The Subprime Flu - Acknowledging the Complexity of Finance -

I do not know, or can possibly imagine, where the current economic situation is going to lead us.

My only conviction is that such events arouse theoretical debates regarding economic policies or measures that shall be implemented to prevent future crisis from happening. This is why I believe such times are worth living: Only in such timeframes is conventional knowledge questioned.

Most people are currently focusing on the "what went wrong" side of the problem. In my opinion, this behavior is flawed.

Flocks of new theories and opinions regarding what led to the subprime crisis  will appear  in the forthcoming years. Some people (Peter Schiff for example), will say "I told you so", others will derive from data the possible causes of the financial collapse.

However, I seriously question our ability to understand the complexity of the system we designed, and therefore the patterns that will emerge from this brainstorming.

Does this mean I think explanations to the current crisis are wrong? I don't think they are. What I believe is that each individual explanation can solely grasp one particular aspect in the system that led to the situation we know:

Was the subprime crisis triggered by the mark to market valuation of assets? It certainly played a role; but one as important as the banks' skyrocketing debt/equity ratio, the incentives for brokers to sell subprime mortgages whether it be to insolvent households, or the tendency for American consumers to see a greener grass in China's products compared to their American counterparts.
Such drivers did contribute to the financial situation we know, but none accounts for the Tipping Point that brought us where we are.

To illustrate this need to consider our system as complex, let's consider this sentence:

"The subprime crisis is a function of the banks, the financial products they structured, and the environment of sheer confidence that home prices were ever-rising. "

Does this describe the events that occured? Could these sentences be extracted from a recent piece of news?

In fact, how you might rightfully suppose, they are not.

This affirmations are inspired by  Malcom GLADWELL's delectable Tipping Point:

"Epidemics are a function of the people who transmit infectious agents, the infectious agent itself, and the environment in which the infectious agent is operating. And when an epidemic tips, when it is jolted out of equilibrium, it tips because something has happened, some change has occured in one (or two or three) of those areas"

I only switched the words "Epidemics", "Infectious Agents" and "Environment". If you want to give a try, please consider this (non exhaustive) list to play Make your own Financial Crisis explanation sentence:

The lesson to be learnt from this little example does not have to do with Banking institutions, Global Imbalances or Confidence.
It deals with the fact that financial crisis, as epidemics, are Complex and Evoluting Systems. Some epidemics have already been compared to the subprime crisis, Crack for example.


Complex, because studying them would imply studying Finance but also Psychology, Technology or Religion.
Evoluting, as the perpetual motion of the Financial Market Environment blurs the comprehension we have of the causes/transmission channels/ impacts of Crisis.


As epidemics, Financial Crisis now spread like wildfire because of the flattening the World has undergone in the last 50 years. As epidemics, they hit stakeholders via a network effect but, unlike them, there  are no short-term geographical bulwark to contamination.

The importance of the too big to fail issue: Switching from a strongly Centralized Network to a Distributed Network.

"On Monday, March 17, 2008, global financial markets opened to news of a Federal Reserve-enabled rescue of Bear Stearns by JPMorgan Chase. We learned, in the days that followed, of a weekend marathon meeting conducted by Federal Reserve officials to find a buyer for Bear Stearns. Urgency was warranted such that the hyper-connected global financial system might escape the effects of a medium-sized U.S. investment bank filing for bankruptcy and risking reverberations to thousands, nay, millions, of counterparties that were connected to it. Speculation grew of which institutions could be next, and more importantly, of which institutions comprised the Federal Reserve’s “too connected to fail” list. In reality, there was no such list at the ready; however, we can think of several universal banks and investment banks that, by virtue of the network age, play a significantly connected role in global finance such that bankruptcy of one or more would multiply the effects on financial markets globally in a cross-defaulting negative feedback loop." PIMCO AUGUST 2008 Report

It may seem a paradox, but Globalisation has fostered a Hubs and Spoke Network Model in Financial Services where a a few big banks (hubs) concentrate a meaningful share of customers (spokes) (see Network Model b).

