The Price of Opacity

Marco Pagano says the opacity of complex financial instruments was an attempt to simplify the information transmitted to the market and expand the customer base. That is, "they preferred to expand the primary market as much as possible, even at the cost of endangering the stability and liquidity of the secondary market." Unfortunately, however, this lack of transparency led to "catastrophic uncertainty" and "paralysis":

The price of transparency, by Marco Pagano, Vox EU: The most surprising aspect of the current crisis is that the estimate of bank losses has been subject to continuous and macroscopic revisions. When the first problems arose in the subprime loans sector in 2006, the problem seemed to concern a quite modest segment of the U.S. credit market. But already in December 2007, the Economist estimated that losses stemming from mortgage loan insolvencies would sit between $200 and $300 bn. In April 2008 the IMF predicted losses of $565 bn on mortgage loans and on related securities, and $945 bn including loans and securities related to commercial real estate, consumer credit and corporate loans. Now the IMF has revised its estimate further to $1400 bn. How could it happen that bankers, central banks, international institutions and economic experts made such macroscopic mistakes in insolvency estimates? And how can it be that they are still so uncertain as to their real extent?

The Origins of Uncertainty

The uncertainty originates from the same roots of this crisis, that is from the opacity of the securitization with which banks “packaged” and then sold their credits in structured bonds, often after slicing them in different risk tranches. In this process, only roughly synthesized information was transmitted to the market concerning the underlying loan portfolio or its tranches. So there was a great loss of information that would have helped to evaluate the credit risk of those portfolios.

Since structured bonds and the derivatives written on them were massively bought by banks, insurance companies and trust funds, the uncertainty concerning their value turned into uncertainty regarding the amount of losses and toxic assets hidden in bank balances, and made it difficult or impossible for them to obtain liquidity or raise fresh capital. Indeed, extreme uncertainty generates fear, and fear generates paralysis. This is best illustrated by the case of Lehman Brothers, the large investment bank that played a central role in the securitization process. When Lehman entered distress, the primary U.K. bank Barclays was the only institution that showed interest in buying up Lehman, but for fear that its balance sheet hid more losses and toxic assets than those declared, they asked for a guarantee from the U.S. Treasury against this risk. As the Treasury refused to offer a guarantee, Barclays held back and Lehman failed. One might say that this bankruptcy, the largest in U.S. history, is the outcome of uncertainty. It cannot be ruled out that Lehman would have been solvent if only their assets and liabilities could have been properly evaluated.

The uncertainty generated by lack of transparency is also at the root of market illiquidity. Since June 2007, the market of structured bonds basically froze and even the liquidity on the money markets rarefied. The reason behind this event too is the fear generated by uncertainty: investors were afraid of buying securities that could hide more insolvent loans than expected, so if they had liquidity they preferred to hoard it. This market paralysis in turn worsened the situation of banks, making their assets illiquid and forcing them to curtail credit.

Uncertainty can even explain the swinging and ill-timed behaviour of U.S. policy makers: on September 8, the Treasury nationalized agencies such as Fannie Mae and Freddie Mac, who guarantee most of the U.S. mortage loans. The Treasury had already obtained Congress authorization in July and at that time had insisted there would be no need for intervention. On September 15, the Treasury let Lehman fail. On September 18, the Fed saved AIG, the world’s largest insurance company, by giving them an enormous loan with the option to buy 80 per cent of its shares, replace its executives and nearly eliminate its preexisting shareholders. Finally, on September 20 Henry Paulson, Secretary of the U.S. Treasury, asked Congress to allocate $700 bn (5 per cent of U.S. GDP) to the purchase of the banks’ bad assets, hopefully with adequate haircuts. Yet this policy move had already been proposed as early as April 2008 on the Financial Times by Luigi Spaventa, who had observed that there would be no way out from the crisis unless the authorities intervened to reestablish prices of structured bonds, which markets can no longer establish because of uncertainty.¹

Maybe the dimensions of the crisis could have been contained if this suggestion had been put into action earlier. But even this delay was probably caused by the uncertainty as to the real proportion of the problem.

