In his ongoing analysis of the earthquake that struck the global financial system’s opacity fault line in 2008, Ben Bernanke discovered the Information Matrix.

Ok.  He didn’t “find” the Information Matrix.  Rather, he stumbled upon how the Information Matrix said this earthquake would play out.

Having discovered how earthquakes along the opacity fault line play out, he took this a step further and said this should be incorporated in how macro economic models are designed.  I couldn’t agree with him more that the Information Matrix should be incorporated in the design of macro economic models.

But before we get there, what exactly did Mr. Bernanke find?

The second channel through which the crisis led to a recession was a severe financial panic – a system-wide run on providers of credit, including banks but also, importantly, nonbank lenders like investment banks and finance companies….

Panics emerge when news leads investors to believe that the “safe” short-term assets they have been holding may not, in fact, be entirely safe. If the news is bad enough, investors will pull back from funding banks and other intermediaries, refusing to roll over their short-term liabilities as they mature. As intermediaries lose funding, they may be forced to sell existing loans and to stop making new ones, driving up the external finance premium….

He found panics occur when the story Wall Street tells about an opaque investment is called into doubt and investors cannot dismiss the story and begin to wonder if their investment has any value at all.

Regular readers have heard this before.  It is exactly what the Information Matrix says happens.

Information Matrix

	Does Seller Know What They Are Selling?
Does Buyer Know What They are Buying?		Yes	No
	Yes	Perfect Information	Antique Dealer Problem
	No	Lemon Problem	Blind Betting

People like a good story.  This is true whether the investment Wall Street is telling them the story about is in the Perfect Information quadrant or in the Blind Betting quadrant.

The key difference between investments in the two quadrants is in the Perfect Information quadrant investors can Trust, but Verify Wall Street’s story.  In the Blind Betting quadrant, opacity (the absence of the necessary information) prevents investors from being able to verify Wall Street’s story.

Whether the story can be verified or not results in a vastly different response when Wall Street’s story is called into doubt.  For Mr. Bernanke, the cause of the valuation story being called into doubt is “news”.

In the Perfect Information quadrant, the story can be verified and the doubt generated by the news dismissed.

In the Blind Betting quadrant, the story cannot be verified.  Not only is the doubt generated by the news not dismissed, but the logical follow-up question arises:  is the investment worth anything?  This too cannot be verified.  Investors recognize this and, as behavioral economics suggests, naturally panic.  The result is a classic bank “run” to get their money back.

Mr. Bernanke then provides a timeline for the crisis.

The chart below shows some representative financial data, which in turn illustrate four stages of the crisis: the collapse of investor confidence in subprime mortgages, the beginning of broad-based pressures in funding markets, panic and fire sales in the markets for securitized credit (including non-mortgage credit), and the deterioration in the balance sheets of banks and other lenders….

In the figure, the variable marked “Subprime,” derived from an index of market valuations of subprime mortgages, shows investors’ developing concerns about the housing market and mortgage-related assets.  In this first stage of the crisis, these concerns grew as house prices declined and mortgage delinquencies rose beginning in early 2007.

The variable marked “Funding,” is a measure of stress in the short-term funding markets that banks use to finance their daily operations. The series rose (showing greater stress) in August 2007, after France’s largest investment bank, BNP Paribas, announced it was unable to value the assets in three of its largest investment funds, kicking off the second stage.  Funding stress reached its peak following the Lehman Brothers bankruptcy in September 2008 but came down by the end of the year as various government programs took effect.

The third stage of the crisis, shown by the series market “Nonmortgage Credit,” reflects the indiscriminate spread of the panic from mortgage to non-mortgage assets. Funding strains and a general loss of confidence in securities backed by private credit forced investment banks and other lenders to sell large quantities of risky assets, often at fire sale prices.

The final series, labeled as ‘Bank Solvency’ indicates the deteriorating balance sheets of large commercial and investment banks caused by mortgage losses, funding pressures, and fire sales. As this variable shows, in the fourth stage of the crisis, bank health worsened steadily through early 2009 (higher values imply a higher risk of default), improved following regulators’ stress tests of large banks that spring, and worsened again at about the time of the credit downgrade of the U.S. government in 2011 and continuing pressures in Europe.

Of course, Mr. Bernanke does not recognize his four stages of the crisis is simply a description of the earthquake as it spreads along the financial system’s opacity fault line.

What started in opaque subprime mortgage-backed bonds spread to opaque investment banks, then spread to the other opaque structured finance bonds and opaque shadow banking securities before finally spreading to the opaque commercial banks.

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He then turned to incorporating his “factors” into the big macro models used to forecast the economy.

I will spare readers the gory details of how this is done beyond saying a new variable, call it “financial crisis factors” is added to the models.  This variable is a 0/1 variable.  It is 0 when we aren’t experiencing a crisis.  It is 1 when we are experiencing a crisis.

By design, this variable is statistically significant as it reduces the the models’ forecast error (the difference between what the economy actually does and what the model predicts it will do).

However, by design, this variable does nothing to help predict a future crisis.  As Mr. Bernanke pointed out, its inclusion once a financial crisis has started reveals how much more fiscal and monetary stimulus is needed.