Tuesday, June 21, 2011

As practiced by Wall Street, the organizing principle of modern credit markets is secrecy

As regular readers of this blog know, the global financial system is suppose to be based on the FDR Framework which combines the philosophy of disclosure with the practice of caveat emptor.  This framework puts the burden of ensuring that market participants have access to all the useful, relevant information in an appropriate, timely manner on regulators.

This blog has focused on two areas of the capital markets, structured finance securities and financial institutions, where the regulators have not ensured that market participants have access to all the useful, relevant information in an appropriate, timely manner.  The results of this lack of information have included:
  • Financial instability as market participants do not know which banks are solvent and which are not.
  • Frozen credit markets as investors have been unable to value structured finance securities.

As Yves Smith discussed on NakedCapitalism,

... opacity, leverage, and moral hazard are not accidental byproducts of otherwise salutary innovations; they are the direct intent of the [financial firms'] innovations. No one at the major capital markets firms was celebrated for creating markets to connect borrowers and savers transparently and with low risk. After all, efficient markets produce minimal profits. They were instead rewarded for making sure no one, the regulators, the press, the community at large, could see and understand what they were doing.
A ZeroHedge post stated the intent in more colorful language.
[Wall Street's] business model is designed around the exploitation of secrecy.   Secrecy is [the] organizing principle that governs modern credit markets. Credit default swaps, privately placed structured securitizations (e.g. CDOs), and hedge funds have all flourished-- they dominate the debt markets--because they are all designed to exploit secrecy.   They all create extraordinary profits by keeping the rest of us in the dark. 
So in late 2006, if you wanted to find out what was happening in this newly created synthetic RMBS market, you couldn't find out much of anything.   You couldn't find out anything about who bought or sold any CDO, or what was in any CDO, or how any CDO performed, unless Goldman or some other CDO underwriter deemed you sufficiently worthy of their selective disclosures. 
  • You couldn't learn anything from the sales or trading activity of mortgage bonds, because the related trading in credit default swaps was kept hidden beneath the surface. 
  • You didn't know anything about the trading activity related to the ABX indices, since that, also, was kept secret. 
  • And since the privately-held company that owned the ABX, CDS IndexCo LLC, operated in total secrecy, and since the privately-held company that published the price of the ABX, Markit Group Limited , operated in total secrecy, you had no way of knowing the extent to which the price of the ABX was manipulated through round-tripping, side deals with synthetic CDOs, or anything else. 
The only thing you knew, your only link to the illusory "reality " of market sentiment, was the quoted price of the ABX.   And you might happen to know that the Chairman of CDS IndexCo was Brad Levy, a managing director at Goldman, which, along with a handful of other banks, controlled CDS IndexCo and Markit Group.

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