A socially harmful choice

But what can explain the behaviour that is at the root of this catastropic uncertainty, that is, the destruction of a large amount of price relevant information in the process of securitization and rating of structured bonds? The answer is that by simplifying the information transmitted to the market, banks managed to expand the market for the structured bonds that they issued: providing detailed and complex information would have kept away from the market many unsophisticated investors, who would have been at a disadvantage compared to those capable of processing this information.

Therefore, greater transparency would have forced issuers to reduce their security issuance or to accept a less liquid primary market, and this would have reduced their revenues, as well as those of rating agencies. Instead, they preferred to expand the primary market as much as possible, even at the cost of endangering the stability and liquidity of the secondary market.²

Now we know that this choice by issuers and rating companies was socially harmful: market liquidity and credit market stability have a social value that exceeds the private one, to the point that that today the U.S. is willing to sacrifice 5 per cent of its GDP to restore them. But this also indicates that the choice of opacity by issuers and rating companies should have met with far more solid and stringent regulatory constraints. We all knew that transparency is important for the operation of financial markets, but to this time few thought that it could be worth 5 per cent of the U.S. GDP and possibly more. Now that we know this, financial market regulators will have to keep it into account for the future.

Footnotes

¹ Luigi Spaventa, “How a new Brady bond could ease the strain”, Financial Times, 11 April 2008. For a more detailed description and motivation of Spaventa’s proposal, see “Avoiding Disorderly Deleveraging”, CEPR Policy Insight No. 22, May.

² Investors who are can interpret more complex ratings would have left only the worse securities to the less sophisticated investors, a problem that in auction theory is known as “winner’s curse”. These arguments, and their implications for the regulation of ratings, are developed analytically in Marco Pagano and Paolo Volpin, “Securitization, Transparency and Liquidity”, September 2008.

Comments

[baileyman]

You make it opaque when you're trying to fool someone. You make it doubly opaque (CDO squared) when you're also desperate to get rid of it.

[Organic George]

It's all about the greed.

[esb]

And you want to keep it opaque (all of it) when you are a government confronting an insolvent financial system.

Just to make it all surreal, we all know that come late in the second quarter of 2009 we will be witnessing the loosest lending regime for residential properties ever allowed in the USA, probably initially favoring real first time buyers.

[mort_fin]

We are talking about loans, here, not equity. If all the recently mortgaged real estate in all the bubble zones went into default and lost 30% or 40% you could never get near the trillion or more dollars in losses that we now talk about. So it seems that there are only two possibilities. 1) The losses are for the losers, and there are winners on the other side getting an enormous wealth transfer that isn't counted in the "loss" tallies or 2) each side of the transaction valued the instrument differently - think of a CDS where the payer valued the contingent liability at $2 million and the receiver valued the contingent receipt at $3 million - when the things triggers and actually costs $3 million, the loss to the payer exceeds the gain to the receiver. If it isn't 1 or 2, then how could these paper losses so massively exceed the actual drop in real estate values on stuff mortgaged in the last 3 or 4 years?

[im1dc]

"...the opacity of complex financial instruments was an attempt to simplify the information transmitted to the market and expand the customer base..."

Are you kidding?

[John]

/begin{snark}
So tell me, how do economists analyze this situation within the framework of efficient markets, perfect information, and perfectly rational behavior?
/end{snark}

As I keep saying, one can't simply address failures of perfect information and rationality as perturbations about a perfectly rational center. Even an almost-perfect rational response can completely differ from a perfect rational response. Both ignorance and stupidity pervade the world. Someone with the information can rationally behave to give us bad results: "A sucker is born every minute."

In a perfectly rational world, all my students would get 100% on my physics tests.

im1dc: I am not sure whether that was intended to be snarky, or whether it was emitted as a serious statement destined to be his bid to immortality. I'm reminded of Don Knuth's statement on a particular computer algorithm: "I've only proven it correct. I haven't tried it."

