Software Crisis A Symbolic Warning to Investors

This year has been a difficult year for software safety. Several months ago the Heartbleed bug was discovered which was described as the worst online security threat in 16 years. It was capable of defeating the “Open Secure Socket Layer” (SSL) used in internet commerce. Now last week a new bug in Windows was discovered which has been in existence for 19 years. One would think that after all this time the bug should have been detected and fixed much sooner. "This vulnerability has been sitting in plain sight for a long time despite many other bugs being discovered and patched in the same Windows library,” said one expert.

If gigantic software companies can’t detect these problems until 15 or 19 years later then what about the Federal Reserve and bank regulators who allowed a massive debt bubble, including mortgage backed securities that ruined the banks in 2007, to build up over the past 17 or so years. The total debt from all sources, at 345% of GDP, is now 1.9 times the traditional metric of 181% of GDP. Since this occurred when CPI inflation was low then the funds were not used for consumption but were instead used to speculate in assets, creating risky unstable bubbles that lure naïve people into reckless behavior. The Central Bank, government and investors should have learned from the 2000 dotcom bubble but instead they were asleep at the switch and ignored or were fooled by the 2007 debt and real estate bubble, and then responded to the crash by creating a new bubble. Perhaps their excuse is that they thought the markets were efficient so they could get away with buying a passive index fund instead of checking carefully to see why strange anomalies were occurring in finance such as dangerous “B” paper mortgages magically becoming rated as “A” paper by ratings agencies.

Excessive debt increases the risks that those who are most indebted may not be able to grow their way out of debt in the current era of low growth. This increases the risk of a sudden spontaneous wave of junk bond defaults including mezzanine and LBO and CLO debt defaults. This risk in turn could result in a shut off of capital to businesses most in need of it which would then trigger an economic slowdown in a low growth economy. This could easy tip over into recession. Today credit is being granted to some very shaky businesses with a low probability of successful repayment. Old metrics of repayment may be less applicable in a slow growth economy so one can’t casually rely on traditional probabilities of default since previous decades had less aggressively underwritten debt and a more robust economy.

Just as software experts need to be aware of 19 year old hidden defects, bankers need to be aware that the past 19 years have had a lot of defective monetary policy that created a credit underwriting bubble which was not properly resolved during the 2008 crash. Yes, mortgages are very safe in terms of default risk, but junk grade corporate loans may have plenty of hidden risk.

Everyone should follow software experts on Twitter and learn about these software risks. Some people to follow are

Investors should get independent financial advice about the risk of a junk bond crisis. I wrote an article “Black swans and risk aware investing.”

About the author

Don Martin

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