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Prof. Andrew Lo, Director MIT Laboratory for Financial Engineering

The first thing I think we ought to do is to create an independent agency whose sole function is to sift through the wreckage of every financial disaster and to be able to produce publicly available reports as to what happened, why it happened, and what may need to be done in order to prevent it from happening again, in other words, the National Transportation Safety Board equivalent for financial markets.

Andrew Lo
Director of MIT’s Laboratory for Financial Engineering

Cambridge

Failures Of Self Government

The greatest and most powerful nation in the world continues to stagger from the massive collapse in financial and credit markets that began in the summer of 2008. Some believe that we’re on the verge of a second major dip in our economy — driven largely by the failure of the job market to show evidence of renewing employer confidence.

“There is an argument that a certain degree of regulatory forbearance may have exacerbated, if not directly caused, this crisis. And, certainly, those regulators have an interest in not sifting through the wreckage, because it will potentially undermine their authority going forward.”

Dr. Andrew Lo

Globalism In Place Of Prudence

Such dire predictions may, or may not be warranted, for the complexities of the world economy make it nearly impossible to ascertain a clear and probative picture of what’s happening here at home without clear insight into what’s happening overseas. Those seeking to know what’s happening are handicapped by what is often untrue, incomplete or unreliable information from those nations, organizations and enterprises seeking to control disclosure.

One need look no further than the immensely threatening deficit problems in Greece to realize that the Euro Zone financial alliance is teetering as much by failures of disclosure as by failures of regulation and oversight. Where once the United States was the most trusted investment environment, due to strict regulations on financial disclosure, corporate governance, and accounting standards, we sold out our credibility for derivative gaming and short term managerial mayhem.

Government Without Governance

In the last three decades, America lost its will to do things right in favor of doing what’s most profitable. It’s not the stale and misdirecting political argument over the size and scope of government that matters to our ongoing success. In the 20th century governments of all sizes, and of all political inclinations, succeeded in governing where recent administrations have largely failed.

No matter which political party is in control on Capitol Hill, or the White House, the outcome has been a sharp swing from responsible government to abstinent government. Nowhere has this been more clear than in the handling of the financial crisis by both the Bush and Obama administrations in ways that purportedly saved the nation from catastrophe by leaving the nation in catastrophe.

If the Obama administration has filed to meet its own lofty goals, as many Democrats and nearly all Republicans claim, its failures have been in identifying what happened, why it happened, and who’s responsible for the cataclysmic collapse of financial institutions and ensuing bailouts of the perpetrators while tens of millions of working Americans lost their homes, jobs, savings and livelihoods.

Where ordinary Americans expected the new administration to protect the interests of all Americans, such expectations have not only not materialized, but worsened as government remained impotent and uncertain of either its purpose or its powers. Fully 18 months after the first signs of collapse were identified, little is known about the people and institutions responsible and even less is being considered in terms of resolution, restitution, or adjudication.

Looking Beneath Rocks Of Concealment

“We develop technologies that allow us to engage in a variety of pursuits that we wouldn’t otherwise be able to accomplish. And, sometimes, those technologies are more powerful than our abilities to manage them effectively.”

Dr. Andrew Lo

Nearly all news, journalism, or commentary publications ( including Newsroom magazine) have failed to speak clearly to how the issues ought to be examined, evaluated and reported. There is legislation pending in the Congress and a full-fledged Congressional inquiry ( Financial Crisis Inquiry Commission ) responsible for hearings and making recommendations to the nest Congress.

But there have been few who have stated the issues, identified the failings of governance, and recommended a framework for thinking about and acting than someone many might consider having been a cause of the catastrophe — a professor of economics and finance at one of the nation’s most prestigious Business Schools.

Dr. Andrew Lo is professor of finance at the Sloan School of Management at the Massachusetts Institute of Technology in Cambridge, Mass. What caught our attention is Dr. Lo’s comprehensive proposal for changing how we regulate and oversee financial institutions — from one of concealment, or what is called the fog of governance, to one that is active and responsible.

We discovered Dr. Lo’s incisive views on both inquiry and disclosure to be so clearly articulated that we recommend reading the transcript ( or watching the video ) of Paul Solman’s piece about him aired on PBS News Hour.

Governance: Protecting People From Themselves

PBS NewsHour: March 12, 2010
Paul Solman – Andrew Lo Segment
Watch Or Listen: Evaluating And Preventing Massive Financial Crisis

JIM LEHRER: Now another of our conversations on the future of Wall Street.

It comes as Senator Chris Dodd, the chairman of the Senate Banking Committee, prepares for a Monday unveiling of his proposals for reforming the financial system.

Tonight, “NewsHour” economics correspondent Paul Solman talks to someone who has studied that system for years.

It’s all part of Paul’s ongoing reporting Making Sense of financial news.

PAUL SOLMAN: MIT finance professor Andrew Lo, whose expertise ranges from math to the medulla, researching how we humans make economic decisions.

ANDREW LO, professor of finance, MIT Sloan School of Management: Pushing the risk out here.

PAUL SOLMAN: Including the disastrous ones that led to the great recession.

ANDREW LO: A situation like AIG.

PAUL SOLMAN: Lo thinks we don’t yet know what went wrong, and has been pushing in Congress and elsewhere a proposal to find out.

