The Tinkerers

by Alec Foege

  The rise of a technological society in general also encourages superior tinkering. To create its cutting-edge bug zapper, Intellectual Ventures bought various parts off of eBay from scrapped consumer electronic devices. They used lasers from Blu-ray players and a mirror galvanometer for steering the laser beam, from a laser printer. In a society that didn’t have laser printers and blue-diode lasers lying around, it would have been much harder to come up with such a novel way to prevent insect-borne diseases such as malaria. “Because there is so much technology in so many things,” said Myhrvold, “if you’re a tinkerer in the twenty-first century, you can tinker at a level that Thomas Edison would be very envious of.”

  Still, tinkering with and inventing stuff is a pretty risky business. Intellectual Ventures tries to hedge its bets by getting involved in as many inventions (based on good ideas, of course) in as many different areas as possible to create a portfolio of inventions. By the luck of the draw, some of those inventions will be bad, but they won’t all be bad.

  Nonetheless, the inventions sponsored by Intellectual Ventures congregate around a few key categories: medical devices, solid-state electronics, energy solutions such as building better batteries. “Each of these areas has different dynamics driving it, and different sorts of inventors involved, but we work in all of them,” Myhrvold said.

  Perhaps the most unusual aspect of most of Intellectual Ventures’ projects is that very few are virtual. Nearly all exist in the material world. The company is not spending the bulk of its resources coming up with e-commerce business models. Rather it is, according to Myhrvold, trying to solve big problems like malaria and trying to make carbon-free energy sources.

  “We try to do big home-run problems that are so big that there isn’t currently somebody working on them, or there is no one who is well positioned to do something about it,” he said. “Because we’re an independent invention factory, we want to swing for the fences and get some really big hits.”

  From a financing point of view, however, Intellectual Ventures is structured similarly to a venture capital firm or private equity outfit. Its legal structure is comparable and it raises funds from the usual suspects: pension funds, university endowments, and the like. Investors typically buy into a fund with a particular time frame and Intellectual Ventures gets to keep a percentage of the profits. If there are no profits, Intellectual Ventures is screwed.

  Myhrvold says his company is doing well, though he warns that invention is a long-term process where you have to be pretty patient. Intellectual Ventures had raised around $5 billion by 2010, which will be spent over an extended period. So far, the company has spent $1 billion and returned a similar amount to its investors.

  Clearly, Myhrvold views big problems as something external, something material and tactile. It’s not that he rejects virtual tinkering—indeed, the majority of his firm’s solutions to those problems are likely to be high-tech in nature—but rather his view of the world seems grounded in its physical manifestations.

  This is not uncommon among people of his ilk. Myhrvold is an innovator, but he is also a performer. In practice, he is a collaborator, but he is also a subscriber to the “great man” approach of getting things done made popular by Thomas Edison. Frankly, his tangibly innovative projects make him look good because they improve our world in novel ways; it’s no wonder he goes to great efforts to downplay the patent-gathering side of his business. How do you show that off to people? And then there’s the ambiguity of its purpose.

  This is all another way of saying that innovation that gets done in the material world is the kind most likely to get noticed. Tinkering that results in laser bug zappers and carbonated fruit is frankly more entertaining to talk about and demonstrate than something virtual and amorphous such as financial engineering. It draws attention to its presenter. It captures the fancy of the general public. Plus, there is something unambiguous about tinkering that results in “good things.”

  By contrast, virtual tinkering is difficult to demonstrate and the benefits of its results, in a number of prominent cases, are often difficult to ascertain. A good example of this is computer file sharing. To the millions who have enjoyed trading digital music, TV, and movie files over the last decade or so via so-called peer-to-peer services such as Napster and LimeWire, the tinkering that produced it solved a big problem: how to gain exposure to an ever-expanding body of culture knowledge. But file sharing during the same time became the bane of the many of the world’s biggest copyright holders, mainly major media companies.

  To complicate things further, virtual tinkering is more often done within the confines of a collaborative environment, far from any notion of fame or even individual recognition and where the greasy fingerprints of hard labor are easily erased. There is, however, one realm in which other rewards may compensate for the lack of these classic talismans. It is the internecine world of financial services: what used to be known in the physical world as Wall Street. And its activities have had a very physical impact.

  CHAPTER 6

  WHEN TINKERING VEERS OFF COURSE

  THE BRITISH SCIENCE WRITER MATT RIDLEY famously and provocatively wrote in 2010 that “for culture to turn cumulative, ideas need to meet and mate,” and that in our current networked culture, “ideas are having sex with each other more promiscuously than ever.”

  If that’s the case, then the financial shenanigans that precipitated the economic downturn were a veritable orgy. In retrospect, many observers of American culture argued that perhaps ours was a nation that was getting too clever for its own good. If the best we could do as a society was to construct highly leveraged investment instruments of mass destruction, then maybe we shouldn’t try our best.

