The sub-prime crisis continues to fascinate me, and while off topic from normal programming, it is critical to the survival of banks, so bear with me on these periodic tangential posts.  Here Frederic S. Mishkin of the US Federal Reserve (Central Bank) speaks about the role of the Fed in the current crisis. 

The speech starts of stilted but well, then rambles. 

FRB: Speech–Financial Instability and the Federal Reserve as a Liquidity Provider–October 26, 2007

Asymmetric Information and Financial Instability We can better understand how financial instability can arise if we recognize the problem of asymmetric information–when one party to a financial contract has much less information than the other party. For example, the borrower is usually much better informed than the lender concerning the potential risks and returns associated with the investment projects to be financed by a loan.

Asymmetric information leads to two basic problems: adverse selection and moral hazard.

These two problems and their solutions are defined

1) adverse selection:  adverse selection arises when investments that are most likely to produce an adverse outcome are the most likely to be selected.  For example, investors who intend to take on large amounts of risk are the most likely to be willing to seek financing.

Minimizing adverse selection requires that lenders screen out bad credit risks.

2) moral hazard:  Moral hazard occurs when the lender is subjected to the hazard in which the borrower has an incentive to engage in activities that are undesirable from the lender’s point of view. 

To minimize moral hazard, lenders must impose restrictions (known as restrictive covenants) that penalize borrowers for engaging in certain activities; lenders must monitor those activities, and they must enforce the restrictions if the borrower violates them.

While the speech has started of well, albeit academically worded, the remainder is classic student mistake 101 in that it rambles on about history, and throws in some opinions, all of which fail to circle back to the logic which began the speech.  For example:

The Panic of 1907 and the Creation of the Federal ReserveDuring
the National Banking Era, which began in 1865 and ended in 1914, when
the Federal Reserve began operations, reserves were channeled to New
York banks, which became providers of liquidity to the financial system
through the New York Clearinghouse.  Nevertheless, the banking system
periodically suffered panics, as the demand for liquidity often
exceeded what New York institutions could provide.  These panics, in
turn, caused large numbers of banks to fail or at least suspend the
conversion of deposits into currency.  During these episodes, interest
rates tended to spike and equity markets to decline, often sharply.3

This is interesting to historians, but in the context set at the beginning about asymmetric information, it is meaningless.

This symptomises the problem with the current financial markets with derivatives of derivatives that result in completely asymmetric information between borrower and lender, as perfectly described at the beginning of the speech.  Financial transactions, and markets are based on quality information.  As the information reduces, then emotion takes over. 

This is one dream of social lending, that it will display one alternative to the obfuscation of people like Frederic S. Mishkin.  Time to eliminate the emotional aspect, and introduce transparency of information, quality data, and broad sets of data. 

The thinking that produces such speeches is so mechanical, and theoritical, that it has lost all connection to reality, and that has to be a significant contributer to the sub prime crisis. 

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