Faced with lack of disclosure, investors migrate to government guaranteed debt

To nobody's surprise, government guaranteed debt is emerging as the biggest source of debt in the capital markets.  This is completely expected when regulators fail to ensure that market participants have access to all the useful, relevant information in an appropriate, timely manner on non-government guaranteed debt.

It is one thing for market participants to buy a non-government guaranteed debt security when they know what is in it, but quite another to buy a non-government guaranteed debt security when they do not know what may or may not be in it.

This blog has held up structured finance securities and financial institutions as examples of where inadequate disclosure leaves investors guessing at what may or may not be standing behind the debt repayment.

When market participants cannot analyze the risk, they do not know if they are being compensated for it.  As a result, market participants have an incentive to purchase securities where they can analyze the risk and see if they are being compensated for it.  Today, those securities tend to be government guaranteed.

According to a column in the Financial Times,

By the time you read this column today, a fascinating shift will almost certainly have occurred in the nature of US finance: for the first time the government will be the biggest source of outstanding home mortgage and consumer credit loans in the US, eclipsing private sector banks or investors. 

Or that, at least, is the forecast recently made by Investor Business Daily, a US publication. 

... What should investors make of this? There are at least three lessons to ponder. 

First, the data provide a powerful sign of just how distorted the US financial system remains in the aftermath of the great credit crunch. This might not seem obvious to investors or voters; after all, in recent months the large banks have repaid their troubled asset relief programme funds, stock markets have rallied and credit spreads have shrunk. 

But behind this veneer of normality, banks are still deleveraging, and the private sector mortgage securitisation world remains almost dead. Indeed, were it not for the activity of Fannie Mae and Freddie Mac, the giant state institutions, mortgage finance would, in effect, have seized up in the past three years. 

Actually, what the data shows is that there is a buyer's strike going on until market participants have access to all the useful, relevant information on private sector mortgage securitizations in an appropriate, timely manner.

As predicted under the FDR Framework, zero interest rate policies were not going to lead to blindly chasing after yield in the structured finance market.  Market participants learned their lesson with the credit crisis that these securities do not have adequate disclosure. Notice how the lack of buyers in this $2 trillion market expressed itself with prices for non-government guaranteed mortgage-backed securities slumping almost 20% when the Fed tried to sell its $30 billion AIG portfolio.

The second fascinating point, though, is the cognitive dissonance surrounding this pattern. Six years ago, when I first started writing about the credit markets, I often heard US financiers praise America’s capital markets as the most developed system of free market finance in the world. Indeed, techniques such as securitisation were presented as a natural outcome of American enthusiasm for free market ideals. 

One of the major themes of this blog has been that "free markets" have a role for both government and market participants.

The US version of free markets under the FDR Framework combines the philosophy of disclosure with the practice of caveat emptor (buyer beware).

• government is responsible for ensuring that all market participants have access to all the useful, relevant information in an appropriate, timely manner.

• market participants are responsible for the outcome of any investment decision and as a result they have an incentive to adjust both the price and amount of their exposure based on the results of their analysis of this information.

The US version of free markets ceases to function when the government does not ensure access to all the useful, relevant information in an appropriate, timely manner, but instead claims that it is the investors' responsibility to require disclosure. [See Treasury Secretary Hank Paulson's speeches and the Presidential Working Group on structured finance.]

Investors have limited ability to require disclosure.  Instead, they go on a buyer's strike covering the types of securities with inadequate disclosure.  While waiting for the government and issuers to provide adequate disclosure, investors turn to alternative investments that do provide adequate disclosure.  It is only when the issuers provide all the useful, relevant information in an appropriate, timely manner that the buyer's strike will end.

But the dirty secret behind this rhetoric was that government-backed institutions such as Fannie and Freddie were playing an important role in the modern financial system, even before the credit crisis erupted. And what is remarkable now, given that the role of Fannie and Freddie has swelled, is just how little debate this patter continues to generate. 

After all, with the US remaining wedded to free market ideals, it is uncomfortable to admit that “capital markets in the US have become reliant on government guarantees”, says Viral Acharya, an economist and co-author of a thought-provoking book.* 

Capital markets in the US are not "reliant" on government guarantees.  They use these guarantees as a substitute for access to all the useful, relevant information in an appropriate, timely manner.

If the US wanted to reduce the total amount of government guaranteed debt, it could simply provide access to all the useful, relevant information in an appropriate, timely manner instead. This would allow the guaranteed debt to runoff and be replaced by non-guaranteed debt.