Myths and Fallacies Watch: Informationally-Insensitive Debt

Myth and Fallacy:  Informationally-insensitive debt exists.

Fact:  Informationally-insensitive debt does not and cannot exist in a financial system based on the FDR Framework.

The reason it does not exist is that under the principle of caveat emptor [buyer beware] the investor accepts responsibility for bearing the losses on all their investments.  With responsibility for bearing the losses comes the incentive for the investor to do their homework before investing so as to avoid losses if possible.  Hence, all investments, debt or equity, are informationally-sensitive.

In a financial system based on the FDR Framework, the government must ensure that investors have access to all the useful, relevant information in an appropriate, timely manner so the investors can do their homework and assess the probability of loss.

Some investments, like demand deposits, require less effort to assess.  If the size of the investment in demand deposits is equal to or less than the amount of the government guarantee, as soon as the investor establishes that the demand deposits are covered by the government guarantee they are done with their assessment of loss until the government announces a change in the amount of the guarantee.

Other investments, like senior tranches of structured finance securities, require a significant amount of effort to assess initially and on an ongoing basis.  To assess the probability of loss, an investor would use a valuation model that combines the structure of the deal, the current performance of the underlying collateral and the projected future performance of the underlying collateral.  Naturally, this investment is highly sensitive to information on the performance of the underlying collateral.  If actual performance is worse than projected, the value of the security is subject to change rapidly.

Myth and Fallacy:  Since the price did not change very much on senior tranches of structured finance securities despite the apparent increase in risk of these securities prior to the beginning of the credit crisis, this proves that informationally-insensitive debt exists.

Fact:  Actually, what this example shows is that bankers were able to design a financial instrument where all the useful, relevant information was not disclosed in an appropriate, timely manner.

The bankers were aided in this by the rating services who did not dispel the notion that they did not have access to all the useful, relevant information in an appropriate, timely manner until September 2007.  Until then, investors relied on these rating services to have this information since the investors knew they did not have access to this data themselves.  As a result, what appears to be informationally-insensitive debt was merely a reflection of how slowly the rating services downgraded the securities.

The regulators also failed to require disclosure of all the useful, relevant information in an appropriate, timely manner for this financial instrument in 2005 because the regulators could not justify it based on a cost/benefit analysis.  Now that the regulators know the financial market can lose hundreds of billions of dollars as a result of their not requiring disclosure, the cost/benefit analysis will always favor requiring disclosure of all the useful, relevant information in an appropriate, timely manner.