ANDREW LO: The first thing I think we ought to do is to create an independent agency whose sole function is to sift through the wreckage of every financial disaster and to be able to produce publicly available reports as to what happened, why it happened, and what may need to be done in order to prevent it from happening again, in other words, the National Transportation Safety Board equivalent for financial markets.

PAUL SOLMAN: After, say, the equivalent of an airplane disaster?

ANDREW LO: That’s right.

PAUL SOLMAN: Do you really think there is an exact analogy between of a part the failure of an airplane, a wing, a deicing system, and the financial crisis?

ANDREW LO: I do. I mean, think about how complicated a Boeing 747 is, and then ask the question, do you think the global financial system is even more complicated? I would argue it is, many, many more times more complicated.

PAUL SOLMAN: But we’re not going to find the frozen O-rings in the rocket that failed, are we?

ANDREW LO: I think we are.

For example, the case of the space shuttle Challenger, it turns out that the O-ring was the proximate cause. That was the actual reason on the day of the disaster that the explosion occurred. But the more important question is, did NASA know beforehand that this was a systemic frailty that they needed to be careful about?

And going through the evidence, the answer seems to be, yes, they knew. At least some engineers knew. Now, to me, that’s the really interesting and important question. Why and how does an organization fail so spectacularly, despite the fact that they have the information?

PAUL SOLMAN: Are we on the verge of creating a national financial safety board? I mean, you testified about such a thing in Congress more than a year ago.

ANDREW LO: Unfortunately, I think that we’re still pretty far away from that. In the case of an airplane crash, everybody wants to know what happened, and everybody wants to know how to prevent it, perhaps with the exception of some undertakers, because nobody, nobody benefits from airplanes crashing out of the sky.

However, it’s been argued that, when a financial firm crashes, or when there’s a major systemic fault, there are certain parties that do not want to know what the answer is.

PAUL SOLMAN: To pursue your cynicism for a moment, who benefits?

ANDREW LO: Well, for one, the individuals that have profited from the disaster. In the case of the recent financial crisis, there are a number of hedge funds, homeowners, mortgage brokers that have taken the money and have run, and are perfectly satisfied with the outcome.

Obviously, those homeowners that have been foreclosed upon, the investors that invested in these kinds of mortgage instruments, they’re left holding the bag. But there are winners, and there are losers. And, so, we have to keep that in mind.

PAUL SOLMAN: And the winners have their winnings to influence the system to keep the regulators at bay.

ANDREW LO: That’s certainly one aspect of it. Another aspect is regulators.

There is an argument that a certain degree of regulatory forbearance may have exacerbated, if not directly caused, this crisis. And, certainly, those regulators have an interest in not sifting through the wreckage, because it will potentially undermine their authority going forward.

I would argue that regulation project protects people from themselves. And the Federal Reserve and other regulatory organizations are really there to help us deal with human frailties, human behavior, coupled with technology.

PAUL SOLMAN: And you think human frailty is a big part of this story?

ANDREW LO: I think it’s the — by far the most important feature of financial crisis. It’s really the combination of human behavior coupled with technological advances.

We develop technologies that allow us to engage in a variety of pursuits that we wouldn’t otherwise be able to accomplish. And, sometimes, those technologies are more powerful than our abilities to manage them effectively.

Neuroscientists have documented that the component of the brain that gets stimulated when we engage in financial rewards is really the same component that is stimulated by cocaine. It’s the dopamine system. And, over time, as we engage in more and more financial gains, we will become desensitized to risks. We will become complacent. We will become much less able to engage in the kind of proper risk management of our portfolios that we should.

PAUL SOLMAN: Are human beings like those rats in the famous experiment that kept taking the cocaine, instead of eating, until they died?

ANDREW LO: Absolutely. All mammals have that aspect to their behavior. Because of our prefrontal cortex, we have other behaviors that we can engage in, like regulations, that prevent us from doing the things that rats can’t prevent themselves from doing. But we do have some common components to our decision-making processes with other mammals.

PAUL SOLMAN: There was a last piece to this interview that we just can’t resist including, though it may seem a bit far afield.

It has to do with another side of Andy Lo, who grew up a practicing Catholic, but now describes himself as an agnostic with an interest in Buddhism. He thinks both it and brain science have insights for financial regulation.

ANDREW LO: Buddhists often say that to live is to suffer.

And, at first, when I heard it, I thought that this was one of these Zen paradoxes that we were not really meant to understand. But it finally dawned on me that it actually is a very simple idea. The idea is that the will to live involves engaging in activities. And those activities are not necessarily happy activities. They’re not associated with pleasure.

More often than not, they’re associated with avoiding pain. So, for example, you need enough money in order to eat. Well, why is that? It’s because, when you don’t eat, you are hungry. And, when you’re hungry, it doesn’t feel good. So, you work in order to earn enough money to make that kind of suffering go away.

In fact, all of life can be viewed as a way to avoid pain. So, in other words, it is suffering. And this is a very deep insight, because what it suggests about us, about the human condition, is that there is a certain degree of hard-wired behavior that all of us engage in.

And in order for us to really understand how not only we behave, but how we as a society behave and what kind of regulations we need to deal with those kinds of behaviors, we have to develop what I think the Zen Buddhists would call a higher level of consciousness, and what I call a meta-model for human behavior.

PAUL SOLMAN: Which is why Andy Lo has been meditating long and hard these days on how to prevent another financial meltdown.