Financial Crisis and the Need for Reliable Information

by: Mark Thoma November 30, 2008    

Mark Thoma

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There has been much debate about whether the financial crisis is driven by lack of liquidity or from fears about lack of adequate capital and solvency, but I'm starting to think a third component is important as well, the complete breakdown of traditional information flows, and a loss of confidence in the models used to evaluate that information. Markets need information to work properly, and the information financial markets need is not available.

For example, investors can no longer trust what ratings agencies tell them. A crucial piece of information, information designed to break informational asymmetries between firms and investors, turned out to be unreliable. In addition, investors can no longer believe the numbers they see on bank books. The numbers might say the bank is solvent, but how reliable are those numbers? And even if the numbers are meaningful today, will they be meaningful tomorrow? Is there any way to actually value the assets a lot of these banks have on their books when there is essentially no market for them, no way to engage in price discovery? Investors no longer trust analysts and the models they use. They watched the business channel dutifully and all they heard was about the gold mine in housing. Sure, there were a few voices on the other side, but they were in the minority and mostly marginalized. All that bullish advice about housing turned out to be wrong. And there's no reason investors should trust the models used to process information either. The models used for risk assessment turned out to be far wide of the mark - a costly deviation - and if you go back and look at the Fed's forecasts of coming economic conditions (or the forecasts coming from the regional banks), it's very clear the models were underestimating the severity and length of the downturn, enough so to be relatively useless. At a more individual, face to face level, I suspect there are many homeowners who believed what their real estate or mortgage broker told them are now wondering how they could have been so foolish. They won't believe them next time. They won't know what to believe.

As I think through each stage of the mortgage process and what has gone wrong, it seems to me that the traditional information flows that are needed for people to make economic decisions, especially risky ones, are no longer present, or if they are present, simply not believed. And without the information people need to make decisions, the markets freeze up.

It's the feeling you have when you suddenly discover that everything you thought you knew about something, something you believed and relied upon for years, is wrong (like when you find out something your parents told you just isn't so). Those are moments that can stop you in your tracks while you reevaluate and figure out what it all means, while you take time to figure out how you should respond in the future.

We have recognized that liquidity and solvency are problems, and we have directed policy to try to address those problems, but I am not sure we are devoting enough attention to repairing the collapsed information structure. You can get around the problem through government guarantees or other types of insurance, but those create other problems, so it's best to avoid this if possible. However, it's going to be difficult to convince people they can trust this information again, people won't easily believe a ratings agency, real estate agent, risk assessment model, etc. just because someone announces that the problems are all fixed now, models can't be repaired overnight, so on some fronts time may be the only real solution. But on other fronts, perhaps we can do better. This is not my area, so maybe what we can do is limited here too, but is there more that the government could do, for example, with accounting standards or required disclosures that would help people evaluate the stability of a particular institution? Are there changes that could be made to give buyers and sellers more confidence that the people acting as their agents in the transaction have the right incentives? Is there some way to immediately change the regulation and structure of the ratings agencies that can help to restore confidence in their assessments of risk? The point is that we need to move now to start repairing the problems that are limiting the availability of information needed for these markets to function.

Perhaps the most important thing the government could provide is confidence in bank balance sheets. There are lots of ways to do this, e.g. the government could purchase toxic assets through auctions, and the auctions would serve as value discovery mechanisms, the government could flood the banks with capital so that there was no doubt about their solvency, or it could simply put a price floor under some of the assets on the books, i.e. say that they stand ready to buy any and all of a particular class of asset at a pre-set price (heavily discounted). People could then put a lower bound on the value of the asset side of the balance sheet, and they wouldn't have to worry that the bank's own actions or events outside the institution's control - an unanticipated failure of another bank that undermines a class of assets in its portfolio - won't suddenly change its balance sheet position beyond a known amount. Somehow people need to be able to evaluate the bounds of the risks they are taking.

Big shocks don't necessarily shake the informational foundations of markets. There can be an event that occurs in the tail of the distribution of possible events that is viewed as just that, an unusual, costly event, but not one that fundamentally upsets our understanding of how the world works while at the same time undercutting the informational flows we use to understand these markets. I don't think the dot.com crash, for example, caused us to question the reliability of the information we receive the way this episode has. After the crash, we still thought we understood how to use models to process reliable information. But this crisis has destroyed confidence in the information and the models we use, and it won't be easy to bring this back.

As noted above, while there may be some steps the government can take to help, solving this problem won't be easy, it will take time to repair the models and the information flows. That will eventually happen, but in the short-run the government must find some way around the problem. One way, the best way I can think of, is through insurance (e.g. the price floor above) and I hope we will see more movement along these lines. The deal with Citibank can be viewed as a step in this direction (there is a 29 billion dollar deductible and a 10% copay in the insurance they were provided - see the update at the end of this post), but more can be done - more must be done - to overcome the lack of reliable information in these markets.

