Information is key to why debt markets collapse

Two Northwestern professors looked at why debt markets collapse and found that it was information, or rather the lack of it, that was key.  They specifically looked at residential mortgage-backed securities.

Regular readers already know that structured finance securities cannot be valued because of current disclosure practices and that restarting it will require observable event based reporting.

My reason for highlighting the article is to show readers just how academics can distort the discussion of disclosure.

As the mortgage bubble was expanding in the early 2000s, anyone with a pulse could get a nonconforming loan and buy a house, often one that was beyond their means. These mortgages were then bundled into securitized instruments known as mortgage-backed securities (MBS), just as individual eggs are bundled and sold by the dozen. Then complex financial derivatives such as collateralized debt obligations and credit default swaps were built on top of the MBS market. 

The world of asset-backed securities can seem impenetrably complex at times, so to simplify things, let’s instead suppose you, along with a handful of others, are bidding on eggs. No one has any detailed information about the eggs, so everyone assumes that the eggs are worth $4 a dozen, and trade is brisk. Dozens of eggs are sold, even though some of the eggs turn out to be bad once cracked open. 

But suppose that some people start to look more closely at boxes of eggs, and buy only the boxes with all good eggs. Other buyers now realize they are getting more bad eggs and start to pay less. As the market price falls to, say, $2, it becomes even more profitable to do the hard work to evaluate boxes of eggs. However, other buyers soon realize their disadvantage and may eventually stop buying eggs altogether. 

What had been a market with lots of eggs sold at good prices becomes a market with few boxes of eggs sold—only those able to get evaluated and, of those, only those found to be good. And the eggs that are sold are sold at low prices. 

Wait a second.  The authors state specifically that no one has any detailed information.  In the absence of detailed information, how are buyers suppose to 'evaluate' the boxes of eggs to determine which have all good eggs?

The simple fact is that buyers could not make the evaluation that the authors assume.

In the MBS market, no one knew which MBS were better than others at first; trade was brisk, and prices were high. The buyers didn’t know what the assets and their future cash flows were really worth. Then, like the sophisticated egg buyers, sophisticated bond traders, such as those who actively managed bond funds, developed the expertise in valuation to distinguish the good MBS from the bad ones. When they began rejecting the MBS that were most exposed to subprime borrowers, prices fell, less sophisticated buyers fled, and the market collapsed.... 

Wait a second.  Actively managed bond funds, like Schwab's Yield Plus  and Fidelity's Ultra-Short Bond Fund, suffered heavy losses when prices in the subprime mortgage market collapsed.

I am the first to say that there was one group that had the information to know which were the good RMBS securities and which were bad:  Wall Street.  Not only did they have the information, but they traded on it (think Goldman and its shorting the market through deals like Abacus).

Unlike equity markets, where all participants can see the bids and offers for various stocks immediately, debt markets are more opaque and bonds are traded in large blocks. 

“Instead of everything being priced based only on its rating, say AAA, sophisticated investors pick and choose which assets to buy, and those rejected by sophisticated investors are either traded at low prices or not traded at all. This is why volume dries up and the value crashes,” Parker explains. “For example, the Paulson fund famously entered the mortgage-backed security market, valued individual deals, and effectively bought the good ones and sold the bad ones. People eventually thought, ‘I can’t get into that market because I don’t have enough information to get in there.’ ”

While I don't think his explanation is accurate, it is clear that investors stopped buying subprime securities because they recognized they did not have the information they needed to be able to independently value the securities.

Sophisticated traders who are able to value assets more precisely can bifurcate such a market by picking the best assets. This causes prices of the remaining, unpicked assets to decline, along with their average values. In the case of MBS in 2008, the derivative house of cards built atop it collapsed quickly, putting some of the world’s largest banks in mortal peril.

This dynamic is difficult to reverse because it is hard to turn the information uncovered by one particular valuation into public information. Both sophisticated buyers and sellers have an incentive to conceal their knowledge gained from valuation. 

When good intelligence from valuation is tightly held, buyers can obtain lower prices for the good instruments, and sellers can obtain higher prices for the bad instruments from uninformed buyers. These buyers subsidize sophisticated buyers’ investments by purchasing the undesirable instruments. This creates a more liquid market than if everyone had access to the same valuation tools, which increases efficiency.

Excuse me, but the problem is not one party can do a better job of valuing a security than another.  The problem was that the securities being valued were deliberately opaque and did not provide the necessary information so that they could be independently valued.

As for liquidity, the market froze when the non-Wall Street buyers realized that Wall Street had access to the necessary information to value these securities and would use this information to trade against them.  This is exactly what was predicted by Joseph Stiglitz in his Nobel prize winning work on information asymmetry.

In the language of economics, the market equilibrium reached after valuation has been done can be “socially inefficient” because it bears the features of a financial crisis: trust declines as due diligence increases....

Trust is independent of the amount of due diligence.  Trust is based on the simple notion that the investor has access to all the useful, relevant information in an appropriate, timely manner.  That is why our financial system is based on the philosophy of disclosure as espoused by FDR.

FDIC insurance demand deposits are an example of an investment that requires little due diligence.  IBM stock is an example of an investment that requires a lot of due diligence.

The mortgage market meltdown of 2008 caused enormous and widespread financial damage, with global write-downs estimated by the IMF at $4 trillion. Regulators were called upon to crack down on the banks and ratings agencies that enabled the subprime mortgage explosion and to prevent such bubbles in the future. However, it is difficult to devise a policy that can maintain healthy debt markets while maintaining a socially efficient level of liquidity.

No it is not.  It is simple.  The solution was implemented in the 1930s.  It was to establish markets based on the philosophy of disclosure.