Slaves to the algorithm

Dip below the surface of the credit crisis and you'll find yourself immersed in a cloudy soup of strange financial instruments - credit default swaps, mortgage-backed securities, collateralized debt obligations.

Even the term "financial instrument" fails to do the job of explaining what's at the center of this crisis, especially when prefixed with words like exotic, esoteric or toxic. Clearly, though, what we have is an economy within an economy that creates value out of its ability to make a transaction rather than the production of any tangible thing.

But in what space do these instruments exist? How is their value calculated? Are they fact or fiction?

In today's NYT, Richard Dooling locates the derivative inside algorithms being processed by computers and asks, is our credit economy at the mercy of the machine?

Somehow the genius quants — the best and brightest geeks Wall Street firms could buy — fed $1 trillion in subprime mortgage debt into their supercomputers, added some derivatives, massaged the arrangements with computer algorithms and — poof! — created $62 trillion in imaginary wealth. It’s not much of a stretch to imagine that all of that imaginary wealth is locked up somewhere inside the computers, and that we humans, led by the silverback males of the financial world, Ben Bernanke and Henry Paulson, are frantically beseeching the monolith for answers. Or maybe we are lost in space, with Dave the astronaut pleading, “Open the bank vault doors, Hal.”

-snip-

When Treasury Secretary Paulson (looking very much like a frightened primate) came to Congress seeking an emergency loan, Senator Jon Tester of Montana, a Democrat still living on his family homestead, asked him: “I’m a dirt farmer. Why do we have one week to determine that $700 billion has to be appropriated or this country’s financial system goes down the pipes?”

“Well, sir,” Mr. Paulson could well have responded, “the computers have demanded it.”