Tuesday, March 1, 2011

The FDR Framework Revisited

At Boston University's State of Financial Reform conference, your humble blogger was asked why must governments implement the FDR Framework.

As regular readers of this blog know, the FDR Framework specifies how a government should and should not interact with the financial markets.
  • It should insure that all useful, relevant information is made available in an appropriate, timely manner to market participants; and
  • It should not endorse a specific investment.
But, why is this important?

Because it puts the responsibility on the investors to do their homework prior to making an investment and while the investors hold the investment.

Please re-read the above sentence on the investors' responsibility to do their homework as it is very important.

Investors are responsible for doing their own homework.  This applies whether they are investing in AAA-rated securities or highly speculative junk.  The combination of having access to all the useful, relevant data in an appropriate, timely manner and doing their homework allows investors to know what they own!

Investors are not required to do their own homework.

The role of the government is to insure that the investors who want to do their own homework, either directly or through a third party, can access all the useful, relevant information in an appropriate, timely manner so the investors can make a fully informed investment decision.

Even with access to all the useful, relevant information in an appropriate, timely manner, the investor who does their homework might still lose money on an investment.

Investors accept this risk because there are no guarantees in investing.

Since they accept this risk, when they have access to all of the useful, relevant information in an appropriate, timely manner, investors do not look to be bailed-out of their losses.

This is very important.  Because they are able to know what they own, investors are willing to accept losses.

When investors do not have access to all the useful, relevant information in an appropriate, timely manner, investors look to be bailed-out of their losses or at least protected from future losses.

This is the important corollary to be willing to accept losses without complaint when there is an ability to know what they own.   There is no reason to believe that investors would not want to be protected from losses if they cannot know what they are being asked to invest in and are being asked to blindly bet on.

This is why investors in senior bank debt are unwilling to accept losses.  Investors do not have access to all the useful, relevant current asset-level information in an appropriate, timely manner.  Without this data, how can they do their homework, evaluate the riskiness of the bank and properly price this risk?

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