Monday, November 17, 2008

Crisis of Confidence

Throughout the crisis that has developed over the last year, and now intensified we have heard that is a crisis of confidence, especially in the banking sector. Mainly this lack of confidence was because of the opacity of the assets that various financial institutions held. Lack of confidence in the leveraged financial world quickly can become a death spiral that envelopes the firm in question. We saw it happen in 2001 with Enron, and we saw it with Lehman, Bear Stearns, Washington Mutual, Indymac, etc. Each case is obviously slightly different, but they share a similar characteristic in that the entity was perceived as being weak or unstable, and that led to a run. So in part, real world actions drove uncertainty, which led to the demise of the institution. The interesting thing about this, is that perception was the driving force, not actual facts.

Governments have responded to this by stating that it was because of a lack of regulation that these institutions went down but then, bureaucrats and politicians need to justify their pay checks, so that they say that is quite predictable.

Looking deeper, I think it goes back not to a lack of regulation, but to a lack of information. Lehman, Bear, WAMU and Indymac were unable to articulate or effectivly inform stakeholders of their financial position. Some of it may be because they did not know themselves, but the startling collapse of Bear I think was an indication that fear, driven by a lack of information was running the market.

The solution is not more regulation, but better information, and better distribution of that information. That way each stakeholder is able to accurately guage the situation. To put this in quantitative terms, the discount rate works conversely to the availability of information.


I have a bit more time now, as I have transitioned from a job where I had a TON of free time, to one where I had to learn the ropes a bit more. So I've gotten back to think about posting, but haven't availed myself of the opportunity, and partly I think its because I was gathering my thoughts and trying to understand what is going on in the economic world.