The Credit Crisis from a Complexity Perspective

1
The Credit Crisis from a Complexity Perspective

• Imre Kondor
• Collegium Budapest and Eötvös University,
  Budapest
• Parmenides Foundation, Munich

OECD Global Science Forum Workshop on Application
of Complexity Science for Public Policy, New
Tools for Finding Unanticipated Consequences and
Unrealized Opportunities Ettore Majorana
International Centre for Scientific Culture,
Erice, Sicily, Italy, October 5-7, 2008
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The purpose of the talk

• To point to a few elements of the present credit
  crisis that cannot be understood within the
  framework of traditional regulatory logic
• To emphasize a few fundamental principles of
  stability

3
What is not the purpose of the talk

• To give a complete overview of the crisis
• To name the culprits
• To suggest a magic formula for a solution

4
The case for regulation

• Failure of the financial sector has far reaching
  economic, social, and political consequences
• Financial intermediation is a high-leverage
  industry
• Own capital is a cushion against risk
• Regulation should protect the system, not the
  individual shop

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Assumptions

• It is possible to gather sufficient information
  about the system
• Institutions and their portfolios are correctly
  rated by the rating agencies
• The risk in the portfolio can be correctly
  assessed on the basis of existing, valid
  theories, and the capital charge can be
  determined accordingly
• Stability of the whole system is guaranteed by
  the stability of the individual nodes

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All these assumptions are wrong
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Do we have the necessary information?

• The total notional outstanding value of
  derivatives exceeds the GDP of the World a
  many-layer structure of circular obligations.
  Most of these are off the balance sheet
• No one knows the precise structure and
  distribution of these claims, and no one would be
  able to make sense out of them even if she knew
• The complexity of the system has exceeded what is
  knowable

8
Accounting

• The industry tries to blame part of the disaster
  on the introduction of fair value accounting.
• Portfolios are impossible to evaluate, because
  they do not have an intrinsic value. (The fitness
  of a creature is not an intrinsic property it
  depends on the whole ecosystem.)

9
Rating

• Rating has conspicuously failed AAA items
  downgraded to junk level in a week, etc.
• Rating agencies openly admit they are not able to
  assess the risk content of securitized portfolios

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Risk management principles

• Diversification is meaningless in a global,
  strongly interacting system whose components are
  nearly perfectly correlated.
• There are no independent variables or subsystems.
• There is no point about insurance if everybodys
  house is burning at the same time.

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Stability of the whole

• Soundness of each node is no guarantee of the
  stability of the network (a crystal can melt
  without anything happening to its constituent
  atoms)
• What is believed about the status of the players
  matters as much as their status itself
• The system learns and reacts quickly the case of
  Northern Rock

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Circular causation the housing conspiracy

• National Homeownership Strategy, spawned in
  Washington and comprising hundreds of companies,
  banks, associations, and government agencies to
  enhance the availability of affordable housing
  via creative financial techniques.
• Home building was seen as a way to stimulate a
  sluggish economy.

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The beginning

• Real estate collapse of the late 80s, the
  savings and loan industry de-capitalized, real
  estate prices falling by double digits.
• The housing GSEs (government sponsored entities,
  like Fannie Mae and Freddie Mac, were insolvent
  by 1991, but the guarantee by the US Treasury
  enabled them to survive and expand.
• Moral hazard

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Promotion

• Lobbying on Capitol Hill
• Copious donations to members of Congress
• 100 loss loans extended to minorities to meet
  the requirements of the Community Reinvestment
  Act essentially political campaign
  contributions
• Homebuilder Realtor Mortgage Banker
  Industrial Complex

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National Partners in Home Ownership (1994)

• Realtors, home builders, Fannie Mae, Freddie Mac,
  mortgage bankers, etc., some 1500 public and
  private participants, the largest PPP to date.
• Stated goal to increase homeownership to an all
  time high (achieved nearly 70)
• Stated strategy to increase creative financing
  methods for mortgage origination.
• First results home prices and ownership level
  started to rise

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Secondary effects

• Decline in risk management standards,
  documentation, mortgage insurance requirements,
  appraisal moving towards automation, etc.
• All this met with enthusiastic reception on the
  part of the public
• Large scale refinancing at the begining of the
  decade

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Positive feedback

• The process includes positive feedback loops at
  every level, leading to a large scale instability
  and unpredictable behaviour.
• The burst of the housing bubble triggered a
  global credit crisis, with grave consequences for
  the whole finance industry, but also for the
  other sectors, as well as for the role of the US
  in the world

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Some trivial stability principles

• Complexity control
• Compartmentalization
• Friction
• Negative feedback
• Etc.