Wednesday, December 8, 2010

Disclosure Worked To Restore Confidence in the 1930s, Will it Work in 2011?

This blog has spent a considerable amount of time focused on how using disclosure could solve at low cost a number of problems (see here, here, here and here, for example).  It is time to backup a little bit and present a primer on disclosure and how disclosure is actually used in the marketplace.

The following brief history of disclosure for public securities is presented with the author's permission:
In his 2007 book, The Defining Moment, Jonathan Alter describes the FDR “Brain Trust” in glowing terms. It included brilliant luminaries such as Adolf Berle and Rexford Tugwell who were to help design the solutions to the problems that would face the President.
Included in this inner circle of advisers was one Charles Taussig, the president of the American Molasses Company. With no college education and no economics training, this “amusing hanger-on,” according to Alter, had an access to FDR that left the other members of the Brain Trust resentful and wondering why he was there.
Perhaps we will never know precisely what it was that appealed to FDR about Charles Taussig. But we do know that Taussig was an early advocate of restoring the country’s shattered confidence by implementing transparency in the securities industry. This advocacy of a transparency solutions found its way into the Securities Act of 1933 and became the cornerstone of Franklin Roosevelt’s process to restore trust and confidence to a nation that had suffered a terrible loss of confidence and which was foundering on fear.
As the Congressional Oversight Panel’s Special Report on Regulatory Reform (2009) states: 
“From the time they were introduced at the federal level in the early 1930s, disclosure and reporting requirements have constituted a defining feature of American securities regulation (and of American financial regulation more generally). President Franklin Roosevelt himself explained in April 1933 that although the federal government should never be seen as endorsing or promoting a private security, there was ―’an obligation upon us to insist that every issue of new securities to be sold in interstate commerce be accompanied by full publicity and information and that no essentially important element attending the issue shall be concealed from the buying public.’ ”

Please note that as designed in the 1930s,
  • Disclosure was based on the idea of providing the investor with access to all the information they need at the time of their investment to make a fully informed investment decision.  
  • Of equal importance, no burden was placed on an investor to use this disclosure!
How does the market for an individual security (stock, bond, structured finance product) work if investors are not required to look at the information disclosed?

The fact that all investors are not required to look at the disclosed information does not mean that all investors will not look at the disclosed information.  

It is the investors who look at the information who are likely to understand how to use it in the analytic and valuation models of their choice to independently value the security.  These investors are also likely to add stability to the price of the security by being buyers when the price is below their valuation and sellers when the price is above their valuation.  

In the absence of investors who look at the disclosed information, prices for securities make movements similar to what occurred for structured finance securities in 2008 - one day the price is par and the next it is 20% of par.

For purposes of full disclosure, this humble blogger has been advocating for providing loan-level disclosure on an observable event basis for structured finance securities since before the credit crisis began.  

The bank/sell-side dominated lobby has pushed back strongly against this type of disclosure.  
One of their leading argument against providing loan-level disclosure on an observable event basis has been that providing this much data would confuse investors.

Frankly, Joe Six-pack cannot analyze or value structured finance securities.  However, Joe Six-pack is not likely to buy these securities directly.  He is likely to invest through a mutual fund or hedge fund with a professional portfolio manager.  The portfolio manager can choose to use the loan-level disclosure to value structured finance securities or they can hire an independent pricing service that is capable of valuing the securities using loan-level disclosure.

Let me repeat that, Joe Six-pack cannot analyze or value opaque structured finance securities.  So, he hires a professional portfolio manager.  That manager and his firm either have the ability to analyze and value the structured finance securities using loan-level data or the firm hires an independent third party service to do so.

Returning to the narrative on disclosure:
The transparency requirements in the securities industry have withstood the test of time as they restored trust and confidence in the financial system when paired with the appropriate government guarantees such as FDIC insurance and safety nets such as Social Security. For the next 75 years, we benefitted from the economic growth that the functioning capital markets helped to promote. However, with the advent of increasingly complicated and opaque structured finance securities, the wheels began to come off.
As we search for solutions to today’s “mother of all financial crises, it is time to reach back to 1933 and ask the question of whether the solution to restoring the “catastrophic loss of confidence” mentioned by Treasury Secretary Geithner is in fact, the very old, very tested balm of transparency.
The toxic assets clogging the arteries of finance may be complex, but the real sin is that they were designed to be as opaque as possible. There is no observable event based transparency for investors into the cash flows of the loans that serve as the collateral for these securities. Because of that opacity, the market cannot value or price the securities. When this became clear to everyone in August 2007, the entire $15 trillion securitization market became frozen and with it, the great credit contraction began.
Understanding the linkage between opacity, the securitization market and the resulting global credit contraction is vital to fashioning a comprehensive solution to the crisis. If Charles Taussig were in President Obama’s inner circle of advisers, he would undoubtedly advocate that the opacity afflicting the marketplace be washed aside by a torrent of transparency, so that investors would once again have confidence and trust in the financial system and trading in structured finance would restart. Coincidentally, in a January [2009] report on restoring financial stability, the Group of Thirty Steering Committee, led by Paul Volcker and Jacob Frenkel, advocated precisely that approach in their Core Recommendation IV.

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