Saturday, October 17, 2009


If you live in Europe or the Americas, every banana you have ever eaten was probably a variety known as the Cavendish. This are other varieties of bananas, but they look so different (for one thing, they may have large, hard seeds, something bred out of the Cavendish) that you may not even recognize them as the same fruit you slice up on your breakfast cereal. And that's a problem. There is so little genetic diversity in the Cavendish that a single disease could wipe the long, yellow, conveniently self-packaged fruit we all know right off the planet.

Alarmist rhetoric? Not so much. That's exactly what happened to its similarly monogenetic predecessor, the Gros Michel banana.

Michael Osinski argues that a similar lack of diversity nearly led to the collapse of Western Civilization. Conspiracy theory? Again, not so much. Osinski, in an article in New York Magazine, admits that the latest global economic meltdown might have been at least partly his fault.

Osinski wrote the software that was used by nearly every investment bank on the planet to bundle mortgages into a kind of bond known as a collateralized debt obligation or CDO, and to compute an asking price for the result. A user of Osinski's software package would pour thousands of individual mortgages into one end, puree them into a smooth consistency, then parcel the results out into many different investment vehicles, each vehicle containing a tiny portion of each of those mortgages. Then many individual investors bought a portion of those investment vehicles. Investors like your 401(k), your mutual fund, and your pension plan. His software computed the value of the CDO based on many factors including the risk of the mortgages that went into it.

Because each mortgage was blended together with thousands of other mortgages, the risk of default of any one individual mortgage was spread out. Because the resulting smoothie of mortgages was distributed into many different investment vehicles, even if many mortgage holders were to default, those bad mortgages would be a tiny portion of each investment vehicle. And because the ownership of each investment vehicle was spread out among many investors, the tiny risk was shared among many. In the case of your 401(k), your mutual fund, and your pension plan, the investor itself was in fact made up of money from many different individuals.

The only way it could possibly go wrong would be if the entire housing market suddenly collapsed. And what were the chances of that happening?

How do you determine the worth of something? As someone who has bought and sold a used motorcycle or two, I can tell you that this isn't the easiest question to answer. My Honda CB700SC that was a basket case (that is, it had been separated into its component parts, and would take some work to get it running again), I sold it for a fraction of its book value, which is, after all, just someone's opinion based on what others have actually paid for a particular model of vehicle. My Harley-Davidson FLHS, on the other hand, I sold years later for more than I paid for it. See, in a free market, the worth of something isn't what some piece of paper or blue book says it is. Its worth is what someone else is actually willing to pay for it. Once you grasp that, it becomes clear why touchy-feely factors like investor confidence suddenly become really important, because the idea of value has a significant psychological component.

When the housing industry collapsed and house prices were suddenly severely deflated, people discovered that they owed far more on their mortgages than their homes were worth, because their homes were worth only what someone else was willing to pay for them.

That may not seem like such an issue if you've never owned a home. When you take out a loan to buy a car (or a motorcycle) for example, the vehicle is probably worth less than you owe on it as soon as you drive it off the lot. But houses are different. When your job transfers you to another state, or you graduate from college, or you lose your job and have to move to where your employment prospects are better, you can take your vehicle with you. But typically you'll have to sell your house, if for no other reason than to take the money you make on the sale to use as a down payment on a house in your new town.

That is, if you make any money on your house. But if you find you owe more on your home than someone else is willing to pay for it, you are seriously underwater. You can no longer afford to sell your home, because you can't afford to pay off the balance of the mortgage. You can't afford a new home, because you don't have the down payment from the sale of your previous home. You can't afford to move, even though your job depends on it.

The solution for many people was to just walk away from their old homes, to default on their mortgages, and leave the mortgage holder holding the bag. And by mortgage holder, I mean, ultimately, your 401(k).

The risk of default of each of those pureed mortgages was among the parameters supplied by the users of Osinski's software package. It took these risks into account when computing the value of the CDOs. The sudden default of so many mortgages more or less simultaneously was not a risk factor that the users of Osinski's software had anticipated. They had seriously underestimated the risk, and hence the software package had seriously overvalued the CDOs. Investor confidence in mortgage-backed securities eroded; taking all of that risk (which had in fact always been there) into account devalued the CDOs, which now found themselves owning toxic assets in the form of defaulted mortgages. And because of the incredibly broad distribution of the ownership of the CDOs, we all ended up owning parts of defaulted mortgages that were worth virtually nothing.

In a talk he gave at a recent conference I attended in Santa Fe, computer scientist and financial software guru Arthur Whitney (who, by the way, decades ago worked with Kenneth Iverson on the programming language APL) estimates that in a matter of days the valuation of these CDOs fell from around US$33 trillion to US$8 trillion.

Let me make this clear: almost overnight, twenty-five trillion dollars in wealth evaporated. It didn't get spent. It wasn't stolen. It simply ceased to exist because thousands of investors suddenly decided not to buy into the consensual hallucination that was the housing bubble.

So what, if anything, does this have to do with the kinds of topics I usually write about? And what the heck does it have to do with bananas?

Here's the thing: just about every investment bank on the planet was using Osinski's software package. For sure, they were all putting in the wrong parameters, and using it for far more complex investment vehicles than Osinski ever intended. But still, it was all the same software package, with the same input formats, the same calculations, the same menus, the same bugs, the same output formats, the same pop-ups, the same errors and warnings. It is possible, just possible, if there had been other software packages being used for this same purpose, that some investment houses might have come to a different conclusion about the risk inherent in mortgage backed securities? Even if the answer is no, the fact that everyone was using the same software package means they were all exposed to the same software bugs, the same design flaws, the same systemic errors.

They were all eating the same variety of banana. Except in this case, instead of losing a much beloved fruit, they ran the risk of a systemic error leading to the collapse of the world economy. Each of us is, in a very real sense, a victim of the success of Osinski's software package.

I recently helped develop an product in which we worked very hard to make the system recoverable in the field by the end-user. If the disk-based system failed, the user could boot up a flash-based system and recover the disk. If the flash-based system failed, the user could boot up the boot loader and recover the flash-based system. If the boot loader failed, the box had to be shipped back.

All three systems ran on the same processor. Much of the very low level code, that which would be typically described as part of the board support package, could have been common between the disk system, the flash system, and the boot loader. It was just a matter of time until someone suggested just that. I argued (vehemently I'm told) against it. Even if the code were exactly the same, I argued against sharing the same source files in the source code control system. Otherwise, a single error in a single source file could lead to a systemic flaw that caused the same defect to occur in all three tiers of the product, rendering the product not just inoperable but unrecoverable in the field.

I understand -- better than most -- the economics of software reuse. And I understand how free markets drive companies to adopt what they perceive to be the best practices, including the software tools, of their competitors (whether they are really the best or not). Economies of scale drive this too. Do all of your employees use the same brand and model of desktop or laptop? Running the same operating system? All purchased about the same time because of a volume discount? And then there's people. Do you hire people that look like you? That share your opinions? That think the same as you so that you feel comfortable around them?

Whether you are talking about software, hardware, bananas, or people, a lack of diversity can lead to dire and unforeseen consequences.

1 comment:

Anonymous said...

Diversity is important as a defense mechanism in many areas. That is the whole purpose of portfolio diversity in investing. It is an argument for portfolio diversity in a product line as well.

I notice an ex CEO of CitiBank, one who actively campaigned for the repeal of Glass-Stegal in the 1990s, has recently publicly called for the reinstatement of Glass-Stegal. Apparently he has learned the value of diversity in banking.

Ken Howard