The Unstable Triangles of the Financial Crisis
Many look back on the financial crisis of 2008 and wonder how we could have let this happen. How could so many people think the housing market could rise indefinitely? To explain this, we turn to an article in the Lombardi Letter that explains the causes of the economic collapse and the idea of stable and unstable triangular networks.
The article identifies the 3 groups of members in this network: 1.) The lender (local bank) that issues the investor a line of credit (mortgage) 2.) The person who takes out the mortgage (investor in mortgage backed securities, 3.) The U.S. central bank responsible for issuing monetary policy to bail out local banks when they cannot provide the liquidity demanded by investors. These three groups are three distinct nodes that form a triangular network and the relationships between them are links that can be identified as positive or negative. At first, the housing market was performing superbly and people were encouraged to take out multiple mortgages, invest in mortgage-backed securities, and realize the gains of the market. However, as more and more people did this, the value of mortgages and subsequently the bundles of securities whose prices depended on them for collateral began to fall as well. Thus people could not repay their loans. When people defaulted on these lines of credit, the relationship between the bank and the mortgage-owner became negative. It is this instability that caused the housing bubble to burst and the financial sector to see a large collapse.
Relating this phenomenon to class material, we employ the Structural Balance Property. According to this idea, a triangular network is considered stable if it contains one or three positive relationships and is considered unstable if it contains zero or two negative relationships. In our example above, there are three negative relationships. As the price of houses fell, people could not pay their lines of credit. They had taken out massive loans to invest in mortgage-backed securities but the market was not realizing the returns necessary for them to be able to pay back these loans. As they began to default on their loans, the relationship between them and the bank became a negative one. The bank was forced to seize houses in collateral and the economy was falling to pieces. Now, it was up to the central bank to inject monetary policy into the market to save a quickly crashing system. The relationship between banks and the central bank and between the central bank and individual investors (who had now defaulted on loans) had also turned adversarial as no one could stop the severe devaluation of the housing market. In short, (The Big Short as some call it) the collapse of the financial sector was caused by too much debt. These toxic loans can be represented as negative relationships in an unstable triangular network that couldn’t help but implode.
So what caused the financial crisis? It’s simple. Too many unstable triangles.