In the Dance of Debt — who is leading?
This network map shows the key roles played in the recent mortgage meltdown. Starting with Main Street on the left we connect the dots out to Wall Street on the right side of the map. The nodes in the network show the various players in the mortgage meltdown, while the links show the exchange of money and value.
Who is responsible for the meltdown? Some blame the poor — they bought houses they could not afford and lied on their loan applications. Others point the finger at Wall Street investment bankers extracting wealth from the working classes. Additionally there were plenty of "middle men" enhancing the flow between the players at either end of the network. Who was critical to the meltdown?
I approach this question as a network scientist — my initial hunch is to look for interesting patterns and players. The network metrics of Connector and Integrator show us that the Mortgage Lender and the Issuer [Wall Street Bank] are key roles in the above subprime network. Each player appears key to each side of the network. The Lender on the left and the Issuer on the right.
Both Main Street and Wall Street participated in this Dance of Debt.
The mortgage lender sells the sub-prime mortgages they have originated, which get packaged into a — residential mortgage-backed security. With the Rating Agencies providing a positive picture of these securities, Wall Street discovers that they can sell them to investors in various forms including CDOs — collateralized debt obligations. The more Wall Street sells the more they want to sell. The ball goes back to the Lenders who further excite their part of the network to generate more real estate sales with new mortgages for securitization. Then Wall Street excites their part of the network by creating more investment vehicles. Send us more, they demand! And so it goes back and forth at an ever increasing fever pitch. No one wants to stop the game.
Who is to blame? Once the dance starts, no one wants to be left out, everyone steps to the emerging tune. The aggressive mortgage broker on Main Street and the re-mix master on Wall Street are each in their element, but they both hide/ignore information to speed up this dance of doom. Everyone influences those in their immediate network neighborhood. While each player acts rationally for himself — to outsiders, the overall system appears more and more irrational as it builds feverishly towards a bubble that will surely burst.
There is no lone culprit. Maybe the system itself is to blame? It was set up to generate positive feedback loops with no monitor of levels or cutoffs when things get out of hand. Maybe the Rating Agencies should have owned the kill switch? Without overly positive ratings on the CDOs, the Wall Street side of the network may not have worked.
Another generator was the ability to play both sides of an investment [sell it to investors and bet against it on a short] allowed the Wall Street end of the network to remain active. In desperate times during 2006-2007 Wall Street banks even arranged for their CDOs to buy parts of other CDOs creating a massively interconnected and interdependent system that would quickly crash once a key connector failed.
Another problem I see in the subprime mortgage flow map is network risk. Investors, who are dependent on Home Buyers making regular and timely payments, are separated from them in the network. They are beyond each other's network horizon, the investor's have no idea of the paying capability of the home buyers they have invested in. In networks, any path longer than 2 steps is usually considered "over the horizon" -- one cannot see, nor influence, over the horizon. In networks, distance leads to distortion, delay, and increased risk. Whose job was it span this network horizon and provide useful and accurate information across the chasm?
We need some way to map and monitor our complex finance systems before they get out of control. Let them operate as open systems but monitor their levels, exchanges, and outputs. As we now map the flow of aircraft from airport to airport, we should map the flow of large transactions from bank to bank. We need a transparent and trackable process so that we are not surprised at outcomes, and are prepared to take action when certain critical conditions emerge.
Update: We helped CNBC look at the financial flow networks in "Goldman Sachs: Power and Peril"