Seeds of their own destruction

The 2008 Financial Collapse and Black Swan events

Guest post by Alan Cunningham

The phrase, “complex systems can contain the seeds of their own destruction,” is a phrase that appears in Ted Lewis’ 2006 book Critical Infrastructure Protection in Homeland Security: Defending a Networked Nation; with this phrase, Lewis means these systems are self-destructing, “due to nonlinearities that become apparent only when the system is under stress”.

In my view, what Lewis is getting at is that there are systems and methods that are utilized by governments to secure their infrastructure and national security/defence platforms that are open to attack in ways that only become apparent once they are attacked. 

For example, during the early 2000s, the phrase “Too Big To Fail” was commonly thrown around when discussing the business and financial industry, with the phrase getting at the idea that, “a company that’s so entwined in the global economy that its failure would be catastrophic…[the word “Big” does not refer to the size of these companies] but rather it’s involvement across multiple economies”. This idea also had the connotation that these large financial industries, due to their necessity for keeping a government and world economy active, must be protected by government entities to ensure a secure and productive society. Eventually, however, in 2008 the housing market, long considered to be one of the most stable, collapsed. This collapse was preceded by, “an earlier expansion of mortgage credit, including to borrowers who previously would have had difficulty getting mortgages, which both contributed to and was facilitated by rapidly rising home prices…high-risk mortgages became available from lenders who funded mortgages by repackaging them into pools that were sold to investors. New financial products were used to apportion these risks, with private-label mortgage-backed securities (PMBS) [also known as MBS] providing most of the funding for subprime mortgages…When house prices peaked, mortgage refinancing and selling homes became less viable means of settling mortgage debt and mortgage loss rates began rising for lenders and investors”.

In 2007, “the steep decline in the value of MBSs had caused major losses at many banks, hedge funds, and mortgage lenders and forced even some large and prominent firms to liquidate hedge funds that were invested in MBSs, to appeal to the government for loans, to seek mergers with healthier companies, or to declare bankruptcy. Even firms that were not immediately threatened sustained losses in the billions of dollars, as the MBSs in which they had invested so heavily were now downgraded by credit-rating agencies, becoming “toxic” (essentially worthless) assets” and the crisis worsened when a large number of subprime lending corporations ceased operations, resulting in banks stopping the lending of money to subprime customers as these banks, “could no longer fund subprime loans through the sale of MBSs…[this in turn] discouraged home buying even among consumers with prime credit ratings, further depressing sales and prices”.

Because of the fact that many financial giants had now toxic assets in their stores, many “investors sold off their shares of investments”. Around the time that the investment securities firm Bear Stearns became unstable, the federal government “brokered, and partly financed, a deal for its acquisition by JPMorgan Chase”.[6]This was followed by federal government bailouts of Fannie Mae and Freddie Mac (“government-supervised mortgage underwriters”), the investment securities firm Lehman Brothers, and AIG, a finance and insurance company and more damage was only stopped after the Bush administration took action in the form of economic stabilization legislation and “quantitative easing measures”. In the end, “the [U.S.] stock market plummeted, wiping out nearly $8 trillion in value between late 2007 and 2009. Unemployment climbed, peaking at 10 per cent in October 2009. Americans lost $9.8 trillion in wealth as their home values plummeted and their retirement accounts vaporized… [while globally] the Great Recession led to a loss of more than $2 trillion in global economic growth, or a drop of nearly 4 per cent, between the pre-recession peak in the second quarter of 2008 and the low hit in the first quarter of 2009”. In spite of this, America’s economy has, by and large, recovered while most financial analysts and economists have noted that safeguards are in place to try and prevent another crisis and limit the damage.

In my mind, this is an example of what Lewis is getting at in his text when discussing how complex systems contain “the seeds of their own destruction”; the financial system is a very complex system and requires a keen understanding of economics, geopolitics, and finance to understand how such a system operates on a large, national and global scale. Very few prior to late 2007 saw the nonlinearities in the financial system and it became apparent only when subprime lending corporations, like Countrywide Financial or New Century Financial Corporation, began faltering. The financial system’s dealings throughout the early 2000s as well also contained the eventual roots of destruction that would bring the financial system to its’ knees and almost result in a catastrophe worse than the Great Depression of the 1930s. Not only did this have a poor effect on the financial performance of the United States, but this event widened the divide between poor, working-class, white Republicans and more wealthy, upper class, Republicans, resulting in a lack of confidence in the U.S. government and animosity towards elected officials by the American public, the birth of the Tea Party and growing attraction towards Libertarianism, and a divide between regular Americans on basic political issues.

