Technology, Venture Capital, Private Equity

Just finished reading Malcom Gladwell’s “Outliers”, where he describes the role that unaccounted events/circumstances play in bringing about extraordinary results. He uses this mostly to elaborate on the achievements of exceptionally talented individuals, but what was also interesting is some of these examples that he uses to describe the causes for human accidents such as airplane crashes and industrial disasters. For example, he analyses the Three Mile Island nuclear accident in Pennsylvania in 1979. He states -

No single big event went wrong at Three Mile Island. Rather, five completely unrelated events occurred in sequence, each of which, had it happened in isolation, would have caused no more than a hiccup in the plant’s ordinary operation. The first minor problem was a blockage in the plant’s polisher (a giant water filter of sorts). This blockage caused moisture to enter the plant’s ventilation system which tripped closed two valves thus preventing cold water from entering the plant’s steam generator to control its temperature. These two problems by themselves would not have caused a problem since the plant had a backup cooling system set to activate in such a situation. However, for some unexplained reason, the valves of the backup system were closed that day. But this too should not have caused a problem since there was a light on the engineer’s control panel that illuminated indicating that the backup system’s valves were closed. Unfortunately, the warning light was blocked by a repair tag hanging from the switch above it. But there was still another backup system in place that should have cooled the reactor when it started heating up. But, as luck would have it, the relief valve wasn’t working properly that day either. It stuck open when it was supposed to close, and, to make matters even worse, a gauge in the control room that should have told the operators that the relief valve wasn’t working was itself not working. By the time Three Mile Island’s engineers realized what was happening, the reactor had come dangerously close to a meltdown.
In other words, for a “perfect storm” to form, a variety of unlikely factors have to align in an extraordinay manner. One could probably argue that the current financial meltdown that we are living through is an example of that. The string of events which has led to the current state of affairs would probably be as follows:

1. The dotcom meltdown in the early 2000s leads to a severe downturn in the U.S. economy
2. The fed reacts by sharply reducing interest rates and pumping up the money supply
3. The huge increase in liquidity results in a credit glut and leads to an era of extremely cheap debt
4. The cheap money finds its way into the consumer home loan market
5.Meanwhile, the Glass-Steagall act, which had stringently limited the risk on commercial banks by barring them from trading of risky securities is repealed in 1999
6. Taking advantage of this, commercial banks like Citi, have invented a means of offloading much of the risk on their loans from their own balance sheet through a mechanism called securitization
7. This gives them an incentive to sell as many loans as possible with the hope of increasing their profits. As a result, they go after anyone who is willing to accept a loan including those who were traditionally uneligible  i.e.- the subprime customers
8. The rating agencies, who were supposed to act as watchdogs for the credit industry fail to discharge their responsibilities because of misaligned incentive structures, wherein more debt being issued translates into more fees for them. To complicate matters, these fees are paid not by the buyers of the debt, but by its sellers (which results in an obvious moral hazard for one cannot obviously bite the hand that feeds him). As a result, what was supposed to be low quality debt, is passed of as high quality
9. Other traditionally conservative institutional like insurance companies (such as AIG), also decide to play along and “insure” these securities against losses
10. Meanwhile, the large investment banks, which traditionally acted only as agents or brokers, have now also assumed the role of principals or investors putting their own capital to work

What follows from above is what we see today – a financial hurricane that has sucked every entity into its fold. Had any one of the above not happened, it is arguable that the current crisis would not have unfolded in this manner or at the very least with this serverity. Truly, this has been an extreme example of an “outlier event”.