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This article has 14 comments:

  •  
    Nov 30 08:36 AM
    As far as I'm concerned the rating agencies are as gulty as Arthur Anderson was during Enron!!!
    I'm amazed at how little attention their getting for screwing everyone over. Of course banks are gonna fudge the numbers but rating agencies were supposed to be the fair impartial referee's.
    Reply | Link to Comment
  •  
    Nov 30 10:21 AM
    You have brought into focus one of the most important problems with the economy. I, for one, have never believed much of the financial crap that has been spewed out since the Enron slight-of-hand. Why would anyone for example take a financial statement seriously that has unknown "off balance sheet" entities on it. The entire derivatives market involving tens of trillions of dollars in transactions was held in the shadows for years -- and still is. Derivatives values and the size of the market and which companies own what garbage are not well identified. Government statistics are subject to politcal manipulation and fraudulent accounting. Much of big biz accounting is suspect. GE, a great shining star of big biz for decades, has squishy numbers. I suspect nearly all of them do. Gee, their loan drug has been cut off for a while (poor babies), and obviously they need new injections to make their numbers look good again. What ever happened to funding companies on their internally generated capital? Thanks for the aricle -- you are the first I have read that has illuminated one of the biggiest financial problems out there.
    Reply | Link to Comment
  •  
    Nov 30 11:32 AM
    Good article, excellent perspective on a serious issue.

    Somehow the analysis of finacial information has turned into a guessing game, and if you guess the worst you will be right more often than not, to judge by what has been happening for the past year or more.

    In the short run, the government has no alternative but to paper things over by applying massive infusions of capital and guarantees.

    It will take time, but the completeness, accuracy and interpretation of business and economic information will need a major overhaul.

    Reply | Link to Comment
  •  
    Nov 30 12:10 PM
    Agree about the issue. But the government cannot solve it by throwing money at it, as you suggest--that's money that has to be borrowed, which only magnifies the existing problems with leverage; and who will pay it back?
    Reply | Link to Comment
  •  
    Nov 30 01:27 PM
    The government could pass legistlation requiring that the ownership of a list of questionable assets -- CDSs, certain tranches of CDOs -- be registered with the Treasury within a set period of time, say 14 days. Any unregistered assets would be declared worthless, null and void.

    Then, the Treasury should release that information to the marketplace.

    That way, everyone would know who owns these things.

    On the credit rating agencies' culpability, see my related article at:

    seekingalpha.com/artic...

    I think the credit rating agencies should be nationalized and/or disbanded entirely. They are a failed institution.

    One serious problem is that the credit rating agencies have used the bundling of CDSs with their underlying asset to raise the rating of those assets for reserve requirement calculation purposes. This means that if the CDSs were to disappear or be rendered worthless in a bankruptcy of, say, AIG, many banks would become insolvent because the rating of their assets would be suddenly downgraded due to the disappearance of the CDS figleaf. That would require them to post substantial increases in required reserves with the central bank which would require cash they don't have.

    This is why AIG had to be saved.

    And other institutions which have issued these meaningless CDSs, also, must be saved, or dozens of other banks would be required to post large sums in additional required reserves.

    I say, let them fail, but at the same time, grant a period of 5 to 10 years for the banks to post the implied required additional reserves. The CDSs are worthless already, anyway. This would require amendments to Basel II, as required reserves are regulated internationally.


    Jan VanDenBerg
    Reply | Link to Comment
  •  
    Nov 30 01:55 PM
    PANDIT SHOULD BE LIKE THE LAST CEO OF MERRILL JOHN THAIN AND ADMIT THE CRISIS WAS AT FAULT BEFORE HE CAME. THE MORE I LISTEN TO THIS STUFF THERE SHOULD BE A lawSUIT AGAINST THE PERSPECTIVE FINANCIAL INSTITUTIONS.

    IN THE BEGINNING OF THE YEAR, former citi CFO SALLIE K AND ANOTHER GUY DEMOTED THEMSELVES, AND THE ARTICLE INDICATED LARGER THINGS TO COME. THEN THERE WAS AN ARTICLE THAT MENTIONED THAT BANKERS LACK TRANSPARANCY AND THAT THE BEGINNING OF THE YEAR WAS ONLY THE BEGINNING OF THE CREDIT FAULT.

    I'M PISSED OFF ... WE HAVE TO SUE THESE INSTITUTIONS FOR ITS NEGLIGANCE.

    JUST LIKE ENRON, HOW COME PEOPLE DON'T DIG FAR ENOUGH. WHERE'S THE DUE DILIGENCE!!