  One of the undercurrents that accompanied the financial crisis of 2008 was a sense that our reliance on complicated financial products that even the experts didn’t fully understand reflected how far we’d gotten away from our traditional strength as an industrialized nation: manufacturing. Instead of tinkering with tools and machines with the purpose of making things, we’d become obsessed with making money at the cost of the nation’s future well-being.

  From the earliest days of his first term, President Obama made speeches that enhanced this narrative. “One of the changes I’d like to see is once again our best and brightest commit themselves to making things,” he announced to students at Georgetown University in June 2009.

  His comments took an increasingly populist tone by evoking a rosy past when manufacturing fueled the economy and condemning the widespread practice of importing foreign goods more affordable than anything American made. “America is still home to the most creative and most innovative businesses in the world,” President Obama told employees at a century-old General Electric turbine plant in Schenectady, New York. “We’ve got the most productive workers in the world. America is home to inventors and dreamers and builders and creators. All of you represent people who each and every day are pioneering the technologies and discoveries that not only improve our lives, but they drive our economy.”

  No controversy there. But what followed took on a decidedly defensive tone. “Folks were selling a lot to us from all over the world. We’ve got to reverse that. We want an economy that’s fueled by what we invent and what we build. We’re going back to Thomas Edison’s principles. We’re going to build stuff and invent stuff.” And, reinforcing the notion that the nation was once better and more productive than it is now, President Obama added, “I want plants like this all across America.”

  Obama’s inspired words, many would argue, were exactly what unmoored American workers needed to hear. Except for the fact that such inspiring talk was overly simplistic and at worst delusional, as Geoff Colvin of Fortune convincingly argued in a September 2011 column. Truth is, US manufacturing actually grew dramatically over the past decade and the value of the resultant products increased in value. The unfortunate truth is that the more sophisticated manufacturing becomes, the fewer workers it needs to inc
rease productivity.

  It’s logical to conclude from this that manufacturing may not be the best place to find the jobs of the future. The most educated and privileged people in American society seemed to intuit this fact at least a decade or so earlier than most, as many abandoned the corporate world for the once sleepy world of finance. No longer would the best and brightest seek to run companies that made things; now they would commit their formidable brainpower to a world of concepts.

  What rarely was mentioned was the role that tinkering played in money making. The main reason, I believe, is that this was virtual tinkering of the highest order. It also was ingenuity that ultimately caused a lot of financial pain for many innocent bystanders, people who had invested in their faith in the American dream only to find themselves drowning in what appeared to be the grandest of Ponzi schemes. In other words, this was tinkering that was destructive rather than constructive.

  Because tinkering, as defined in this book, involves solving a problem with whatever is at hand, it would seem financial engineering, arguably one of the United States’ most significant contributions to contemporary society, doesn’t fit the bill. After all, the complex, arcane products of banks and investment vehicles fashioned by some of America’s most fertile minds did not seem to emanate from a place of passion. That is, unless the desire to earn huge heaps of cash can be said to be, in any way, soulful.

  It also cannot be said that this particular brand of tinkering was born without a clear purpose. The stated goal was to eradicate volatility in the financial markets. The architects of the complex web of collateralized mortgage obligations (CMOs)—sophisticated investment vehicles composed from slices of groups of home mortgages—that set the stage for the nation’s financial misery were pitched to investors as an extremely sophisticated solution to an age-old problem: how to manage the risk inherent in the investment process.

  But the characteristic that, in my mind, qualifies this corner of American know-how as tinkering is its role as a disruptive force. Many of the financial concepts put into play prior to the economic crisis had existed for many years, but never before were they applied with such precision. The newfound precision, enabled by computer technology and a passion for problem solving, transformed the concept of risk to such an extent that, for a brief period, very intelligent people became convinced that the age-old rules of finance simply didn’t apply. And perhaps for the first time, virtual tinkering played a significant role in shifting the course of history.

  Derivatives. That one word sent a chill through the average American consumer in late 2008. Needlessly complex and faintly understood, even to the analysts at the major ratings agencies who gave them their stamp of approval, credit derivatives came to represent everything that had gone wrong with our economic system and financial values.

  For the average person, that is when the term “credit default swaps” came into the mainstream. Credit default swaps, also known as CDSs, didn’t create anything, goes the common wisdom. Rather they and other financial derivatives destroyed massive value and cratered the American economy, without regard for those in our society who actually still make something.

  But the reality is that credit default swaps were a result of an exceptionally brilliant spate of tinkering. Indeed, they were invented to solve a problem, not to create one.

  It all began with the “Morgan mafia.” A group of young bankers at J. P. Morgan were frustrated. They were some of the best minds on Wall Street in the early 1990s. Derivatives, the financial world’s equivalent of insurance policies, had become the ultimate intellectual challenge. Many had stepped away from other career paths to pursue the creativity finance suddenly had to offer. But unlike in other fields, finance did not offer protection for innovators and tinkerers. Unlike other engineers, financial engineers cannot patent their inventions or prevent others from stealing their ideas.

