The Crash: One Vision, part I
A story of a crash - Part 1
This article is structured in two parts; the first, what you are reading, and the conclusion next week. We will discuss how information asymmetry has deeply undermined people's trust in the financial sector.
What is Information Asymmetry?
Information Asymmetry is a situation in which one party has more or better information than the other. The party with the better information can use this to their advantage and exploit the other party.
The term was first coined by Akerlof and Shiller in their paper "The Market for Lemons" in 1970, describing it as a market failure that causes a? quality decline. They argued that asymmetric information about a product makes it difficult for consumers to make informed decisions, leading to "lemons" problems (a term coined by George Akerlof).
What is the Impact of Information Asymmetry?
Information asymmetry is one of the biggest problems in finance; the emergence of non-performing exposure (NPLs + UTPs) is caused by it.?What an NPL (distressed credit) is will be a future topic analyzed. To simplify things, I attach a picture of the classic diagram of how an NPL works. Moral of the photo: make something less transparent so that they do not have to declare that the money they collect from citizens is used to buy other citizens' troubles (distressed credit).
The decorrelation of the financial market to the real market, post-2008 monetary policies, and the absence of the adjustment on wages to real inflation have created a vast market where Investment Funds, Special Vehicles, or Hedge Funds have been profiting for over 15 years. The Ebitda of these financial structures is impressive, sometimes close to 100% on a three-year basis. No real-world business can compete with remarkable returns. The chances are that such "easy money" will create more and more "moral hazards," the tendency to greediness and to disinvest in the real economy, slowing down the overall economy instead of advancing it.
The creditor (financial structure) has an X set of information, and the debtor has a Y set of data which, of course, does not share with the "enemy." For this reason, financial structures to overcome this problem have opted for two paths, increased workforce and some use of technology.
Note: I do not consider the purely statistical study of past events as an algorithm. Many claims AI models are spreadsheets with a few macros and nothing more. The majority of models in volatile time series rely on moving averages. These tools are sometimes the most effective.?
The overall impact of information asymmetry is evident: the creditor prefers to lose some of its gains but disinvests that non-performing loan (with little information). On the other hand, the debtor sees the asset's value destroyed by that impairment. Only a proper, now missing, data curation can eventually diminish the gap between debtor and creditor different evaluations.?
Lehman Brothers and their Role in the Financial Crisis of 2008
When Lehman Brothers, an historical financial institution, filed for bankruptcy on the 15th of September 2008, massive shockwaves hit the world markets. A giant of finance crumbled overnight, passing the idea that "too big to fail" had, in this case, an exception, triggered panic and turmoil in the global markets.
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The story of this bankruptcy, and countless minor events of the 2008 financial crisis, appeared in books, documentaries, and famous movies. Greedy banksters created complex financial operations to mask all sorts of Ponzi schemes and pocketed huge payouts. At the same time, the ordinary people were fired a few days since the crisis began.
To save the financial system, central banks of the USA, UK, and other European countries injected into the system huge recovery plans to absorb the bad assets in the hands of the major banks, avoiding an even larger propagation of panic. The program, known as TARP (Troubled Asset Relief Program), authorized by the Bush administration in 2008, injected something like 700 Billions US dollars into the financial system to buy deteriorated assets.?
The move worked, and the markets recovered in a few years. The financial euphoria of 2000-2008 inflated a giant bubble in the housing market. Real estate prices were constantly increasing, and investors started buying houses at an unprecedented pace.?
To hedge against the risk of defaulting, banks sold their credit to secondary markets that tried to make their profit by further restructuring debt into complex derivatives: the asset-backed securities.?
As additional protection against the risk of defaulting for excessive leverage (remember that all these operations were merely speculation), they acquired the famous (or infamous) Credit Default Swaps from other financial institutions.?
Their idea was simple: let the CDS parachute mitigate the risk of default. These plans turned out to be ineffective. CDS did not work. They never saved financial institutions from their risky situation. It was a nightmare that reduced economic growth and social unrest.
Measures of financial distress
DebtRank is a measure invented in 2012 by S.Battiston and M.Puliga (along with 2 Ph.D. students of the ETH Zurich) to measure the riskiness of large financial institutions according to their position in the network of assets and liabilities.?
An important systemic institution is the one that, if removed from the network (i.e., declared defunct for bankruptcy), will pertubate the network generating a significant loss of value in all the network, even by propagating a cascade of failures.?
Starting from this study by the ETH Zurich researchers, the underlying concept of "too big to fail" became "too central to fail." Being at the center of the network of mutual exposures, closer to other essential actors,? will make an institution subject to significant network effects. These externalities can be several orders of magnitude larger than the direct effect of debt and asset devaluation.?
Centrality is a geometrical and flow concept related to the presence of virtual nodes in our neighborhood. In popular terms, we can say that "a person is powerful if he/she knows powerful people." Not only is it essential to know many people, but also to know the right one. This example explains why financial institutions at the center of the network and close to other large ones are the most central and systemically relevant.
Too central to fail is an intuitive and fascinating concept, limited by a lack of information. A correct evaluation of the DebtRank can be done only when the mutual exposures of banks are fully known. Ideally, every financial institution's and every company's entire map of debts and assets must be known to evaluate the risk associated with a cascade of failures.?
On the left is the DebtRank situation at the beginning of the 2008 crisis, and on the right is what happened during the maximum mutual exposure and asset devaluation of the crisis. Red dots represent the most systemic risk banks at the center of the financial turmoil.