Wall Street bankers know they make more money selling high margin, opaque products (like structured finance securities) rather than low margin, transparent products.  While that is good for the bankers, the toxic side effect of these opaque products is a financial crisis that negatively affects all of us.

By design, these high margin products are always opaque to investors.  The products are opaque when created and initially sold in the primary market.  The products are opaque when resold or traded in the secondary market.

However, when the products are originally sold in the primary market, they are not opaque to the bankers.  Bankers take advantage of information asymmetry to guarantee they generate their high margins (for example, think of bankers representing subprime mortgages in a deal met a specific underwriting standard and then including mortgages they knew did not meet this standard).

This informational advantage may or may not continue when the product trades on the secondary market.  When it doesn’t continue, you are left with opaque financial products  nobody can value.

From the perspective of the Information Matrix, these opaque products start out in the Lemon Problem quadrant and move into the Blind Betting quadrant.

Information Matrix

I don’t blame economists for not understanding the information asymmetry can disappear or that the sale of these securities would result in huge opaque sectors of the global financial system.  They had blinded themselves to these possibilities with their believe in the strong form of the Efficient Market Hypothesis.  The strong form asserts price reflected insider information too.  It never occurred to the economists there might be securities where there were no insiders and hence no one actually had the inside information to trade on.

Instead, their view of the Great Financial Crisis is

So knowledgeable insiders repeatedly withheld crucial information from their clients. Asymmetry of information – sellers not sharing information with buyers – crops up at every stage in the mortgage supply chain. And long before the GFC, economists had explained the challenges that information asymmetry poses to the free market (unregulated) model.

Nobel Laureate George Akerlof used the example of the sale of ‘lemons’ in the used car market to analyse the scope of the detriment arising from sellers withholding information about the quality of the goods they were selling. He concluded that failure to disclose threatened to undermine the whole market, with the costs from cheating of driving legitimate business out of existence often exceeding the amount by which the seller had cheated the buyer.

Baruch Lev applied the argument to financial markets where the problem of assessing the quality of a security is often greater than that of assessing a used car:

“At the extreme, suspecting gross information asymmetries, uninformed investors may quite rationally withdraw from trading…altogether. A massive withdrawal of uninformed investors from the market will…deprive the economy of the allocational and risk-sharing benefits of large and efficient capital markets.” (Baruch Lev, The Accounting Review, 1988, 63:1, p.7)

When investors in the markets realised they had been misinformed in the period leading up to the GFC, the shrinkage of markets was rapid and massive. Financial markets froze: a witness to the FCIC reported: “The REPO market [for overnight borrowing], I mean, it functioned fine up until one day it just didn’t function” (page 136 of the report). And the panic and losses spread to the real economy.

This view completely misses the transition of the securities from the Lemon Problem quadrant to the Blind Betting quadrant.  If the banks still possessed an information asymmetry advantage, why wouldn’t they have purchased these securities instead of being sellers too?  This would have kept the market from freezing.

The market for these securities froze because even though the securities started out in the Lemon Problem quadrant they subsequently moved into the Blind Betting quadrant and the banks couldn’t value them either.