A Black Swan event is described best in mathematician and risk analyst Nassim Nicholas Taleb’s 2007 book The Black Swan. He writes, “What we call here a Black Swan…is an event with the following three attributes. First, it is an outlier, as it lies outside the realm of regular expectations because nothing in the past can convincingly point to its possibility. Second, it carries an extreme impact. Third, in spite of its outlier status, human nature makes us concoct explanations for its occurrence after the fact, making it explainable and predictable. I stop and summarize the triplet: rarity, extreme impact, and retrospective (though not prospective) predictability”. Taleb also argues, “that because black swan events are impossible to predict due to their extreme rarity, yet have catastrophic consequences, it is important for people to always assume a black swan event is a possibility, whatever it may be, and to try to plan accordingly,” while also capitalizing on the 2008 financial crisis too, “argue that if a broken system is allowed to fail, it actually strengthens it against the catastrophe of future black swan events. He also argued that conversely, a system that is propped up and insulated from risk ultimately becomes more vulnerable to catastrophic loss in the face of rare, unpredictable events”. This same article also agrees that the 2008 financial crisis was a Black Swan event. 

Examining the facts of the matter, it is true that very few foresaw the housing bubble as being within the realm of possibility. To quote from the University of Pennsylvania’s Wharton School of Economics’ online business journal Knowledge@Wharton, Wharton finance professor Franklin Allen, “[argues] that many economists used mathematical models that failed to account for the critical roles that banks and other financial institutions play in the economy…Over the past 30 years or so, economics has been dominated by an “academic orthodoxy” which says economic cycles are driven by players in the “real economy” — producers and consumers of goods and services — while banks and other financial institutions have been assigned little importance…But it was the financial institutions that fomented the current crisis, by creating risky products, encouraging excessive borrowing among consumers and engaging in high-risk behaviour themselves, like amassing huge positions in mortgage-backed securities,” while in short stating, “It’s not just that they [economists] missed it, they positively denied that it would happen”. Other professors interviewed for the piece agreed that economists did not foresee a collapse of the magnitude the world experienced in 2008 even though much of this was common sense analysis and prediction.

Certainly, the 2008 financial crisis carried an extreme impact, becoming one of the worst financial crises since the Great Depression of the 1930s. The New Yorker broadly writes, “millions of Americans lost their homes to mortgage foreclosures, and by the summer of 2010 the jobless rate had risen to almost ten per cent”. To put a finer point on what exactly the impact of the 2008 financial crisis had upon the United States and the globe, Pew Research summarized their findings in 2010, writing, “U.S. households lost on average nearly $5,800 in income due to reduced economic growth during the acute stage of the financial crisis from September 2008 through the end of 2009. Costs to the federal government due to its interventions to mitigate the financial crisis amounted to $2,050, on average, for each U.S. household. Also, the combined peak loss from declining stock and home values totalled nearly $100,000, on average per U.S. household, during the July 2008 to March 2009 period”.

Brian Duignan, a senior editor at Encyclopædia Britannica, writes, “In 2012 the St. Louis Federal Reserve Bank estimated that during the financial crisis the net worth of American households had declined by about $17 trillion in inflation-adjusted terms, a loss of 26 per cent. In a 2018 study, the Federal Reserve Bank of San Francisco found that, 10 years after the start of the financial crisis, the country’s gross domestic product was approximately 7 per cent lower than it would have been had the crisis not occurred, representing a loss of $70,000 in lifetime income for every American. Approximately 7.5 million jobs were lost between 2007 and 2009, representing a doubling of the unemployment rate, which stood at nearly 10 per cent in 2010. Although the economy slowly added jobs after the start of the recovery in 2009, reducing the unemployment rate to 3.9 per cent in 2018, many of the added jobs were lower-paying and less secure than the ones that had been lost…Those who had suffered the most—the millions of families who lost their homes, businesses, or savings; the millions of workers who lost their jobs and faced long-term unemployment; the millions of people who fell into poverty—continued to struggle years after the worst of the turmoil had passed”.

Finally, much of the current readings on this incident have tried to explain the crisis and make it seem as though the event could have been predicted. The Financial Crisis Inquiry Commission, in January of 2011, called the crisis an avoidable one and faulted, “Wall Street bankers, regulators, government officials, and even homeowners”. National media organizations and local newsgroups have also endorsed the idea that the 2008 financial crisis was a preventable and predictable one. Academic journals and institutions too have endorsed this idea as well, publishing commentaries and examinations of the collapse that has a predictable attitude when discussing the crisis.

I think it would be very accurate to call the 2008 financial crisis a Black Swan event, examining how Taleb defines such an event while examining the beginnings, impact, and aftermath of the 2008 crisis. In fact, in my own view, a similar argument could be made that the current COVID-19 pandemic is a Black Swan Event (with the only true hurdle of this classification being the wide amount of people within the epidemiological and immunology communities who foresaw another, massive 1918 Spanish Flu-like pandemic on the rise). However, while a vast majority seem to agree that the 2008 financial crisis constitutes an event, there are a few outliers who dispute this reading.


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