  Peter Hancock, an ambitious J. P. Morgan banker from England who ran its derivatives department from the age of twenty-nine, wanted to be an inventor and took science courses at Oxford University before landing in the financial world in the late 1980s. His gravitation to derivatives seemed like a natural occurrence since they were relatively new at that time, complex in both their construction and use, and suitably obscure to entrance a young, academically inclined mind. As the head of the derivatives department, Hancock would walk the trading floor, constantly tossing out what his team labeled “Come to Planet Pluto” ideas, because they were sometimes so nutty that they seemed to fly in from outer space.

  Derivatives were more of a theory than an actuality back then, allowing for plenty of creativity and experimentation. As is now well known, derivatives were novel in that they allowed investors to capitalize on the value of a variety of asset classes such as stocks, bonds, commodities, and cast, without actually having to own the assets themselves. Highly educated investors saw the value in hedging the risk of their portfolios by buying derivatives, as well as the potential benefits of taking on more risk via derivatives for a shot at outsize gains. Banks liked them because they were something new to sell and to profit from. The young financial whizzes who toyed with them, creating ever more arcane permutations, loved them because they were intellectually challenging, almost ethereal and, at least, to anyone outside of their immediate circle, inscrutable.

  Derivatives are a contract between two parties regarding the price of an asset. An owner of stock shares, for example, can take out a contract to sell them around the current price if he thinks the price of the stock will fall. The advantage of owning derivatives is that the investor doesn’t have to sell his shares if he thinks the price will indeed fall. Thanks to the contract, the shares will be sold automatically at the higher price if the price actually does drop. But if the price rises instead, the investor still owns the shares.

  But the use of derivatives that created trouble for the economy involved buying derivatives contracts for assets that investors didn’t own. Speculators can borrow money to buy derivatives that bet on a rise in the price of particular stock or other asset without ever owning the stock itself. If the stock price ascends, the rewards can be substantial. If it plummets (or if the speculator misunderstands the math behind the contract), buckets of money are inevitably owed.

  If you’re still skeptical about the level of tinkering that went into the creation of this fantastical realm of space-age financial products, it’s worth knowing more about the culture that spawned them.

  Hancock, though determinedly cerebral, also fancied himself a student of experimental management. First, he reorganized his team so that the sales staff could quote the price on deals without consulting the traders who put them together. Later on, he brought in a social anthropologist to assess J. P. Morgan’s corporate culture. Then he polled the entire firm to figure out which departments worked most closely together and then set up a system to encourage more interaction and sharing of ideas. He also styled the makeup of a group inside the derivatives team called Investor Derivatives Marketing. Marketing certainly was one of this group’s functions, but it more often served as an incubator for new structured-finance concepts.

  Hancock and some of his colleagues first began brainstorming about derivatives in 1994, during a J. P. Morgan retreat in Boca Raton, Florida. They were looking to solve a few of their problems simultaneously.

  The first problem was the financial industry’s policies regarding innovation. Since innovations in the finance world (one of the few ways to spur rapid growth in this traditionally change-averse industry is to invent a new investment product to sell to a bank’s customers) were easy for rivals to copy, the only way to prevent such rampant thievery was to come up with a new product that was essentially impossible to copy. That meant devising a new financial instrument that virtually no one could understand but that everybody wanted.

  The second problem was more specific to J. P. Morgan. The legendary bank’s stock price had been suffering because Wall Street didn’t like its way of making commerc
ial loans. The traditional commercial-loan business was a relationship business, and J. P. Morgan’s bankers had the best relationships in the industry. Unfortunately, that meant that they were likely to grant virtually any loan they encountered, including ones they expected wouldn’t be profitable. This only increased J. P. Morgan’s exposure to risk. This second problem became increasingly problematic in light of the Asian financial crisis of 1997.

  Hancock locked his team in a hotel conference room in Boca Raton to come up with some fresh ideas to solve both of these problems while growing the successful global derivatives business he now headed. Lots of ideas were thrown around, but the most compelling involved taking the derivatives concept and applying it to credit. The threat that a creditor might default on a loan had always been a risk. The idea behind credit derivatives—or credit default swaps, as they became known—was to bet on whether bonds or loans would default, thus taking some of the edge off a negative outcome. If the owner of the credit default swap bet correctly, he or she could profit handsomely, even if the loan defaulted.

  Morgan had marketed itself to Wall Street on the notion that its commercial loans would ultimately reap high gains for the bank. But the behavior of its Asian debtors under duress erased any chance of that happening. These loans would not have the 20 percent profit margins that Morgan had said they would to its investors. Furthermore, the bank had made way too many of them, exposing it to a risk profile of exponential proportions.