Tuesday, July 27, 2010

Natural Selection, Finance and Extinction

The current U.S. financial sector has been selected to reap enormous profits off a very narrow ecology of speculation, credit, risk and leverage. That parasitic specialization makes it highly vulnerable to extinction.

One of my projects is to integrate the insights offered by the processes of natural selection into the Survival+ critique and recommendations.

This line of inquiry has led me to ask: is the current financial system as robust and resilient as its many backers claim, or beneath the hype and propaganda, is it actually acutely vulnerable to collapse?

From the point of view of selection, we would start by considering the ecology the system has evolved in, and ask how specialized the system has become--in other words, how dependent is the financial system on narrow and potentially vulnerable sources of energy?

In nature, species which go extinct often do so when they have become increasingly specialized to exploit a narrow source of sustenance. Such species evolve that specialization in order to exploit the windfall offered by a food supply that has fewer (or even no) competitors.

This lack of competition offers the species rich rewards for specializing (long beaks maximized to fit certain flowers, etc.) even as they increase the species' vulnerability to a breakdown or collapse in the limited source of food they have been selected to exploit.

The narrower the base of food and the greater the specialization, the more vulnerable the species will be to reductions in that food source. Thus a plant disease which wipes out the specific flowers will drive the bird with a highly specialized beak to extinction unless it can adapt quickly enough to another food source, or leave that ecology for one with a new source of similar flowers.

The U.S. financial system has already exploited the standard ecologies of capital and lending. How profitable is originating and holding plain-vanilla mortgages? Not very profitable at all, compared to the vast profits generated by securitizing mortgages and writing derivatives against those bundled and tranched loans.

The U.S. financial system in effect stumbled into a new ecology of profitable windfalls that no one else had ever seen or exploited: extremes of leverage and securitization were not just possible in this new environment, they were rewarded with vast profits.

It seems to me that the U.S. financial system, dominated by highly profitable money-center and investment banks, is akin to a species which has adapted to exploit a very specific ecology of finance: a world in which leverage is unlimited, and assets, liabilities and risks can be gamed and cloaked in a "shadow banking system" free from competition and interference.

But unbeknownst to the members gorging on the windfall exploitation of this newly discovered "financial innovation" ecology, the system had become precariously dependent on ever-rising leverage, securitization, credit expansion and the "shadow banking system" which enabled this exploitation.

Were this ecology to collapse, so too would the financial system which had become dangerously dependent on this source of profits.

It seems that is one way to describe precisely what happened in 2007-2008 when the system's source of profits--the highly specialized ecology of ever-rising credit, leverage and derivatives--collapsed.

The old environment of originating mortgages and business loans with modest margins is full of competition and thus not very profitable; there is no way for the U.S. financial system to reap the kinds of staggering profits it has become accustomed to from "old style" banking, credit creation and lending.

Thus the Central State's political leaders are trying desperately to do the impossible: to limit the opportunities for profitable windfall exploitation without undermining the entire narrow financial ecology upon which all the sector's huge profits depend.

Exquisitely sensitive to the possibility that limiting the sources of profit--the shadow banking system, the leverage, the derivatives--might end up killing off the highly specialized species of finance which feeds their re-election campaigns, the politicos have engaged in a convoluted facsimile of reform which leaves the ecology open for exploitation by money-center and investment banks even as it attempts to rein in the most extreme exploitation.

But the foundation of the financial sector's gigantic profits are not broad--they are very narrow. The financial sector does not depend on the sprawling U.S. economy for most of its profits--it depends on a narrow slice of fecund financial territory that would wither under transparency and strict regulation.

The irony is that State manipulation and a studied lack of oversight enabled the blossoming of this highly specialized species of profit, and now State manipulation threatens to undermine it.

But Nature itself may foil the plans of both the supremely specialized financial sector and its State toadies. The financial sector is now so specialized and so dependent on dwindling sources of profit that even State manipulation cannot broaden its withering supply of financial fodder.

The financial system cannot go back to the slow-growth, unleveraged transparent financial environment and retain its vast profits. So as it clings to the dwindling ecology of leverage, risk and shadow banking, the system is selecting itself for extinction.

Given its parasitic, predatory nature and the little value it adds to the real economy, that extinction of the shadow banking system would be a highly positive prospect for everyone but the parasites themselves, who can always choose to become lower-paid bankers doing traditional, transparent low-profit banking.




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