The Information Matrix makes it easy to understand why opacity is the necessary condition for a financial crisis.
By definition, an opaque security does not provide sufficient disclosure so an investor can know what they own or are thinking of buying. So where does an opaque security fit on the matrix below?
|Does Seller Know What They Are Selling?|
Does Buyer Know What They are Buying?
|Yes||Perfect Information||Antique Dealer Problem|
|No||Lemon Problem||Blind Betting|
Based on their definition, opaque securities fit into the two cells titled Lemon Problem and Blind Betting. Lemon Problem opaque securities are like used cars where the seller of the security has information for assessing the risk and therefore the value of the security that the buyer of the security does not have. The information for assessing the risk and value of Blind Betting opaque securities is unavailable to both buyer and seller.
But is there any reason to think Lemon Problem opaque securities are the necessary condition for a financial crisis to occur? No.
Ultimately, the seller of a Lemon Problem opaque security has the information needed to value these securities. As result, they have the potential to become a buyer for these securities. Equally importantly, they have the information incentive to limit the decline in the security’s price to where it represents a good investment. Therefore a market will develop for the Lemon Problem opaque securities without any interference from the government.
This is not true for Blind Betting opaque securities. There is no logical price greater than $0 for the seller of the Blind Betting opaque security to step in and repurchase the security from the buyer.
It is the existence of Blind Betting opaque securities that is the necessary condition for a financial crisis.
In the run-up to the financial crisis that began on August 9, 2007, these securities could be found in large portions of the global financial system. Examples of these securities included the private label mortgage-backed securities and their related derivatives as well as financial institutions like commercial and investment banks. Since no one had the information necessary for assessing these securities, there were no buyers when the price of the Blind Betting opaque securities began to fall.