culture, Politics

How was financial system destroyed?

Here is very informative, accurate and readable paper about how did the financial system break down. You must have read many analysis and news reports but they mostly leave out some important technical details. So, it becomes very hard to pin point who and what was responsible for the crisis.

Beware of the technical financial jargon appears in the paper . You might have to do googling for usage of dozens of words. To get some basic definitions read Appendix A from this another paper. This another paper is written by a computer scientist to demonstrate that evaluating the quality of “structured financial deal”  was EXPTIME hard therefore it is not so bad that the finance guys couldn’t see the crisis coming. 😉

Let me talk a bit about structured finance.  A definition of “structured finance”:

The essence of structured finance activities is the pooling of economic assets (e.g. loans,bonds, mortgages) and subsequent issuance of a prioritized capital structure of claims, known as tranches, against these collateral pools.

[Bold faced phrases are either jargon words or jargon usage of common word. You have to do a bit of wok to understand them.]

The natural question arise that why someone likes to engage in such complicated financial activity.  Many people couldn’t have bought into this if it was simply a greedy move by the bankers. Actually, there has been a strong argument in favor of structured finance. The argument was that structured finance reduces cost of asymmetric information between buyers and sellers. Usually, seller knows more about his product than the buyer. So, both will assign different price of the product. The difference in the assigned prices is the cost of asymmetric information. This cost is also known as lemon cost. The term was introduced by economist George Akerlof.

This asymmetry mostly happens when market is full of look-alike fake products. In this situation,  buyer naturally thinks that the product may be fake so he assigns less price to the product compare to actual worth. This leads to less efficiency in the market. As, seller will not sell the object at lower price and buyer will not pay the higher price. At the end somehow, the deal happens and seller agrees to sell his product at some-what lower price than he expected. So, seller is suffering therefore inefficiency in the market. Sometimes, buyer also suffers when he ends up buying look-alike fake product.

I don’t fully understand how this phenomenon works.  Moreover, how structured finance solve this inefficiency? May be! this phenomenon is result of mental gymnastics of economists and has least connection to reality like many economics theories. May be! That is why whole structured finance thing collapesed.


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