Since the Information Matrix was first introduced during the acute phase of the Great Financial Crisis, I have received a lot of feedback about the “Blind Betting” label for the lower right quadrant.  With the help of Boston College professor Edward Kane, the matrix has a new and improved label for this quadrant.  Going forward it will be called the “Imperfect Information” quadrant.

By definition, a buyer or seller has “imperfect information” when the information they have does not allow them to make a fully informed decision because the information is insufficient and/or incomplete.

Information Matrix

The Information Matrix shows imperfect information is THE market imperfection.

In the financial markets, imperfect information takes the form of opacity.  In the presence of opacity, investors cannot assess the risk/return of an investment.  Without this assessment, investors don’t know what they own beyond what Wall Street tells them.  Policymakers in the 1930s focused on eliminating opacity by creating the SEC and making it responsible for ensuring investors had access to the information they need to know what they own.

Of course, this put the SEC directly at odds with Wall Street.

Wall Street understands it makes more money selling opaque, high margin products than it does selling transparent, low margin products.  This gives Wall Street an incentive to lobby the SEC for disclosure requirements that are insufficient for investors to know what they own.

Wall Street knows and behavioral economics has shown everyone likes a good story.  Wall Street firms deliberately creates opaque securities they can sell based on a good valuation story they tell.  The difference between the Perfect Information and Imperfect Information quadrant is in the Perfect Information quadrant buyers and sellers can Trust, but Verify this story.  In the Imperfect Information quadrant, buyers and sellers can only trust the story as opacity prevents their verifying if it is true or not. When doubts arise about an investment story that cannot be verified, investors run to get their money back (the classic “financial panic” we see during financial crises).

The subprime mortgage-backed securities at the heart of the Great Financial Crisis are a classic example of Wall Street’s prowess at lobbying and story telling.  Subprime mortgage-backed securities were designed to be opaque.  The SEC recognized this.  Wall Street aggressively lobbied while the SEC was going through its formal process for setting disclosure requirements for these securities.  The individual responsible for this process justified issuing Regulation AB saying it was the most disclosure the SEC could require given the intensity of Wall Street’s lobbying efforts.  The individual also told me the SEC knew the disclosure required was incomplete and investors would not be able to do the analysis necessary to know what they owned.  Once the regulation was issued, Wall Street firms sold trillions of dollars of these and related opaque derivative securities based on a valuation story they told.  In the fall of 2008, this story was called into doubt.  The result was the acute phase of the Great Financial Crisis.