[Patricia Shannon]

$10.2 trillion = 10,200,000,000,000
There are about 300,000,000 people in the U.S.
So our national debt is about $34,000 per person, and climbing.

http://news.yahoo.com/s/ap/20081009/ap_on_re_us/odd_national_debt_clock;_ylt=AtQ_UgNblwD4Hx21wn4sEjms0NUE

35 minutes ago

NEW YORK - In a sign of the times, the National Debt Clock in New York City has run out of digits to record the growing figure.

As a short-term fix, the digital dollar sign on the billboard-style clock near Times Square has been switched to a figure — the "1" in $10 trillion. It's marking the federal government's current debt at about $10.2 trillion.

The Durst Organization says it plans to update the sign next year by adding two digits. That will make it capable of tracking debt up to a quadrillion dollars.

The late Manhattan real estate developer Seymour Durst put the sign up in 1989 to call attention to what was then a $2.7 trillion debt.

[save_the_rustbelt]

This was a case of putting poop in a silk bag and declaring that it was gold.

Nice bit of alchemy, 'cept it didn't work.

says...

Yes, lying to investors is often used by criminals to increase the markey and their share. Boiler rooms do it all the time.

[Patrick]

Concealing the truth from customers and investors is usually called fraud, regardless of the intent.

He got the consequences right though.

The CDS market way more dangerous than the MBS market and CDSs are not that complex (compared to CDOs). They are, however completely opaque. All $60-odd trillion of it. And to top it off, the SEC is forbidden from regulating it!

I honestly can't see how anything other than forced mass nullification of 'naked' CDSs is possible. Sure, the seller loses the cash flow, but at least they are off the hook for the principle (which they don't have anyway), and the buyer isn't giving up anything other than the illusion of a payday, since a triggering event would bankrupt the seller anyway.

[Bruce Wilder]

mort fin: "If all the recently mortgaged real estate in all the bubble zones went into default and lost 30% or 40% you could never get near the trillion or more dollars in losses that we now talk about."

I spent an afternoon on the Calculated Risk blog, several months ago, and made some rough calculations of the losses. The IMF estimate of $1.4 trillion in mortgage losses is perfectly reasonable, based on a decline in housing prices of around 25%.

The loss in residential housing value is on the order of $6 trillion. So, the idea that $1.2 trillion or so of residential mortgage losses might occur is not at all far-fetched. There are significant skews in the distribution, with subprime and alt-A, and San Diego and Las Vegas and other major bubble markets, figuring in disproportionately.

Bottom line is that losses of $1.2 trillion from mortgages is pretty sensible. Add in the effect of the recession commercial real estate, auto loans, credit cards, etc. . . . and it is not a pretty picture, but can easily get you to $1.4 trillion.

I really don't think exaggeration of the mortgage problem has been a factor, to date.

Now, whether leverage and exotic financial "products" (derivatives, etc.) actually amplified the losses, still seems unlikely to me. I cannot pretend to understand the "contagion" sweeping world banking. But, I'm disinclined to think that any of these exotic leveraging opportunities "amplified" losses.

De-leveraging is a form of deflation, which carries its own burdens, and deflation can amplify losses, but that's a different problem.

[Rickster Sherpa]

In 2005 and 2006, Dean Baker, basing his work on Robert Schiller's index, established that the bubble price of houses was at least 30% over its sustainable value. The bubble value of residential U.S. real estate was approximately $24 trillion dollars at its peak. If we subract 1/3rd of that value, which a realistic (since a good argument can be made that with the deepening recession and the over-investment of the bubble years that the price decline may overshoot the long-term trend), that means $8,000,000 of reduction in residential real estate value and probably at least 10,000,000 underwater mortgages and home equity loans, I would say $1.2 trillion in losses is conservative Mort.

[Trust]

Savers of the world are on strike. They won't loan any more money on terms they don't understand, and they don't understand much of anything in the private sector. Its all a big black box product that relies totally on trusting the issuing institution. Trust is gone, all the way gone. No one wants the black boxes.

Back to basics. Plain vanilla products that ordinary people understand.