Hence, a modelisation of the financial  landscape would show similarities with the one of an Epidemic (SARS in this example)

Globalisation has, more than anything, leveled the playing field and linked every domino in the game. In good times, the rising sea lifts all the boats. In bad ones, a butterfly's wing flap can produce a worlwide recession.

In more scientific terms, Globalisation has given birth to a Financial Ecosystem:

• which is simulateously robust and fragile - a property exhibited by other complex adaptive networks, such as tropical rainforests;
• whose feedback effects under stress (hoarding of liabilities and fire-sales of assets) added to these fragilities - as has been found to be the case in the spread of certain diseases;
• whose dimensionality and hence complexity amplified materially Knightian uncertainties in the pricing of assets - causing seizures in certain financial markets;
• where financial innovation, in the form of structured products, increased further network dimensionality, complexity and uncertainty; and
• whose diversity was gradually eroded by institutions’ business and risk management strategies, making the whole system less resistant to disturbance - mirroring the fortunes of marine eco-systems whose diversity has been steadily eroded and whose susceptibility to collapse has thereby increased.

To understand events leading to Financial Crisis, Researchers are to look at long time series as  Market Cooperativity (as defined by SORNETTE in 2003: the growth of correlation between investors' decision process, driven by feedback loops) is built on the long-term. 

 Let's consider the two most important types of transmission channels:

• Common Shocks: Affecting simulateneously  Financial Sectors worldwide, they were mostly linked with the over exposure of investors and Financial institutions to increased risk of securities to the US Sub-Prime Market. This is where the flawed VaR measurement of exposure to risk certainly played a role. Another form of Common shock was provided by the liquidity shortage on Financial Markets and the shared risk aversion of investors. 

• Spillover, or Contagion Effect: Financial shocks affecting one particular geographical location are likely to spread, or spillover, to other areas. Feedback loops between the real economy and worlwide financial markets are an example of Spillover Effect: gloomier Growth forecasts for the US economy will easily be transmitted to equity prices worlwide. Yet Another example of Spillover Effect provided by financial markets is transmitted via arbitrage opportunities: Changes in asset prices in one market entail portfolio adjustments by intermediaries and investors in other markets until one global price for the asset emerges. Foreign Banks holding US mortgages and US mortgage backed securities that were sold to them by Freddie Mac or Fannie Mae had to report significant losses, sometimes even before their american counterparts.

The subprime crisis has shown every sign of an epidemic: "Spreading rapidly and extensively by infection and affecting many individuals in an area or a population at the same time"


As R.SHILLER argues in his The Subprime Solution:

"Every disease has a contagion rate (the rate at which it is spread from person to person) and a removal rate (the rate at which individuals recover from or succumb to the illness and so are no longer contagious). If the contagion rate exceeds the removal rate by a necessary amount, an epidemic begins. The contagion rate varies through time because of a number of factors. For example, contagion rates for influenza are higher in the winter, when lower temperatures encourage the spread of the virus in airborne droplets after infected individuals sneeze. So it is in the economic and social environment. Sooner or later, some factor boosts the infection rate sufficiently above the removal rate for an optimistic view of the market to become widespread. There is an escalation in public knowledge of the  arguments that would seem to support that view, and soon the epidemic spirals up and out of control. Almost everyone appears to think—if they notice at all that certain economic arguments are more in evidence—that the arguments are increasingly heard only because of their true intellectual merit. The idea that the prominence of the arguments is in fact due to a social contagion is hardly ever broached, at least not outside university sociology departments."

We know epidemics to be complex, and that several diseases can stem from a common core but not be cured by the same treatment.
The Subprime Crisis may  produce a paradigm shift, or it may not. The race to specialization, and the clustering of knowledge it fomented, certainly played a strong role in how the situation rolled out.
Tackling Global issues, such as future financial crisis, will certainly imply more Global thinking.