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Sub-prime and climate change

By Graham Young - posted Friday, 30 January 2009


Is there a link between the demise of Lehman Brothers and global warming? Jennifer Marohasy certainly seems to think so, but she doesn't say why. There is a spate of theories from her commenters.

I think that there is a link, but it's not specific to Lehman Brothers, but rather systemic, and it has to do with computers and modelling.

When I first started in finance in 1983 I was issued with a Hewlett Packard HP12C calculator. This nifty little beast, which I still own, was programmable, although we mostly used only the five or so buttons needed to work out lease rates. But this was before personal computers, so for most investors and developers cash flows were still laboriously produced using pencil and paper. Changing one variable meant rubbing out a lot of spreadsheet, so you made sure your assumptions were very robust.

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Personal computers changed all of that. A few years later I was programming Lotus 123 spreadsheets to automatically predict development profits in which I could tweak the assumptions ad nauseum. I wasn't the only one, and pretty shortly no valuation was complete without a discounted cash flow, with sensitivity analysis.

At the same time, as a result of the 1987 sharemarket crash, New York stockbroking firms were going one step further and hiring physics PhD graduates to construct computer programs to predict the direction and magnitude of stockmarket prices. These graduates shamelessly took their millions, even though they should have been aware that the task was the philosopher's stone of sharemarket investment.

In the real estate investment and development industry computer models never really took over. Valuation practice meant that valuers had to check their calculations by using at least two, and preferably three methods for comparison. Cost of construction and direct market comparisons didn't negate computerised discounted cash flow models, but they did mean banks wouldn't lend to you on the digital blue-sky valuations. The models might be right, but few lenders were prepared to risk their shirts on them.

I know I soon realised that if it didn't work on the back of an envelope, then making it work with a computer program was very dangerous.

The same thing can't be said for equity and credit markets, where asset pricing models for risk have taken over at the large ticket end of things. Which brings us to the sub-prime mess.

Even though a cursory explanation of how the mortgage packages were structured sounds daft, the models said that they were fine. GIGO (garbage in garbage out) is the technical term for this. And the models were so complex, and the products they were used to produce so opaque, that no one really knew the full risks of what they were "investing" in.

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And at the bottom of the pile, making all of this possible with abstract computerised models, were undoubtedly a lot of physics and maths graduates.

Which is pretty much where we are with climate change. There are some "back of the envelope" models of what happens with increases in CO2, like this one. Or slightly more complex ones like this (thanks to Jennifer for both the links). Neither requires a computer, just a pencil and a sheet of paper, plus some advanced maths. While both predict temperature rises, there is nothing too scary about them.

To get the scary temperature rises requires GCM (general circulation models) which run on computers and are programmed with positive feedbacks. Like the models under-pinning sub-prime mortgage securitisation, you have to be a specialist to get a good handle on them, so most decision makers just trust the programmers, because, as they have PhDs in physics and maths, they must have sound judgment, mustn't they? Just like those graduates programming the assets risk allocation models? Whoops.

Which is where Lehman Brothers legitimately comes into the argument. It didn't go broke because it ran a program promoting carbon trading. They went broke because they, and many others, relied on smart people to construct models which ultimately didn't reflect the real world. Undoubtedly many inside Lehman Brothers and the other Wall Street firms knew that they didn't, but there was a conspiracy of silence. No one wanted to risk this year's bonus or next year's promotion by pointing out that the only thing transparent about these opaque models were the emperor's clothes!

So it is with global warming. Other methods of evaluating the risks, like reviewing the historical record, suggest that nothing happening at the moment can't be accommodated, but the models say otherwise, and the weight of money and ambition has gone behind the models. As a result, we in the West are caught up in an environmental bubble economy where everyone is spruiking climate change.

Which is where Lehman Brothers comes in again. While these phenomena can persist long past their natural life, in the end, they burst. It's costing perhaps a trillion dollars to clean-up the subprime modelling mess in the US. How much will it cost to clean-up the AGW modelling mess in the world?

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First published in Ambit Gambit on September 22, 2008. This article has been judged as one of the Best Blogs 2008 run in collaboration with Club Troppo.



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About the Author

Graham Young is chief editor and the publisher of On Line Opinion. He is executive director of the Australian Institute for Progress, an Australian think tank based in Brisbane, and the publisher of On Line Opinion.

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