landscape conatining many differnt chambers in which the bacteria could isolate themselves. Food sources were spread unevenly through the landscape. They also found a way to "manufacture" the selfish bacteria by fiddling with their DNA, and they dyed them a different color from the altruists to discern the interactions between the two.

In this situation, the altruists and the cheaters managed to coexist by segregating themselvs. The altruists gathered in dense clumps (and lived in harmony?) while the cheaters spread out sparsely (they don't even like each other!) around the altruists, occasionally gobbling up a dead one. Somehow, the altruists are able to segregate themselves in such a way that the cheaters can't steal their food; a marked contrast to the first experiments in which the bacteria were continually mixed together. Here's what this segretation looks like within two of the "chambers":



The chamber on the left, which is nutrient-poor, contains mainly cheaters waiting for others to die. The nutrient-rich chamber on the right contains "patches" of altruists and cheaters, never fully mixed. You can't see it from the picture, but the green altuists are very densely clumped and the red cheaters are spread apart from each other.

The possible life lesson here is that altruists can exist in a society with cheaters if the altruists can segregate themselves to form (utpoian?) communities. If there is forced mixing between the two groups then, unfortunately, it all ends in tragedy.

A very similar lesson can be found in the work of Werfel and Bar-Yam, but that's a story for another time.