    JUST LIKE CONDY RICE clearly LIED TO TARVIS SMILEY ON NPR, PANDIT IS CLEARLY SMOKING CHARLIE ROSE. WHERE'S TED KOPPEL?
    Reply | Link to Comment
  •  
    Nov 30 03:28 PM
    Asking the government to solve the problem through more regulation will only lead to and even greater (and false) sense of security in the accuracy of the information.
    Reply | Link to Comment
  •  
    Nov 30 04:00 PM
    It's not solely about information. It's about honesty, and timing - subject to no rules.

    For example, don't think for a second that just as tier 3 assets hide the bad, that they don't also HIDE THE GOOD! Think Exxon, why not report less and spread it out (bring it out of the dark over time). There are countless incentives to do this, and I for one know without a shadow of a doubt that this practice is widespread with the good, as well as the bad.

    Company valuation is utterly a joke. You're an idiot if you trust it.

    As the author states, throw the rest out the window and invest on emotion and luck, like everyone else.
    Reply | Link to Comment
  •  
    Nov 30 05:17 PM
    not sure thats true. regulation is the same as the laws that make it a crime to rob a bank. its doesn't completely stop it (nothing short of every one being in a prison will) but it does reduce it (a lot usually. but thats partially based on the chance of being caught). so while the regulation existence is only part of the governments job. it must enforce it, and be willing to carry the big stick. we have some regulations today that exist but aren't enforced. we also have regulators (AKA police) that treat those the regulate (aka criminals) as customers.

    On Nov 30 03:28 PM JohnAl wrote:

    > Asking the government to solve the problem through more regulation
    > will only lead to and even greater (and false) sense of security
    > in the accuracy of the information.
    >
    Reply | Link to Comment
  •  
    Nov 30 06:31 PM
    Exactly.

    Investors have been scalded and have no one to trust.

    The government response has been smoke and mirrors and rewarding the culpable and the lazy.

    Without trust people will continue to run for cover.

    Let's see: debt leveraging by the Fed to solve debt leveraging combined with no transparency and rating agencies that can't be trusted. This doesn't add up to a a bottom, a quick recovery, or good news in the next several years in my opinion.

    Reply | Link to Comment
  •  
    Nov 30 07:03 PM
    Maybe we need to re-think the wisdom of allowing tiered capital adequacy ratios. This would require a Basel III that treats all assets the same, as if they were marketable. Sure it's radical, but it beats the weighted gradients that helped hide the subprime mess for so long.
    Reply | Link to Comment
  •  
    Nov 30 09:45 PM
    "There are lots of ways to do this, e.g. the government could purchase toxic assets through auctions, and the auctions would serve as value discovery mechanisms"

    investing in a bank is one thing, but assuming responsibility for a toxic asset is another. these assets must remain with the bank. the taxpayers are already carrying too much risk on a problem they did not create but must help solve.
    Reply | Link to Comment
  •  
    Dec 01 06:56 AM
    There's error in thinking that we should ask the government to continually try to reduce risk through more regulation so that uninformed investors won't get hurt. The better policy is to reduce regulation and let market risk and reward be clearly seen. Investors need to see the market as the shark infested waters that it is. In doing so, smart but uninformed people will either stay out of the market all together and put their savings in bank CDs, hire informed money managers to manage their money, or inform themselves.

    All of this government intervention is moving us in the wrong direction. People have to understand the risk involved in any transaction. Continuing to ask the government to take on all risk makes it less likely that people will act with the caution that they should. Uninformed investors are now being programmed to think that that in ANY transaction there is NO risk since government will always bail them out. More regulation sounds good, but the sharks will always find ways to eat. They always have and no amount of government regulation is going to change it.
    Reply | Link to Comment
  •  
    Dec 01 08:34 PM
    Transparency through better information won't solve a problem that has been created by rewarding not only the top managers but hundreds if not thousands of middle managers with large bonuses for creating more and more highly leveraged paper that created growth ,however, fictional. Fueling economic growth by creating more ond more velocity of paper is not and has never been real. Some easy steps that don't cost anything should be put into practise immediately; e.g. 1] up the margin requirements on commodities to 80 cents on the dollar, 2] Insrtitute a regulation that only mortgages can be sold from one institution to another, no derivatives, 3] No off-balance sheet transactions will be permitted by standard accounting rules, 4] Short selling in any stock that is more than 5% in any day of the outstanding publically traded stock will automatically trigger a stop in short selling of that stock for 48 hrs. If the government guaranties a floor on the derivatives held by financial institutions, it should be no more than 20 cents on the dollar. We don't know what this will cost but it might be worth the risk. We are now in the rediculous cycle whereby the holders of cash are withdrawing it from mutual funds, money markets and banks and lending it to the government so that the government can infuse it into the banks. If it weren't so serious, it would be the fodder for a very funny farce.
    Reply | Link to Comment
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