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The Lehman Brothers Effect and Bankruptcy Cascades

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  • Pawe{\l} Sieczka
  • Didier Sornette
  • Janusz A. Ho{\l}yst
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    Abstract

    Inspired by the bankruptcy of Lehman Brothers and its consequences on the global financial system, we develop a simple model in which the Lehman default event is quantified as having an almost immediate effect in worsening the credit worthiness of all financial institutions in the economic network. In our stylized description, all properties of a given firm are captured by its effective credit rating, which follows a simple dynamics of co-evolution with the credit ratings of the other firms in our economic network. The dynamics resembles the evolution of Potts spin-glass with external global field corresponding to a panic effect in the economy. The existence of a global phase transition, between paramagnetic and ferromagnetic phases, explains the large susceptibility of the system to negative shocks. We show that bailing out the first few defaulting firms does not solve the problem, but does have the effect of alleviating considerably the global shock, as measured by the fraction of firms that are not defaulting as a consequence. This beneficial effect is the counterpart of the large vulnerability of the system of coupled firms, which are both the direct consequences of the collective self-organized endogenous behaviors of the credit ratings of the firms in our economic network.

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    File URL: http://arxiv.org/pdf/1002.1070
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    Bibliographic Info

    Paper provided by arXiv.org in its series Papers with number 1002.1070.

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    Date of creation: Feb 2010
    Date of revision: Sep 2011
    Publication status: Published in Eur. Phys. J. B 82, 257 - 269 (2011)
    Handle: RePEc:arx:papers:1002.1070

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    1. Battiston, Stefano & Delli Gatti, Domenico & Gallegati, Mauro & Greenwald, Bruce & Stiglitz, Joseph E., 2007. "Credit chains and bankruptcy propagation in production networks," Journal of Economic Dynamics and Control, Elsevier, vol. 31(6), pages 2061-2084, June.
    2. Neu, Peter & Kühn, Reimer, 2004. "Credit risk enhancement in a network of interdependent firms," Physica A: Statistical Mechanics and its Applications, Elsevier, vol. 342(3), pages 639-655.
    3. D. Sornette, 2000. "Stock Market Speculation: Spontaneous Symmetry Breaking of Economic Valuation," Papers cond-mat/0004001, arXiv.org.
    4. Domenico Delli Gatti & Mauro Gallegati & Bruce C. Greenwald & Alberto Russo & Joseph E. Stiglitz, 2008. "Financially Constrained Fluctuations in an Evolving Network Economy," NBER Working Papers 14112, National Bureau of Economic Research, Inc.
    5. Frank Schweitzer & Giorgio Fagiolo & Didier Sornette & Fernando Vega-Redondo & Douglas R. White, . "Economic Networks: What do we know and what do we need to know?," Working Papers CCSS-09-010, ETH Zurich, Chair of Systems Design.
    6. Kartik Anand & Reimer K\"uhn, 2006. "Phase Transitions in Operational Risk," Papers physics/0609130, arXiv.org, revised Dec 2006.
    7. Pawe{\l} Sieczka & Janusz A. Ho{\l}yst, 2009. "Collective firm bankruptcies and phase transition in rating dynamics," Papers 0904.4430, arXiv.org, revised Sep 2009.
    8. Giesecke, Kay, 2004. "Correlated default with incomplete information," Journal of Banking & Finance, Elsevier, vol. 28(7), pages 1521-1545, July.
    9. Sornette, Didier, 2000. "Stock market speculation: Spontaneous symmetry breaking of economic valuation," Physica A: Statistical Mechanics and its Applications, Elsevier, vol. 284(1), pages 355-375.
    10. P. Sieczka & J. A. Hołyst, 2009. "Collective firm bankruptcies and phase transition in rating dynamics," The European Physical Journal B - Condensed Matter and Complex Systems, Springer, vol. 71(4), pages 461-466, October.
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    Cited by:
    1. Jean-Philippe Bouchaud, 2012. "Crises and collective socio-economic phenomena: simple models and challenges," Papers 1209.0453, arXiv.org, revised Dec 2012.
    2. D. Sornette, 2014. "Physics and Financial Economics (1776-2014): Puzzles, Ising and Agent-Based models," Papers 1404.0243, arXiv.org.

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