The Credit Crunch - Information Black Hole or Moral Hazard
The Credit Crunch
There are many attempts to explain the factors behind the current economic crisis, yet few allude to the lessons that can be learned from the role of information and technology in changing banking processes.
Historically, someone needing a loan to buy a house would go to the bank manager personal credibility supported by documentary evidence. It was relatively easy to price the risk and the size of the deposit and loan multiples would reduce the risk. The deregulation of financial services made this type of process unrewarding for all but the most conservative managers.
Recently, there has been a growing use of financial instruments such as Collateralized Debt Obligation (CDO) and Credit Default Swaps.These instruments helped transform illiquid assets such as long-term fixed-income mortgages to ones that could be traded as a security.The issue with this transformation is that investments depend on the quality of the metrics and assumptions used to define the risk and reward. Sophisticated algorithms emerged forthe pricing of CDOs such as Gaussian copula models.
As those familiar with GIGO (Garbage In, Garbage Out) know that if the underlying data are unsound no amount of clever calculations will work. This is effectively what happened to information on risk when sub-prime mortgages were offered to those who could not afford repayments, a situation exacerbated when house prices started to fall.
With homeowners missing payments, and many defaulting on their mortgages, the real value of the CDOs became lost in the uncertainty of the credit risks. The CDOs were like black boxes, the inside was hidden from view.There were so many players - homeowners, mortgage companies, debt consolidators, insurance companies, and banks - that it was impossible to determine the quality of the debt.As the contagion spread, the ability of financial institutions to borrow money was severely limited.Who will loan money to an institution for which no information is available on its ability to survive and repay the loan?This represents a huge information quality problem.
Information Gaps
How do these gaps in information arise? Information Asymmetry deals with the study of decisions in transactions where one party such as the seller of a product has more or better information than the other party such as the buyer.For example, the seller of a second-hand car may be aware that the car had been in an accident and not share this information.
Some gaps are natural in the context of a market where there are information asymmetries between buyers and sellers. These will not occur, in what the economists call a perfect market.However, in these troubled financial markets, there were notable information asymmetries between brokers, banks, rating agencies and regulators.
This then translates into potential moral hazards.These arise because an individual or institution can act with a degree of impunity because it does not have to suffer the consequences of any problems arising from the sale.It explains why people are willing to pay a higher price to buy from a dealer they trust and can go back to if there is a problem.
Of course the situation is complicated if a third party is valuing the risk, as with the rating agencies. Arguably, the buyer who has less knowledge than the seller should pay for the rating agency to assess the risk and hence reduce the information asymmetry. However, credit rating agencies are usually paid by the seller of debt rather than the investor (buyer) and have been criticised for assigning top ratings to CDOs which then suffered large losses.
Clearly information quality is a central problem and it is not one that can be assessed totally objectively. In a further development, the economists Isabelle Brocas and Juan D. Carrillo refer to the concept of Information Ignorance. This relates to a situation where power comes from controlling the flow of public information, as opposed to the possession of private information. One case cited is that of Merck who stopped monitoring patients once they had taken off the market a drug which had caused increased heart risk. Hence there was no information to support the contention that the risk disappeared after usage stopped. It can be argued that the sellers of sub-prime and self-certification mortgages operated with a similar philosophy of information ignorance. Individuals and organizations may reject accusations of blame on the basis that they were unaware of the real situation. In practice, the question may be whether they chose to remain in a state of information ignorance.
Lessons
Large organizations are aware that complex businesses cannot be managed without computer-based information to support their operations.Enterprise resource planning systems, as an example, collect, store and process large volumes of data necessary to integrate the operations of an organization from its suppliers to its customers.When these systems fail, it can lead to bankruptcy, as claimed by American LaFrance in early 2008 while citing many data problems.
The flow of information about products through a supply chain applies also to financial instruments. Yet accurate shared information about the value of these instruments was sadly lacking. This raises the question of how this information quality problem could have been addressed. The first lesson is that the role of information in the integration of complex enterprises, systems and networks is not just a competitive goal.Integration through IT may be central to the basic stability of the system.Without access to data across all components, this stability can be jeopardized.Arguably, where independent parties (such as banks, insurance companies, and brokers) participate, some degree of regulation is necessary to ensure that essential data is moved through the system to reduce information assymetry.
A second lesson is that even if we have management and control systems in place, information ignorance may still occur. Joe Nocera, In a New York Times article (The Worst is Yet to Come, November 25, 2008), writes that the next domino to fall in the credit crisis will be credit card defaults. The article is critical of credit card companies who basically ignore credit scoring data and aggressively place credit cards in the hands of consumers in the hopes of earning up to 22 percent interest on outstanding balances.
The final and perhaps the most important lesson is to identify who is responsible for the quality of information in these organizations.Our reviews with CIOs suggest that few of them, despite having the title of Chief Information Officers have either the authority or the capability to assess and improve the information quality.Neither does anyone else in the organization have this explicit accountability. This is a major gap that the financial crisis has made even more critical to address.
