The mortgage mess as a cognitive problem

The sub-prime mortgage debacle is a problem of cognitive complexity. A lack of understanding of the risks entailed by deeply nested loan relationships is leading to a lack of trust in the markets, and this uncertainty is leading to a sell-off. More transparency will help – but has its limits.

A story on NPR quotes Lars Christensen, an economist at Danske Bank, as saying that there is no trust in market because of the unknown complexity of the transactions involved. (Adam Davidson, “U.S. Mortgage Market Woes Spread to Europe,” All Things Considered, Aug 10th, 2007; more was broadcast than seems to be in the online version.)

This is a ‘hard intangibles’ problem: intricate chains and bundles of debt arise because there’s no physical limit on the number of times these abstractions can be recomposed and layered, with banks lending to other banks based bundles of bundled loans as collateral. When questions arise about the solvency of one of the root borrowers, it’s in large part because there’s no transparency into what they’re holding. According to the Economist (“Crunch time” Aug 9th 2007), complex, off-balance sheet financial instruments were the catalyst for the market sell-off. Phrases like “investors have begun to worry about where else such problems are likely to crop up” suggest that lack of understanding is driving uncertainty. The entire market is frozen in place, like soldiers in a mine field: one bomb has gone off, but no-one knows where the next is buried.

One of the drivers of the problem, according to the Financial Times (Paul J Davies, “Who is next to catch subprime flu?” Aug 9th 2007), is that low interest rates have propelled investors into riskier and more complex securities that pay a higher yield. “Complexity” is a way of saying that few if any analysts truly understand the inter-relationships among these instruments. The market is facilitated by the use of sophisticated models (i.e. computer programs) that predict the probabilities of default among borrowers, given the convoluted structure of asset-backed bonds. As the crisis has evolved, banks have come to realize – again, suggesting that this was not immediately obvious – that they’re exposed to all forms of credit markets, to more forms of credit risk than they thought.

This suggests a policy response to a world of hard intangibles: enforced transparency. The US stock market, the most advanced in the world, has of necessity evolved to be more transparent in terms of disclosure requirements on company operations than its imitators. According the FT, the Bundesbank is telling all the German institutions to put everything related to sub-prime problems on the table – indicating that increased visibility for the market will improve matters.

It’s striking how little the banks seem to know. BusinessWeek quotes an economist at CalTech as recommending that the Federal Reserve insists firms rapidly evaluate their portfolios to determine exactly how much of the toxic, risky investments they hold – by implication, they don’t know. (Ben Steverman, “Markets: Keeping the Bears at Bay” Aug 10th 2007.) The situation summed up well here:

“The problem here is that the financial industry has created a raft of new, so-called innovative debt products that are hard, even in the best of times, to place an accurate value on. "You don't have the transparency that exists with exchange products," the second-by-second adjustment in a stock price, for example, says Brad Bailey, a senior analyst at the Aite Group. The products are so complex that many investors might have bought them without realizing how risky they are, he says.”

Transparency may be a useful solvent for governance problems in all complex situations. For example, in an unpublished draft paper on network neutrality, analysts at RAND Europe recommend that access to content on next-generation networks be primarily enforced via reporting requirements on network operators, e.g. requiring service providers to inform consumers about the choices they are making when they sign up for a service – one of the keystones of the Internet Freedoms advocated by the FCC under Michael Powell. This may be one of the only ways to provide some degree of management of the modularized value mesh of today’s communications services.

However, transparency as a solution is limited by the degree to which humans can make sense of the information that is made available. If a structure is more complex than we can grasp, then there are limits to the benefits of knowing its details. A hesitate to draw the corollary: that limits should be imposed on the complexity of the intangible structures we create.