Business Skeptic

The subprime crisis is becoming a field day for our society’s addiction to the blame game. I am not going to heap additional fodder into the cannon of public opinion. While questionable acts and motives abound in this situation, they did not cause the crisis but are an artifact of the real reason behind the collapse. The chilling fact is, the crisis would have occurred regardless, because it was engineered to fail from the very beginning.

A free market, whether mortgage backed securities, structured investment vehicles or coffee, is a dynamic system that is stabilized by feedback. A free market is defined by feedback. The process of negotiating a price, the force pushing a market or transaction to equilibrium is feedback. It was the structural lack of systematic feedback which caused the crash.

There are three essential characteristics for feedback to effectively stabilize a system. These are:

Relevant Information: The feedback signal must be directly related to the feed forward momentum of the system.

Timeliness: There must be a minimum of delay between the information feedback and forward signal. Too much delay causes the system to become unstable and it becomes increasing out of sync with the controlling information.

Amplitude: The strength of the information. Basically is the feedback signal strength strong enough to be heard over the noise and strong enough to effect the system process.

Structured investment vehicles, for which I am including subprime mortgage backed portfolios, where constructed in a manner which precluded effective feedback. In a structured investment vehicle, the base transaction (the feed forward signal) was dissected into multiple components. Repayment risk was decouple from credit risk, which was decoupled from interest rate risk, which was also decoupled from base asset value risk. Now under the mathematical laws of associative commutation, the whole is just the sum of the parts, and hence nothing related to the underlying base transaction is affected by this dissection.

The first notice of caution should have arisen at this point. Specifically, the reason for the dissection was that the parts could be sold for more than the whole (this is due to different risk / return profiles of the different buyers of the parts). One should ask at this point, whether there is a financial equivalent to the Second Law of Thermodynamics, the conservation of energy. Ask yourself a simple philosophic question. I take a pie and if I cut the pieces just the right way, I end up with more pie. Don’t think so, but this is a philosophic argument. The actual math of valuing structured investment vehicles does work and I don’t want to get into that here. It is the system dynamics regarding feedback which are broken.

What essentially happened is that by dissecting the base transaction, we decoupled the parts from the information flow about the whole. Information about the underlying asset could not be so precisely partitioned. Hence, each part had a market but it did not have relevant information feedback, because the information market was not and could not be partitioned and parsed along the same mathematical rule of the SIV.

In addition to the lack of relevant feedback, the partitioning of the base asset resulted in large time delays in information flow between that which effected the base asset and its parts. Part of this was due to the loss of information relevancy, context and fidelity and also because of the long and many hands that the parts had passed through. Image you are at an open air market negotiating for a hand woven rug. Each time you counter offer, your offer is broken in different pieces of information and each piece of information has to go to another city for an answer. Your counter price goes to a city 10 miles away, your delivery desires yet to another city and the warranty yet a third. Not only is this highly inefficient, the lack of relevancy and context of each information piece is likely to cause valuation problems.

The last aspect of broken feedback is amplitude. The strength of the feedback signal declines both because the signal is divided into parts and secondly because it begins to dissipate and lose its strength as it travels the long distances to the owners of the various parts.

The subprime and other Structured Investment Vehicles were designed to fail because they were engineered in a manner that seriously compromised the necessary feedback that systems rely on to be stable.

The amount of correction is a function of the three broken variables. As the time delay gets longer, the amount that the part values can diverge from the base asset’s value grows exponentially. As the relevancy of the information declines, the feedback declines in inverse proportion of the loss of relevancy. Lastly the reduction in amplitude, due to signal loss, reduces the feedback by the gain factor of the system which is proportional to the risk adjusted (almost a oxymoron in this context) compounded rate of return over the maturity of the base asset. Stated in somewhat mathematical terms, a structured investment vehicle such as subprime mortgage backed securities can diverge from its correct or feedback stabilized value by the following equation:

dV = 1/ a RIR * (TD)**et*(1/(A)**eM)

Where:

dV = diverged value of parts compared to base asset.

a = proportionality constant

RI = Relevant Information Ratio (Less than one)

TD = Time delay. This is a multiple of market trading speed.

t = time between initial investment and calculation.

AL = Amplitude. This is always less than one because of signal dissipation.

M = time to maturity.

In a perfectly free market with transparent information and almost instantaneous transactions, the calculated dV (divergence value) is unity. Or the sum of the parts equals the whole. In feedback compromised systems, there can be considerable value divergence. However, like quantum mechanics, this probabilistic divergent value function must eventually collapse to unity at either maturity or upon inspection. Hence the “created” value must collapse to zero. Welcome to the now.

This entry was posted on Wednesday, March 26th, 2008 at 21:07 and is filed under Strategy, Economics. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.